The Automated Trader: January 2008

"Don't focus on making money; focus on protecting what you have" - Paul Tudor Jones.

It is common for those trading with mechanical systems, to have a system stop. This is the point where the system switches off, and is usually when the drawdown surpasses the maximum drawdown seen in backtesting.

The reason for this is, a larger maximum drawdown than seen in testing, is a sign that the system is trading in unchartered territory, and is trading in market conditions not seen in testing. This means that you are pretty much trading blind, and you can no longer have confidence that if you follow the system parameters, you will achieve the results seen in testing.

In the last 15 years (since 1992) we have only really seen one market, and that was between 2000-2003. The peak saw the All Ordinaries (XAO) at 3,450 which was roughly 01-07-2001 and the trough was 2,666 which was roughly at 01-03-2003. So in this 21-month period, the market lost 22.7%.

The testing of my system over this period, and this is a monte carlo analysis over 20,000 portfolios, showed the following results:

Simulation Stats
Number of trade simulations: 20000
Trades processed per simulation: 287
Maximum Number of Trades Executed: 70
Average Number of Trades Executed: 56
Minimum Number of Trades Executed: 40
Standard Deviation: 3.92

Profit Stats
Maximum Profit: $23,967.45 (36.31%)
Average Profit: $1,690.05 (2.56%)
Minimum Profit: -$14,030.01 (-21.26%)
Standard Deviation: $4,899.62 (7.42%)
Probability of Profit: 61.96%
Probability of Loss: 38.05%

Percent Winning Trade Stats
Maximum percentage of winning trades: 56.60%
Average percentage of winning trades: 37.07%
Minimum percentage of winning trades: 20.34%
Standard Deviation: 4.61%

Maximum Peak-to-Valley Percent Drawdown Stats
Maximum Absolute Percent Drawdown: 25.6386%
Average Absolute Percent Drawdown: 10.9312%
Minimum Absolute Percent Drawdown: 2.8526%
Standard Deviation: 2.8416%

So from the 20,000 portfolios, the worst portfolio lost 25.6%.

So if the live system reaches a drawdown of 26%, and these values apply only to closed equity, then the system will be shut down.

Now the obvious concern here, if we turn the system off, when does it turn back on?

We have to remember that historically the stockmarket has shown a strong bullish bias, and we have no reason to think this fact will change. As we can see from the chart above, the downtrends are usually sharp corrective moves, lasting 1,2,3,4,5 years, but then the market continues to go up again.

The reason long term trend following systems work so well (in the long term! mine is a bad example, LOL) is because they take advantage of this historical bullish bias that the stockmarket has shown. My system even works well in what you would call a very average market.

Between 1998-2003, the market averaged a return of under 7%p.a., well below its longterm average of about 11%p.a. Here are the stats for my system through this time:

Simulation Stats
Number of trade simulations: 20000
Trades processed per simulation: 1070
Maximum Number of Trades Executed: 182
Average Number of Trades Executed: 167
Minimum Number of Trades Executed: 151
Standard Deviation: 4.29

Profit Stats
Maximum Profit: $536,473.93 (812.84%)
Average Profit: $339,851.99 (514.93%)
Minimum Profit: $194,702.54 (295.00%)
Standard Deviation: $49,123.14 (74.43%)
Probability of Profit: 100.00%
Probability of Loss: 0.00%

Percent Winning Trade Stats
Maximum percentage of winning trades: 60.39%
Average percentage of winning trades: 51.50%
Minimum percentage of winning trades: 43.86%
Standard Deviation: 2.18%

Maximum Peak-to-Valley Percent Drawdown Stats
Maximum Absolute Percent Drawdown: 19.0027%
Average Absolute Percent Drawdown: 10.3125%
Minimum Absolute Percent Drawdown: 4.6984%
Standard Deviation: 1.9226%

So that's an average of about 35%p.a. Backtesting is not an exact science, but I'm more than happy with 20-25%. If I want to achieve these results I need to be in the market for a decent period of time.

So what I am looking at designing and testing over the next few weeks, is a system switch based on the index (XAO). It won't be designed to cash out at the top and buy back in at the bottom like a champion, but rather to keep my system out of a prolonged bearmarket. If I can achieve comparable results while enduring less pain (drawdown), they why not.

Some will say I should have implemented this from the beginning. Well, you live and you learn. And at the end of it all, it's only money.

Doing a bit of selling next week, as portfolio moves to mostly cash.

And for once, there are no candidates for next week!

I used to get 20-28 stocks to choose from in the October/November period.

As for MIN i was hoping to ride it longterm, but the market has a mind of its own.

Though it may look like it did a BKN, actually CEY gave a capital return of $1.88/share during the week. But I am exiting the stock as I want to trade as closely as I can to TradeSim, and TradeSim would have exited the stock, as I suspect it wouldn't tell the difference between a capital return and a Centro!

The sum of $2,350 ($1.88*1,250) will be added to the bank in a column titled dividends, but only once I can see the money in my bank.