When “Bad Things” Happen To “Good Systems”
An article to help deal with and understand “draw-downs”

by Mike Levin

In the last issue of Futures Truth Magazine, I wrote about how to put together a portfolio of trading systems and used a discussion between Bob and Carol to illustrate my points.

This issue we will “speak with” Bob and Carol’s best friends, Ted and Alice. This couple is a little different from Bob and Carol in that they are not the nicest or smartest people on the planet. Ted and Alice are the kind of people that can ruffle even a wise man or woman’s feathers.

They insist that everything they do is right, but the “market” is always against them and that everyone in the financial business is “out to take their money”… Yet they still have some hope that things can turn out right…

Let’s pick this up as I begin going over what they have done so far and how they are handling the results of the two systems that they now have trading for them.

Ted: Hi Mike, I read your last article on selecting a portfolio of systems and I still didn’t really get what you were talking about when you spoke of draw downs and when systems lose. I mean, aren’t all systems supposed to make money over time? They all show such great track records.

ML: Well Ted, I agree that when people are marketing a system, they only pick the best ones from their arsenal and put that info out to the public. What isn’t always known, is how did they put together their track records, are the results real (meaning, was money actually traded)or were the results purely hypothetical (real system, just looking back in time without actual money being traded.

Alice: I heard that some unscrupulous venders even make up their own numbers and won’t tell you that, they just put together track records based on whatever they want. That can’t be true or legal is it?

ML: Unfortunately Alice, that is true, I have run across more than a few sales organizations that all they want to do is sell you something that has no basis in reality other than their own minds. I don’t want to get too much into that right now, let’s just focus on real companies with real systems for now and how we can deal with that, so we can fine tune our portfolios for maximum return without undue risk, ok?

Alice: Ok, but I tell you, if I find out that we were sold a lie, why I’ll (grumbles)

ML: (Chuckling) Don’t worry, I see what you have and both systems are from vendors that I know of and who
are reputable.

Ted: Of course! I picked them!

ML: Ok, I see that you have a system that trades the Russell e-mini and that it is a volatility based system and an intra-day only system. Looks like it averages two trades a day on a monthly basis. Tell me Ted, why did you choose this one?

Ted: It was highly listed in the rankings of a very popular magazine and the company’s website looked good, so I decided to lease it on a quarterly basis.

ML: When you say “highly listed” are you talking about the returns?

Ted: Yes, they have been up over 254% the past four years net of fees and commissions.

ML: Nice returns, I agree. How was the process of leasing the system, was it smooth?

Ted: Yea, yea it was fine, but I don’t think their results now are as good as they said.

Alice: I told Ted to wait, because I heard that some systems that do good one year, may not do that well the next, is that true?

ML: Well, there are two questions to ask/answer here. Ted, you said that you felt the returns were lagging from prior years versus what you are receiving now, tell me about that.

Ted: We started in April of this year and the system vendor said they were up over 30% net at that time and since then; we are actually down 4%.

ML: All systems have some sort of drawdown or sideways movement from time to time, did you see a chart
or picture of the equity curve over time? There should be periods of draw down and relative sideways action,
which seems to be what you are experiencing.

Ted: Seems that every time we do anything in the market, it goes against us, why is that?

ML: You’re not the only one! Many times I have seen that traders or investors wait until they see excellent performance before they commit to a stock, commodity or system, its human nature. Oftentimes it is at a recent high or recent good run when people clamor to get in, fearing they will miss a nice pop. What they should do more, is to either wait for a sideways move or even a 10-15% pullback to get a little better
settlement in the price/results action of that system.

Alice: I told him to wait and as soon as we got in, we took a 15% hit on our first 5 trades.

ML: This is also what I mentioned in that last article: Be diversified! Having just 1 or 2 systems that trade just 1market each, isn’t really that diversified or correlated and if a system is more geared to being short and the market rips higher, or vice versa, your entire portfolio can suffer more than it should. Or truth be told, the gains can be better too, so it goes both ways. Remember also that systems are built by many different kinds of traders and a system, if based on a methodology that is sound one year, may drift the next couple  of years if/when that style takes a turn for the worst.

Alice: Can you give us an example?

ML: Sure, an easy one is one I also discussed in my last article, when a commodity spread system that a firm I know trades, went through a major shift in how the long term pricing models of the markets it trades, shifted for the worst for them.

This system bought longer term contracts in a commodity, say like Oil, out about 6 months to a year and then they shorted a much closer month. They did this to take advantage of the decay in shorter term or near term months as the futures contract became ready to become the cash month.

There is a lot of volatility in that example, but it has paid off time and again. That and the fact that when spreads are involved, “usually” the margins and risk are lower, but sometimes things can go haywire and if not correctly risk managed, a “Good System” can “Go Bad” real quick.

Example is if we were short a November crude contract at $115 and Long a May Crude at $134 we would profit if the spread expanded in any way. But if Oil were to spike higher here because of a short term incident like a hurricane, then the spread would shrink dramatically, saddling us with losses.

It doesn’t mean the “system” is bad at all though, it just means that the “environment” that the system does well in, is changing or shifting.

Ted: Well, how do you know when these things are changing?

ML: It can be hard to say. In Florida, where I live, we know that Hurricane season starts in June and ends in
November. We know to be prepared for storms at any time and we usually see them coming. Other storms, like tornados, can appear almost out of the blue, how do you prepare for that? Tough to say.

Alice: But we’re talking about sophisticated systems, shouldn’t they adjust to market conditions?

ML: Great point, sometimes having a system that has human intervention behind it is a wise thing. Some developers can “tweak” a system or optimize it based on “what they think is going on in the market… But do they really know or are they guessing, getting caught up in a mania or the fear/greed cycle? That could work for you short term, but against you long term.

Ted: So what are we paying for when we buy a system, just past performance?

ML: I’d say yes to that, I believe that just as in sports, when a team drafts an athlete out of college, they are doing so based on the time the player has played and how well they have done versus others of the same age and approximate skill level.

But when a team that play its games in a domed stadium then goes to Lambeau field on the frozen tundra as legendary announcer John Facenda used to call it and is out of their element, they may not perform as well as when they were in their cozier clime the week before. It’s the same with systems. They have opportune times where they work well and others when they don’t… It’s us as humans that then get upset or angry or frustrated and we then think that what we have paid good money for, is now broke or worse yet, that we were scammed somehow…

Here’s what I say to that: “Hogwash” .

Taking an example of when “bad things happen to good systems” is when a system thrives on volatility to make the majority of their gains.

Systems that buy volatility in hopes of making big gains or sell it when it gets “too fat” thrived back in 1998 through 2002 as there were very high rates of volatility as measured by the VIX index. This index measures volatility by a rate of between 10 (on the low side) to around 30-40 on the high side. There are spikes higher, usually when the market is getting crushed and everyone is rushing for the sidelines, but for the most part, lately, the swings haven’t been as great to the upside in volatility as measured in historical terms in the indexes.

In the futures markets however, we are seeing almost unprecedented moves in cotton, wheat, corn, soybeans, oil, natural gas, gold and silver… you name it. The moves are enough to make major brokerage firms collapse. If the “Smartest guys in the room” are ready to go bankrupt, what is the average or above average Joe supposed to do? Or the systems designed by even the most supreme “Joe”?!

Ted: Look, Mike, I expect the best when I decide on a trading system to trade for us. We do our homework, we ask all the tough questions, we review past performance and we open our account and then we are at the whims of a mechanical trading system. My family wants to win more than we lose dollar wise and win more than we lose on a % basis. No excuses.

ML: When systems go through periods of rising and falling over time (winning and losing) we know as investors that, that is part of what systems do: they enter a trade based on their parameters and then the position is risk managed according to risk management parameters.

Humans don’t control the outcome of the trade, other than to make sure that profits are taken in accordance
to targets established when entered and that losses are limited by the stops in place to protect the downside. To correct myself a little here, actually, humans DO watch the signals that are given and sometimes hold back on a signal or two, to mitigate excess risk. Never to add risk, or overtrade in times of extreme volatility.

ML: I consult for a firm that has some great systems that run off of Market Profile levels as well as volume and volatility. I speak to probably 75% of those that come through their doors…

Everyone is affected when a “prolonged” losing streak or run of trades comes forth from a system we have trading our capital.

Ted: Sounds like you’re talking about me!

ML: This firm’s system has over the past 6 months, moved more sideways than up and more down recently
than up. Even though the market in general has been horrible and not many are making money, we still have the expectation that our system will outperform. After all, that’s why we paid our money upfront, was for the expectation of exemplary returns. Good market or not!

Every system out there has a statistical litany of outcomes and many of the best long term systems I have seen, can pull back 30% to even 45% at times. The brightest and brawniest of traders have been known to run and hide, to cash out and bail at those levels… Only to see those same systems, on their virtual butt, turn around and run 100% or more the next 6-12 months…

Take a look at a book by Michael Covel on Trend Trading. It’s called Trend Following: How Great Traders
Make Millions in Up or Down Markets and is a must read for systems buyers/leasers:

Here he interviews some of the best all time traders on their systems and the draw downs and how it affects
them… Even the big boys get skittish. WHY?

Because as systems draw down, no one knows “how far will they go?”

What’s my point with all this?

It is to speak to those who are in systems now, particularly those who joined a system after a relatively strong cycle, only to see their system sputter and dive a bit…

I am going to boil all of this down to just a few sentences and I hope you get my drift on this:

1. If you have a strong system and it isn’t making money for you right now, remember: It is a system, it is not broke, it is generating exactly what it does: Results. It is just that the results you would rather have are not turning the way you want it to.

2. It is as important to manage the downside in a portfolio as it is the upside, probably even 50% MORE important. So make sure your systems and vendors are not over trading as they are generating lackluster results.

3. Strong system developers do not meddle with their systems or their signals. At times it will move sideways to down, let it! BUT always have a point of “max-pain” that you can stand and stick to it and stop trading. I use 50% as my max pain, others may not be able to stand that much.

Remember though, THAT is what systems do, they outperform the market and they underperform the market. Furthermore, systems also outperform themselves and underperform themselves.

It is my belief that systems are here to stay and to grow exponentially throughout the world. There will be
drawdowns, underperformance and outperformance… In math and statistics there is what is called “regression to the mean”.

Here are a few links to read a little about it:

http://srsfinance.blogspot.com/2008/02/regression-tomean.html

http://filteringwallstreet.blogspot.com/2006/11/regression-to-mean.html

Alice: So are you saying that even though I am paying for a system, it may not do what I want initially, but to
hold on because it “will”?!

ML: I don’t know, every system is different, but during this market cycle we are in, I see so many systems
under performing, that I wouldn’t necessarily say to jump ship, but I would say that we are in unusual times and I wouldn’t let go of a good system because some turn on a dime and can way out perform in a very quick timeframe.

ML: My best advice is this:

Don’t Look. Really, just walk away for a few weeks and let go of any negative thoughts about what is going
on. Many professionals and institutions have millions in these same systems that you have and other systems that wrap other strategies around their portfolios.

Most developers of repute treat their systems like it is “Their baby” and are on their performance as closely as you may be skeptical of it. Let them “worry” about the market while you sit back and relax and at the end of your 3 or 6 or 12 month subscription, you can judge them however you see fit.

Again, don’t let a system take more than 50% of your money or whatever percentage you can stand. Make it a priority to keep to your own max pain level, and then cut it off. Then, wait for a period of average to above average performance until you start up again.

These are tough times in the market, cash can be king at times like this, and sometimes systems may be able to take the angst and the despair that we sometimes feel when our long-term holdings go against us.

Ted: Mike, Thanks for taking the time to go over all this with us, even though we expect more from our systems then we sometimes get, we understand that even systems can be human too..

Alice: Amen!