Trading System Drawdown and Emotion

 

What do baseball and trading system drawdowns have in common? A lot more than I ever realized.

If you haven’t read the book or seen the movie Moneyball (which I highly recommend), professional baseball adopted a statistical approach to recruitment and gameplay around 2000.

The Oakland Athletics adopted the approach before any team. They experienced tremendous success in their first system-driven season, despite countless expert predictions of imminent failure.

I started reading The Signal and the Noise by Nate Silver last night. The baseball chapter picks up where Moneyball left off. Dustin Pedroia, a star second baseman for the Boston Red Sox, enters the scene as an unlikely success story.

Most scouts overlooked him. He is short. He has a paunch and bowed legs. Nobody looks at the guy and thinks “professional athlete”.

Dustin Pedroia held strong through a trading system drawdown of his own

Dustin Pedroia held strong through a trading system drawdown of his own – an unexpectedly low batting average.

Sticking with the system

Pedroia batted a lackluster .198 when the Red Sox brought him to the major leagues in August of 2006. The first month of the 2007 season started off even worse at .172.

 

A team like the Cubs, who until recently were notorious for their haphazard decision-making process, might have cut Pedroia at this point. For many clubs, every action is met by an equal and opposite overreaction. The Red Sox, on the other hand, are disciplined by their more systematic approach. And when the Red Sox looked at Pedroia at that point in the season, James told me, they actually saw a lot to like. Pedroia was making plenty of contact with the baseball – it just hadn’t been falling for hits. The numbers, most likely, would start to trend his way.

“We all have moments of losing confidence in the data,” James told me. “You probably know this, but if you look back at the previous year, when Dustin hit .180 or something, if you go back and look at his swing-and-miss percentage, it was maybe about 8 percent, maybe 9 percent. It was the same during that period in the spring when he was struggling. It was always logically apparent – when you swing as hard as he does, there’s no way in the world that you make that much contact and keep hitting .180.”1

Trading System Drawdown

Every trader goes through a slump – even the best of them. When your trading system drawdown reaches uncomfortable levels, how do you cope?

I had the opportunity to lead managed fund sales at one of the largest forex brokerages in the world. The product was the Sentiment Fund and it was AWESOME. When the fund took off and upper management suddenly got involved, the fund had $40 million under management and nearly 1,000 investors.

If there’s one thing that you can count on with forex traders, it’s that they are going to lose. All the time. No doubt about it.

The firm received real time information on the positions of all clients. Whenever too many traders held positions long or short, the fund did the exact opposite.

That’s it. The automated strategy was stupid simple, but the returns were amazing. The aggressive fund kept the leverage at 2:1, yet was on track to earn 40% annually.

Bad luck

Two months before the hand off, the fund experienced a sharp drawdown of -8%. Like most people, investors thought of 40% returns as 40/12 = 3.3% profit per month. They don’t think about the natural slumps that happen – just like the one Pedroia experienced.

That “surprise” drawdown caused a mass herding effect. It didn’t matter that the fundamentals of the strategy were unchanged. Forex traders didn’t wake up smart last month and know how to game the system. Bad luck happens to the best strategies. Nonetheless, investors ran for the exits from a world class strategy.

Were the guys on the systems desk worried about the strategy that they built? No way! When Pedroia went through his slump, he could have overreacted and start messing with his batting stance. He could have adjusted his distance to the plate or any number of things.

Pedroia knew that his system was good. The systems guys knew their strategy was phenomenal. In spite of all the pressure, they held firm and blew past the drawdown by the time I handed off the sales effort.

What element of trading matches the “swing-and-miss percentage”? The Red Sox clearly used it to justify sticking with their system. In Sentiment Fund’s case, it was knowledge of the underlying system.

How can quantitative traders with less obvious fundamental theories know that their system is sound? I’d love to hear your comments.

1. Excerpted from The Signal and the Noise by Nate Silver, page 104.

 
Trading System Drawdown and Emotion

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About the author

Shaun is a passionate and proud nerd on a wide variety of topics, most of which have absolutely nothing to do with each other. He loves math and systems, which makes him a natural fit for designing trading systems. The most random fact about him is that he speaks fluent Arabic.Shaun's hobbies are running, church and spending as much time as possible with his wife and two young boys.

 
 

11 Comments

  1. life rockss says:

    Awesome observation by red socks and great thought by you to apply it to trading, did you finally find answer on how to implement it ?

  2. Scott says:

    Hi Shaun,

    With cycle work, so long as the projected cycle high centers around a peak (and/or the projected cycle low, centers around a trough), I consider the methodology to be in synch with the market.

    IOW, a trade might not reach desired levels of price projection —– such as lower-highs and higher-lows, but the time-cycles are still working.

  3. Bob says:

    The question was, “How can quantitative traders with less obvious fundamental theories know that their system is sound?”

    How about the inventors of the system explain exactly how their trading systems work and let the investor make an intelligent decision instead of investing on faith. My one system took over 3,000 trades without loss, but guess what, the inventors explained exactly how the system worked. To me, that is what safety is all about, the others are gamblers, and for gamblers, when the streak is broken, it’s time to take your money off the table. Draw-down is not a problem when we understand the whole processes.

  4. Scott Gaul says:

    For a long time in my trading (demo account) I consistently lost 80% of the time. Despite my best efforts and reasoning. I even played the game of taking the opposite position; if I predicted I should buy then I would actually sell. Still 80% loss. I always wondered why this happened given a 50-50 chance. I must say I’m doing better now, a little better than 50%.

    • Hey Scott,

      Most losses like that are exclusively due to over-trading. I’d encourage you to try a much higher time frame if you ever get stuck in the 50-50 range again.

  5. N.H.C says:

    “If there’s one thing that you can count on with forex traders, it’s that they are going to lose. All the time. No doubt about it.”

    I love your honesty. My prop team use to trade against order flow, not as a market maker shaving between bids and offers but taking the exact opposite sides of large retail block trades in the futures market. Statistically, we knew our risk control were much more robust than the average retail guy, and indeed we were profitable. However, it does not mitigate the emotional strain when draw downs occur, this is a fundamental aspect in trading that is the most challenging to cope with… sometimes the retail guy wins. It’s playing for the long term that will edge out the retail!

  6. Aaron Eberle says:

    So the most profitable system would be one that not only wins, but can also predict draw downs. This is when you take some time off from trading. Then come back refreshed ready for more profit. Now, if we only knew when our systems would start losing. Are market cycles this predictable? Or with enough data on a system, could this be charted and predicted?

  7. Sam says:

    Nice article!

 

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