Thoughts on the Current Drawdown
I’d like to take a few minutes to give you my perspective on the drawdown of the Vista Portfolios from mid-March through July, 2009. After an exceptional 2008 and reaching new equity highs for most of the portfolios in late March, results have been dismal. April was the worst real-time performance I can recall, and May/June have put us at new maximum drawdowns. While a drawdown can provide an excellent time to start trading, it is another matter for those already invested and in the midst of it. I think we are all asking what’s going on, and I’d like to try to answer that.
First, EarlyBird II and Impetus are exactly the same systems that had record performance last year and that have had good real-time performance for 6-7 years (and they are both remain in the Futures Truth all-time Top Ten recommended daytrading systems). No changes have been made to them. Because each year I use walk-forward analysis to derive new inputs values for Delphi II, planned changes were made to several inputs on January 5 of this year as a result of adding 2008 to the backtest database, but there have been no changes in logic. Additionally, after 12 straight months of profits, Delphi II was “due” for a pullback, which it had in April and May. Similarly, it is also to be expected that the Vista Portfolios, which were up in my accounts on average close to 200% in 2008, would have drawdowns. With such extensive real-time, out-of-sample performance, the current drawdown is clearly not the result of having over-optimized the systems or of making injudicious changes. It would be very surprising to have systems that have years of good out-of-sample performance to suddenly and permanently lose their ability to trade successfully. What has changed is the markets. Systems can only do so much with the opportunities offered by the markets. Volatility in general offers opportunities to most systems. We have seen volatility subside considerably since late 2008, and this accounts for some of the poor performance, but the volatility still remains at fairly healthy levels, and the larger factors are that 1.) there has been very little intraday follow-through (particularly for short positions), which defeats the logic of EarlyBird and Impetus. In fact, most systems, since they are trend following, depend on follow-through for winning trades. Impetus in particular depends on late-session follow-through, which has been stunningly absent for weeks. Here’s an example of what has frequently been happening.
2.) many days are characterized by several sharp reversals of 1-3%, which whipsaws systems.
3.) when the market is not in this reversal mode, it often has a single strong move or two in the first hour, and then dies.
None of these patterns usually affords profitable opportunities.
A logical question then is, are these current patterns likely to last? I believe not. Markets require a certain amount of predictability. If there is no predictability, then few people will participate, because they can never rely on an outcome (i.e. a profit or a hedge). With few participants, a market dies, so markets therefore have to “allow” a degree of predictability, in order to stay alive (it’s akin to gambling, where the house has to allow enough winners to keep people in the “market”). However, markets cannot allow too much predictability. This is because if a pattern becomes too clear, then everyone will see it and try to exploit it, which will ultimately destroy the pattern. It’s like being on a party boat and fishing. If the fishing is really good on one side (i.e. “predictable” outcome), then everyone goes to that side of the boat. Pretty soon, there are no more fish: The pattern has been over-exploited and is now gone. Good systems succeed because they exploit a pattern, but one which is not obvious (i.e. a good system knows where the fishing is likely to be good, but it’s in a fishing hole that most others aren’t aware of). The pattern may become obvious for a time, which then leads to over-exploitation and the loss of the pattern. But if the pattern is a fundamental one or has a basis in some enduring structure (people’s psychologies, economic realities, time cycles, etc.), then it will eventually return. The time/price patterns that Impetus and EarlyBird rely on have existed for over a dozen years, over 7 of which have been in real-time trading. Delphi relies on less obvious price patterns, but I believe the same principles apply. To me it is unlikely that these patterns will just suddenly disappear.
Secondly, the markets are in a prolonged, dramatic up move (56% for the Russell since the March low), with only one appreciable pullback and no real retest of the March low.
This is a very unusual event, one which I would characterize as a “3 standard deviation event,” which means that it happens only 1% of the time, or there is only a 1% likelihood of it happening. When markets are in such a rare period, then it is likely trading system performance will also be. This can be positive, as it was last fall when the markets had unprecedented volatility, yielding unprecedented profits, or it can be negative, as it is now. I think it’s fair to say that we are still experiencing the “ripple effect” or aftershocks of the historic selloff and volatility of 2008, and because the event was historic, the aftershocks will also tend to be historic (i.e. rare). So we have a historic event—the worst economic challenge since the Great Depression—which caused a historic selloff and volatility, which caused a historic run-up, which caused the equity curves to have both historically good and bad results. Are we likely to return to “normalcy”? I believe so because of the reasoning above, that markets must exhibit some degree of predictability (patterns, normalcy) in order to keep participants involved.
A primary purpose of the futures markets can be seen as separating us from our money (the person on the other side of our transaction is hoping to profit at our expense). One way they do this is to go to extremes, in order to shake us up. We capitulate and walk away with our losses, often to eventually see that if we had been able to stay, we would have been “right.” This pattern can be seen in market action, but it is also evident in analyzing equity curves. Two examples from 2008 illustrate this (these numbers are from my personal accounts, with $20 commission deducted).
By March of 2008 I had traded Impetus ER 4 ½ years in my account. The worst drawdown to that point had been just over $2700 ($20 commission deducted). Over the next 3 months the pattern that Impetus depends on evaporated (similar to the present situation), and by early July the drawdown had reached $5500. Understandably, many clients stopped trading Impetus because they lost faith in a system that was losing so consistently and had more than doubled its previous maximum drawdown. Fortunately for those clients who stayed, the next 5 of 6 months were profitable, with 3 of them becoming the most profitable months ever. Delphi II ER had a similar story. By the end of 2007 its previous maximum drawdown had been about $4350. By mid-March the drawdown was at $6890, and because of that and 3 months of losses, many clients stopped. Those who remained got to participate in 12 straight months of profits. Four points can be drawn from this: 1.) most people start trading systems following a period in which they have performed well. This makes good sense, since there are not many of us who would start trading a system during a drawdown. Systems catch our attention because they have had a good performance record (Impetus ER and Delphi II ER had both had good performance in the period preceding the record above). 2.) Unfortunately, it is very typical that a period of profits will be followed by a drawdown, and especially if this happens shortly after we’ve started trading a system, we haven’t had the time to build up our confidence, so we are more likely to quit. 3.) Drawdowns have a tendency to be followed by runups (this of course is not always the case, though it is more likely for systems that have withstood real-time, out-of-sample trading). 4.) Just because a system exceeds its previous maximum drawdown does not mean it is “broken.”
Lastly, I’ll mention peer performance. When we invest in a mutual fund, determining whether our results are underperforming the results of similar funds is an easy matter, since there are so many of them, since there are many tracking services, and since we can easily see how the equity markets are doing. If the markets are down 20% and the peer mutual funds are down 20%, then our mutual fund being down 20% doesn’t seem quite so bad because it is the norm. With systems it is a very different picture. There is no simple way to see how peer systems are performing, and it is therefore easy to think that the systems we are trading are the only ones doing poorly, since that is the only information we see on a daily basis. If we knew that many or most index daytrading systems were having a rough time, then we at least wouldn’t feel that our results were abnormal. While I do not have comprehensive data on peer performance, I can see from looking at sites like Striker and talking with brokers that the last several months have been tough trading for many others. Although this doesn’t put any money back into our accounts, it at least lets us know that there are some larger issues that may be affecting results, giving us perspective.
This drawdown is not a theoretical matter for me. I continue to trade the systems myself and therefore know very well what these losses are like. I wish very much that I could change things by working harder or seeing some flaw and fixing it, but unfortunately, the markets themselves are largely what determine performance. Nevertheless, I will continue to work for better performance. I remain hopeful, and I do personally expect a turnaround, though when that may be I cannot say.
Thank you for your time and your patience.
Sincerely,
Lincoln Fiske
Developer and President, TradingVisions, Inc.
