Underwater, Tapped Out

Well, I am about 18% down from the start, at almost a 50% maximum drawdown from my peak equity.

To make matters worse, the trades I am currently in have gobbled up all my initial margin, so I cannot put on any more trades.  Of course, the few trades I've missed already have cost me probably a couple of thousand dollars.

Both of these facts are a result of starting out with a small account.  There is a good lesson here for people with small accounts - realize your drawdown will likely be more severe, and you might have to skip good signals.

But, I'll continue to forge on.  Hopefully things will turn up soon.

Step 9 - How To Backtest

Contest Update:

Still underwater (about 10% loss from start).  Still trading exactly as planned (except where initial margin becomes issue).  Still VERY disappointed at the last month of performance.  Still feeling more than a bit depressed and embarrassed at having to show this to the world.

I hope that readers get one takeaway from my current performance: anything can happen in trading.  Historically winning strategies can turn negative (for either a little while, or maybe forever).  Don't position size assuming that you will be profitable - that is trading suicide.


**************************

The Trading Process - Backtest the Right Way - Step 09

Last time we discussed "expectancy."  If your trading approach doesn't have a positive expectancy, DON'T TRADE!  It is critical.

Of course, to get historical trades to determine your trading system expectancy, you must backtest.

You can either backtest by hand, or use trading software to help you.  Backtesting can be very tricky, though.  Here are a few tips to help you backtest properly:

1) Make sure you include realistic costs for commissions and slippage.  I typically use $25-50 per contract per round turn trade.  My numbers are based on actual trading.  Many strategies look great with $0 commissions and/or slippage.  THESE SYSTEMS ARE FANTASY!

2) If you use backtest software, learn the tricks and pitfalls in it.  In Tradestation, for example, the default setting for limit orders will assume a limit order is filled if touched.  Traders know that in most instruments, you'll never get filled on a "touch" of your limit price.

3) Make sure you aren't "peeking" into the future.  This is really easy to do if you backtest by hand or with Excel.  An example of this would be buying today's close if tomorrow's open is up - you can;t know this in advance.

4) If your results look too good to be true, they probably are.  You either done something wrong, optimized your backtest too much, or curve fit rules to match the data.

5) Your backtest should definitely include either a significant out of sample test period, or should use walkforward backtesting.  If you don't know why this is important, make sure you research it and learn.  I guarantee that following this step alone will save you thousands.  Only the inexperienced optimize over all their data, and then start trading.

Obviously, proper backtesting is a huge topic.  I've just scratched the surface.

Next: Incubation, not just for baby chicks any more!

The Bug and The Windshield

In trading, sometimes you are like a car windshield.  As you roll down the road, anything in your path gets out of the way, or hits you and gets smashed.  But you just keep going.

Other times in trading, you are a bug, just merrily flying along, when out of nowhere this big windshield appears, and splat! you get crushed.

I always like to say: "In trading, sometimes you are the bug, and sometimes you are the windshield."

Right now, I feel like the bug!

Everything is Relative

If I told a non-reader of this blog that I was up 19% for the year, they might be duly impressed.

But, readers of this blog realize that 19% isn't so great, considering I was once up over 60%.

A straight line equity curve, ending in 19% up, is certainly more preferable to what my curve has done.

So, performance is relative.  Keep that in mind as you search for suitable trading strategies.  The ups and downs (especially the downs) is what will kill your resolve, shatter your confidence, and cause you to abandon ship right before the equity curve shoots up.

Not that I complaining (although I am disappointed somewhat).  I just wanted to put it in perspective.

Positive Expectancy

Contest Update:

Up about 11% for the year (see chart below).  All I can do is follow the plan.  I say that over and over, but it is the best thing I can possibly do. Most people fail when they start to deviate from their plan.  This contest system may still fail, but I know it has historical positive expectancy.  That means it has been profitable in the past.  But, I need to follow the plan to reap the benefits of positive expectancy.


That is a good intro to step 8 in my continuing series of "Developing a Trading System"...


Comments and questions, as always, are encouraged...




Trading Process, Step 08 - Have Positive Expectancy



Many people look at a chart, "see" a few instances of a profitable pattern, and then start trading it.


Other people see a flashy new indicator being sold by someone who probably doesn't even trade.  Every example shown leads to profit.  It is the Holy Grail indicator!


Does either case sound familiar?  Unfortunately, that is what most people do before they trade - they find a few profitable examples that back up their thoughts (and conveniently ignore or hide the losing examples), and then start trading.  That is the wrong way to do it.


The right way to evaluate a strategy, whether you are backtesting or evaluating in real time, is to:


1) Have a statsitcially significant number of trades.  5 or 10 trades is not enough.  You want at least 50, preferably 100's or more.  In my contest account, I had over 500 trades evaluated as part of my research.  In my SFE Trading system (available on my website), I evaluated over 3,000 trades.


2) Have an evaluation period that includes bull markets, bear markets, flat markets.  A month or two of market action is never enough.  You really need years.


3) HAVE A POSITIVE EXPECTANCY SYSTEM.  Here is how to calculate it:
Expectancy = ((Probability of Win * Average Win) – (Probability of Loss * Average Loss))/(-Average Loss)
This number must be positive, ideally 0.2 or higher.  The higher the better, although if it is too high, I'd wonder about overfitting or  over optimizing, or some other backtest error.


If you have all 3 of these items, your chances of success go up a great deal.


Next: How To Backtest

The Market is Messing With Me!

Have you ever had that feeling - one that the market is just playing around with you, kind of the way a cat plays with a mouse (just before the cat eats the mouse)?

That is how I feel now.  So, the market turned against my positions in the past few weeks, and I could not enter 3 positions in the past few days.  Not enough margin in the account to open new positions.

So, take a guess: do you think these positions, ones the market would not let me enter, were profitable, or not?

If you said profitable, you were right.  $1,500 in missed contest account profit.  Ugh.

[But in the end, I won - I opened those positions in another account (non-contest) I have.  Of course, I'd rather have that $1,500 in my contest account!]

Contest Update:

Up about 15% for the year.  Not feeling very confident about this endeavor.  But that is OK - my emotions, personal feelings and state of mind don't really matter - as long as I FOLLOW MY PLAN.

Embarrassing

This is not going to plan!  It is funny - it is one think to think beforehand "Hey, I could have a 50% drawdown," but it is a TOTALLY different thing to have to live it, in real time (not accelerated backtest time).

This is starting to get ugly!

Still Following The Rules...

Up 5.5% for the year.

Like always, I'm still following the rules exactly.  Sometimes it works in my favor, sometimes not.

In times like this (big drawdown period), it is important to remember that anything can happen.  You can do everything right when developing a great system, you can have perfect psychology, discipline and mental control, you can execute your plan flawlessly, and yet YOU CAN STILL LOSE!

Why? - Trading is all about probabilities.  People who forget that will lose in the long run.

Excellent Question From a Reader

A reader asks:

"Does your in-sample testing account for almost a 50% drawdown? If not at what point do you say the strategy is not working any longer?

Thank you for your blog and your transparency. It's encouraging."


Thanks for the question.  The transparency unfortunately sometimes makes me look like a fool.  Seriously, what kind of "professional" trader has a 49% drawdown, and a 41% drawdown?  Having to post my equity graph the past week has been awful - really, it is 10 times worse than the $5,000 I've lost during the drawdown.  It is an ego deflater (which is probably a good thing, in the long run - I know arrogant traders, and I know rich traders, but I do not know any rich, arrogant traders.).  


Many people would have quit after that first big drawdown.  Emotionally, I can relate.  BUT, if the numbers predict it could reasonable happen, then it doesn't make sense to quit.  That is the case here.


Let's look at the system I am trading.  I started with only $10,000, which I knew would likely put me in a precarious drawdown situation, sooner or later.  But I was going for absolute percentage return, so it makes sense to start with the least amount of capital you can.


There is an important lesson here, and it all goes back to what your goals and objectives are.  My goal was percentage return.  If the goal was risk adjusted return, I would have done things differently.  Started with more money (probably not a help), or likely traded a whole different system (one that had more limited upside, but less drawdown potential).  


Anyhow, I ran the contest system through my Monte Carlo spreadsheet (free, on my website), and I determined that within a year, there was a 65% chance that I would have a maximum drawdown of at least 50%.  In other words, there was a very good chance of a 50%+ drawdown.  The graph is below.


The flip side, is how much gain could I get out of this system?  The same analysis shows I have a 60% chance of at least tripling my money.  And that assumes that I keep trading 1 lots through the year.  I'd probably increase size, so I might do even better.


Basically, I decided that these were odds I could live with.  Not everyone can.  And I certainly would not have these types of odds for my other accounts.


For this system, since it is a contest, I am going to quit only if I cannot place a trade.  Again, in my "normal" accounts I'd never do that, and I don't recommend you do this.  But this approach fits my objectives, which is the key.


If this analysis in confusing, please feel free to ask questions.  I want to make sure readers understand.

"You're Going The Wrong Way!!!"

Why do I feel like I am riding in the car with these guys - Steve Martin and the late John Candy?  Along with my contest trading system?

http://www.youtube.com/watch?v=_akwHYMdbsM


The ironic thing is May was a terrible month for my contest account, but overall (multiple accounts, 11 total systems) was my best percentage gain month so far in 2012 (over 13%).  Yes, it has been a tough year - last year, I had 5 months over +13%.


Maybe June will have everything go the right way!