Trading Systems 101: Can You Handle The Drawdowns?

04/13/09 01:22:16 PM

by Donald W. Pendergast, Jr.

I'll bet you've seen a hundred ads for various trading systems in the past month, especially if you're an active trader who reads most of the trading-related magazines and papers out there. But could you really stay with a good system when it inevitably goes into an extended drawdown period?

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Trading systems. The phrase seems to conjure up mental images of pushing "easy" buttons, ATM-like machines that dispense truckloads of trading profits and an endless stream of pina coladas and bikini-swathed beauties on pristine beaches in Maui. Ha! If it were only that simple. Trading a system for the long haul has got to be, in the words of a grizzled, close-to-retirement, veteran trader, "The hardest 'easy money' you'll ever make."

And as Andy Rooney might reply to the old trader (60 minutes before the market close, no doubt), "Why is that, anyway?"

Let's see if we can't provide Andy and all of the other system-trading hopefuls out there with some of the reasons why trading even a good system with a profitable track record can be so difficult.

FIGURE 1: SHORT-TERM MOMENTUM. Rising equity curves are wonderful, but what if you were the unlucky trader who decided to deploy $50,000 into this system in June 2008, right near the all-time equity curve high? Would you still be trading this system?

Graphic provided by: Compuvision's TradeSim Enterprise.

Figure 1 is the equity curve graph for a simple daily-based momentum system in MetaStock, one that I specially modified to suit my own trading temperament, adding two technical filters to hopefully help keep it on the right side of the markets. A diverse mix of large-cap US stocks from every major sector were used for testing purposes; everything from gold miners to semiconductor manufacturers were included in the nine-year-long backtest.

An interesting (if not downright disturbing) feature of this purely mechanical system: there was no stop-loss used in the test. In addition, a maximum of six stock positions could be held at any given time and only one new position could be added to the portfolio at any given time. While it may seem that only a deranged trader would actually put real money to work in a system without a means to cut losses on losing trades short, the backtest, which included 1,196 trades, seems to indicate that this system (which normally exits a few days after entry, being a short-term momentum system) does just fine without an official stop-loss order.

Launching the backtest at the start of the last major bear market (March 29, 2000), $25,000 in initial capital eventually turned into almost $85,000 in nine years, despite nearly two years of sideways chop in 2001-02 and a rather sharp equity drawdown in 2008-09. Overall, the system produced a nice, steadily rising equity line for the balance of the test, such periods of underperformance notwithstanding.

So could you have stayed with this winning system had you begun to trade it in 2001, just before it went into a two-year period of sideways to flat returns? Or would you have ditched this system, hoping to find another one with a hot equity curve? Here's a news flash -- any system that has had an extended winning streak is more likely than not about to enter either a period of consolidation and/or drawdown, duration unknown. It's just a fact of life when trading a system, and that's why those who always bail out of a winning system during periods of drawdown will never last long enough to reap the eventual rewards that such a system can provide over the long haul.

Let's examine some of the system's stats to see if there are other important details that we'd need to be aware of in order to ensure that this system's behavior would be a good match for our own trading temperament. Starting the backtest on March 29, 2000, with $25,000, here are the vital stats:

1. The system wins about 69% of the time.
2. The maximum drawdown (MDD) was 11.67%.
3. It made about $50 per trade (commissions of $0.008 per share included).
4. It had 16 consecutive winners at one point.
5. It had seven consecutive losers at another point.
6. The profit factor was 1.5977.
7. The average winner was $193.32.
8. The average loser was $269.07.

Looks pretty good, right? Yes, but could you really handle seven consecutive losers or even more in the future when trading this system? Even with a nearly 70% win rate, seven, eight, nine, or even 10 straight losers aren't out of the question, especially if another October 2008 is lurking somewhere down the road. Could you really handle the stress of holding six open stock positions overnight with no stop-loss? On a $100,000 commitment of capital to the system? Got you thinking on that one, right?

Bottom line: Is this a tradable system in the real world? Yes, it could be, but only for those traders who understand the risks involved. A wise trader would do some further testing on this system to see if adding a stop-loss (either a fixed percentage stop, volatility stop, or even a time stop) would help to smooth out the equity curve -- or not. Those of you who've read Curtis Faith's excellent systems trading masterpiece, Way of the Turtle, already know that some systems (particularly long-term moving average crossover systems) can perform just fine without a fixed, predetermined stop-loss.

Here's a final word of potential wisdom - make what you will of it. After analyzing thousands of systems, it seems that the most opportune time to begin trading a system with a well-documented history of winning behavior is when it has just made a new maximum drawdown in equity. If the system has a decade-long history of profitability, the odds are (if the system is built without a curve-fitting bias, as this system has also been built) that you'd be deploying your trading capital at the very best time. Then the real trick is to hang on and ride that horse to death -- right into the sunset. Hopefully in Maui.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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