When It Comes to Trading Systems, Focus on the Negative

02/03/2010 12:01 am EST

Focus: STRATEGIES

With almost every decision in life, people tend to focus on the positive and minimize the negative. Think about buying a house—what entices you first? Usually, it is curb appeal, and if your first impression is favorable, you'll tend to minimize negatives, like maybe the amount of rehab the house needs on the inside.

It is the same thing with trading systems or strategies. Most people tend to focus on the rate of return, or maybe even the winning percentage, and if that looks good, they'll downplay the negatives like the drawdown. For those of you who do not know, "drawdown" is the amount of money lost from the highest equity point. It might be a temporary loss, but you'll have to endure it if you trade the system. Low drawdowns are best, but they are usually tied to low returns (think of interest on a bank account).

When looking at a trading system, signals, or service, your focus should be on downside risk, and drawdown is a great way to measure it.

Drawdowns are extremely difficult for people, especially those among us who follow an advisor or trading signal recommendations in a Web service or a newsletter. Since the subscriber did not develop the system (assuming there even is a "system," not just random selection of trades under the guise of an established method), they do not know what to expect. The only thing they can see is what is shown in the trading record, which is usually only a small snippet of time in the system's history (if the developer did the right thing, and used at least a few years of history to test out his idea).

And, if that record is not independently verified and auditable, then even that history should be regarded with suspicion. There are plenty of services out there that independently verify trading records, and they are definitely worth using.

So, what is a good way to evaluate a trading system, newsletter, or service? Here is what I'd recommend to potential subscribers of any system:

1) Make sure the trading history you see is actually representative of what is being traded today by the developer. There are a lot of knucklehead developers who will significantly change a system midstream, yet keep the same system! So, when you look at an equity curve, you'll be seeing the combined results of two or more systems. That is ridiculous at best, misleading and unethical at worst!

2) Before you subscribe to any service or system, find out what the historical maximum drawdown was. As a rule of thumb, multiply that by 1.5. Could you handle that amount of drawdown right off the bat? If not, then you shouldn't subscribe.

3) If you have the ability, put all the trades in a Monte Carlo simulation and see what shakes out. Monte Carlo simulation is a technique that introduces randomness into future trading results. Since the past is never repeated exactly, it is a good way to simulate possible future results. You will be able to see drawdowns in terms of probabilities. So, for example, you might find out that trading system X has a 50% chance of having a drawdown greater than 30% in the first year. It may have this severe of a drawdown, it may not, but the point is at least you'll have some better data to go off of.

4) Before you subscribe, determine your walkway point, and stick to it. Your thinking might be like this:

"I checked with the developer, and he has not changed his system since introduction. A check of his trades confirms that he is trading the same way he always has. His independently verified records show he had a 20% drawdown. Developer's hypothetical history shows a 25% drawdown, and Monte Carlo simulation shows a 50% chance of a max drawdown of 30% in the first year. So, I'll take the worst case of them all, and multiply by 1.5. That gives me 1.5 x 30 = 45% drawdown that I should be ready for.

That is too much drawdown for me, so I either need to add capital to the account or not trade this system. Looking at the results, if I double my initial capital, I still get a very good rate of return, and I can withstand a 22.5% drawdown. If that drawdown gets hit, I am out—no questions asked! Otherwise, I’ll stick to the system."

The major point is not to be sucked in by the fancy curb appeal of net profits or rate of return. Dig deeper and look at the potential risk, especially drawdown. It takes more effort, but in trading, there is no easy way out. Those who try the easy way usually end up losing all their money.

By Kevin Davey

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