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Today's Featured Article
Over the last two articles ("Truth" and "Truth, Part II"
), I have tried to convey that there is a separation between what is true and what some traders believe is true when it comes to trading. The last article began to describe some statistical analysis of market movement to better determine whether system performance statistics can be relied on to have uncovered some sort of bias behind the market movement, or whether they are just number crunching.
One problem with being able to do this kind of analysis is that there simply are not the available tools that allow us to easily look at market action BEFORE putting an entry and exit rule on a set of conditions. There are simple questions that can be asked without building a full-fledged system. In fact, traders can save themselves a ton of time and effort if they had the ability to quickly ask these questions and look at a simple set of statistics that reveal where the market moved.
For example, what happens when %K moves above 80%? Some say sell, some say buy. Which is it? Most likely, there are other conditions that come into play, but rather than trying to find out what those conditions are immediately and then at the same time, having to wrap those conditions with an entry and exit rule(s), you start with the simple question and then build from there.
Below is an example of the market movement stats as presented in the last article. This set of stats is from a random set of conditions that simply show market movement.
 If you cannot view the above chart,
go here.
From these stats, we can gather a great deal of information long before we start looking at trying to figure out where to enter and exit. Market movement is the core of creating a system with performance statistics that can be trusted. In the above stats, we know that we have a potential buying opportunity. We also know that we want to hang onto a long for at least 2 bars (if these stats were extended to bars 3, 4, 5, etc), we could very accurately see the range in how long we should consider hanging onto the trade. There are many other things that can be gleaned from these stats in helping us determine a few potential entry and exit points without grasping in the dark with hit and miss
results. This saves a tremendous amount of time and effort.
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In the context of a simple question, like what happens when %K crosses above 80%, and any other simple question like that, these stats are invaluable for saving time with finding the core logic of a trading system without having to fill in all the details first. You start with simple conditions and move forward from there. However, once those details are filled in and you have solid entries and exits, a drawdown analysis is the next thing you want to really take a look at. Below are some drawdown stats that
Quantum Charts provides so you can get a big picture. Most programs simply provide the largest drawdown and little else. Sometimes the largest drawdown can be highly deceptive if you do not have additional information for context.
If you cannot view the Drawdowns chart, go here.
This group of stats goes much further to help determine the complete picture of what can be expected in a trading system. The typical stats provided are generally limited to the largest drawdown and a few related statistics. They by no means give the whole picture, and accordingly, it is difficult to determine the true expectation once you start trading the system. I will go through the stats one by one.
The largest drawdown is self-explanatory. It is the largest drop in equity prior to new equity highs being made. It is the most common drawdown statistic provided by system analysis systems and only provides one small piece of the puzzle.
The length of the largest drawdown can be viewed in two ways, by trade and by time. The stats provide a gauge of how long you might be waiting to come out of a drawdown. Traders often are not prepared to go through the enormous amount of time a system can be in a drawdown. The next stat helps give the context of the total amount of time a system spends in a drawdown. Many traders are shocked to find out that most systems are in a drawdown between 65% to 80% of the time. This stat is a good reminder that new equity highs are not a constant experience in trading. This particular system was tested over a 10-year time period, or specifically 124 months. To look at the total time in drawdown
in months is a real eye-opener. 94 months is a long time to suffer through various drawdowns. Most traders don't stick around a system for this very reason, not realizing that most systems will go through the same type of cycles.
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The average drawdown provides a comparison of all the drawdowns compared to the biggest drawdown. Sometimes this spread is very large. When this occurs, it usually means that the system went through a period of time that was unusual, which can in turn mean one of two things. The first is that the system is unstable and may not be uncovering a consistently profitable opportunity. The second is that the market went through a specific type of market action that was highly unfavorable for the type of system being analyzed. If this occurs, it is vital that the trader go to the time period when the largest drawdown occurred and see whether there was a
distinct difference in market action during that period over other time periods when the system was not in a drawdown. If the market action is relatively the same, then the system is most likely unstable and unreliable, regardless of the other stats. Remember, stats can often be manipulated to seem like something they are not, but a close analysis will often reveal discrepancies that will throw up the red flags. (Note - In order to weed out the single trade drawdowns, any drawdown counted in the average drawdown figure must last longer than 5 trades).
The largest drawdown to average drawdown ratio (LDAD Ratio) simply provides a quick view of the difference between the largest drawdown and average drawdown. Generally I begin to look closely at market action during the largest drawdown if it was twice as large as the average or bigger.
Another great ratio to look at to gauge how much risk is involved with a system on a monthly basis compared to how much risk is normally experienced on a monthly basis. The average monthly profit is obviously something that occurs having overcome the average monthly drawdown. Also, to calculate this ratio, both numbers are zeroed out at the end of the month (drawdowns are not extended nor are profit strings from one month to the next). One stat that is often over-emphasized is the maximum drawdown to total net profit ratio. For example, the maximum drawdown over a period of time may be $5,000, with the total net profit at $20,000. The one missing piece of critical information is how
much time was tested. The one way to generally make this ratio better is to simply show a longer test period. This is highly deceptive. The MPMD Ratio is one stat that helps to bring this into perspective.
The MPMD Ratio (Monthly Profit to Monthly Drawdown Ratio) is simply a quick reference of the relationship. Anything at around 0.5 or higher is generally a pretty good number. Lower numbers do not necessarily mean the system is not worth trading, but certainly a closer analysis is prudent.
Once these stats are analyzed, the next thing a trader should look at are the drawdowns next to the largest drawdown in size. By looking at the 2nd, 3rd and 4th largest drawdowns, the trader can get a solid feel for the overall picture.
These additional stats are emphasized because a trader needs to be able to make the decision to begin trading a system with as much truth as possible. I have talked with hundreds of traders who have readily admitted that they lost money not necessarily because the system was no good, but because they quit trading it during a drawdown that was bigger than they expected, or lasted longer than they expected, or they simply expected more consistency in making new equity highs. All of these expectations are often based on a lack of information that fails to give them the full story. It is essential that your decision to both begin trading, and then continue trading a system is based on as
much relevant information as possible. This is one area that will help the psychological aspect of trading in a tremendous way.
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About the Author
| Ryan Jones
is considered one of the trading industries "most complete traders". Starting his trading career at the early age of 16, he had traded nearly every major market and strategy by the age of 21. At the age of 26, Ryan signed a book deal with John Wiley making him one of the youngest authors ever in the field of futures trading. His book, The Trading Game, Playing by the Numbers to Make Millions is still considered to be the authority on the subject of trading and money management by many leading traders. Ryan's advanced experience and knowledge across many trading fields such as Technical Analysis, Option Trading, Money Management and the S&P have lead to several
trading feats, including turning a $15,000 account into over $107,000 in less than 90-days short-term trading the S&P (real money). |
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