Waiting For Resolution

There's little to add after today's action. We are still awaiting confirmation of wave c of D down in the triangle or wave 3 of (5) down. However, if it is going to go down into the January 31(30) turn date, then it must begin tomorrow. Otherwise, we can expect a continuation of the muted rally until this Friday and then a selloff into Feb 6. So far the Dow has moved perfectly with my projected Gann turn dates with a top on January 6, a bottom on January 23 and so a possible top January 30 or February 2 would fit the pattern well.

One thing about trend following systems that traders must understand is that conditions like we have experienced since November 21 can do significant damage to your account, and this may be perfectly within the expected performance of the system. It is not enough to have a trading system with a trend filter, and entry and exit signals. You must know the system's expectancy, payoff ratio, optimal heat(portfolio risk) and the expected maximum drawdown.

The psychology of trading has become a popular field of interest in the last few years, but I think that perhaps there is too much emphasis put on psychological solutions to perceived trading problems. As long as you have a plan, you are trading the plan, and you do not hesitate to take the trade that comes in accordance with your plan, then any problems you might be experiencing have nothing to do with your state of mind. Rather, if you perceive a problem, you need to do more analysis and testing of your system with the objective of understanding the performance of the system under all conditions and what the optimal heat level should be.

One system that I tested this weekend had an expectancy of 31.46%, a payoff ratio of 3.49 and produced a CAGR of 62% with 40% heat and 3 x margin. The maximum drawdown was 50%. The same system with 10% heat and no margin produced a CAGR of 18% with a maximum drawdown of 17%. Notice how the maximum drawdown seems to be correlated to the CAGR. This is what one should expect, which means that annualized returns in excess of 100% may eventually lead to a total account meltdown.

However, there is one other factor that significantly affects the expected maximum drawdown and that is the stability of monthly (or specific) period returns. The more stable the returns are the lower the expected maximum drawdown will be. One way to estimate the maximum drawdown in your account is to multiply the standard deviation of your last N months returns (N>=12) by 5.

Suppose your average (not CAGR) monthly return over the last 12 months is 10% with a standard deviation of 6%, then you can expect a 30% drawdown at some point. On the other hand, if the standard deviation was 2%, you could expect a drawdown of 10%. Clearly, stability of returns is the most important factor in determining your ability to sustain high annualized returns without a significant drawdown.

This will be one area that I will be diligently working on this year and I look forward to sharing the results with you.