The Right Stuff - Contrary to popular opinion,
the most important factor in trading commodities
profitably is not "knowing" where the
market is going. Nobody knows for sure exactly
what a given commodity market will do next! The
most important thing is to have a plan of attack
that will allow you to successfully cope with
the uncertainty that is an inherent part of commodity
trading or investing in anything.
It is a well-documented fact that the world's
most consistently successful commodity investors
and commodity traders (in any market, including
stocks, bonds, commodities, etc.) do not have
any inside information and do not know what will
happen next.
What they do know is that they have an excellent
chance for success in the long run if they can
develop the discipline to stick to their plan.
Their "secret weapon" is that they have
survived their mistakes long enough to develop
a good clear common-sense trading plan. Any they
survived long enough to learn that even though
their plan isn't perfect, it is more profitable
to exercise the discipline to stick to the plan
through thick and thin, than to deviate from it
after some losses.
So you see, this discipline to follow a plan
even when the chips are down, so crucial to success,
comes from the confidence that comes from experience.
If you do not have the time and/or inclination
to develop your own trading plan, develop supreme
confidence in that trading plan and the discipline
to stick to that trading plan, then the odds will
be stacked against you. That is, unless you can
join forces with someone who does have the time,
inclination, plan, experience and discipline to
trade successfully.
"There are those who sit and wait for the
world to change for them. Some few guess correctly
that they are the ones who must change. In commodity
trading, one usually gains by yielding, by admitting
that he needs help, that here is a better way."
Maximum drawdown is a very important figure which
is normally reported as one of the factors in
analyzing a system by historical testing software.
It is generally defined as the greatest decrease
in equity at any time during the testing period
under consideration and it is usually reported
both in terms of actual dollars and as a percentage.
Only recently have I begun to realize that various
testing software programs differ in how they report
this figure. The two biggest variations seem to
center around whether or not the maximum drawdown
figure is based on closed trades only or on both
open and closed trades.
Open and closed trade calculations: When maximum
drawdown is based on open and closed trade equity
it will tend to vary every day that any trades
are in progress. The benefit of this figure is
that it monitors daily fluctuation in equity throughout
a trade or a portfolio of trades. The limitation
of figure is that it counts losses of open profits
as actual losses.
For instance, let's say you are trading a system
and you currently have open trades in 4 markets:
JY, SF, BP and DX. All the markets are moving
well and you have a current open profit of $5,000
per market or $20,000 total. Then, as it often
happens, the markets move against you and your
long-term system doesn't get you out until you
have lost half of your open profit. So, you exit
the 4 trades with $10,000 in profit. This would
be common of many long-term systems which allow
a market to move a large amount against you before
exiting the trade as a tradeoff for giving the
market room to stay in the major moves.
The problem is that these 4 profitable trades
will be reported as a $10,000 drawdown since you
had a $10,000 loss in open equity. If this period
were immediately followed by an extended period
of closed trade losses totaling $10,000, those
total losses would be added to the previous open
profit drawdown of $10,000 to arrive at a new
figure for maximum drawdown of $20,000. In this
case half of the maximum drawdown figure would
represent actual closed trade losses and half
would represent decrease in open trade profits.
Closed trade calculation only: When maximum drawdown
is based on open and closed trades it will only
vary when your system exits a trade. The only
factor taken into consideration is the affect
of actual closed profits and losses.
The limitation of this figure is that it does
not tell you anything about open equity when you
are currently in trades. The benefit is that it
reports the important maximum drawdown figure
only on the basis of actual losses.
Let's look again at our above example where you
were currently in 4 trades in 4 currency markets.
In that scenario the system would report a $10,000
profit and 0 drawdown since you actually made
money upon exiting the trades and you did not
actually lose any money.
Personally, I am more interested in knowing the
maximum drawdown based on closed trades since
that tells me the greatest decrease in capital
I could have had if I had started trading at the
worst possible time, although it's true, drawdown
figure will change even over the same testing
period depending on when you start the test.
There is a vast difference in going through a
drawdown of $20,000 in actual capital and in going
through a $20,000 drawdown in open profits that
ultimately ends up as a profitable trade. Also,
there is a big difference psychologically.
My complaint with reporting maximum drawdown
as a percentage is that it is usually based on
the greatest percentage decrease in equity at
any time during the testing period. This would
often include equity based on open and closed
trades which I have already given my opinion concerning.
The other problem here is that it is a figure
that is based on the current equity which begins
as the initial start-up capital and by design
it will almost always identify the greatest decrease
in equity by percentage to be in the earlier years
of a test. This stands to reason since equity
will generally increase over time with a profitable
system.
If you begin with $50,000 in capital and immediately
have a $20,000 drawdown, then that number represents
a 40% drawdown. However, if you initially have
some profitable trades and ultimately double your
capital to $100,000, the same $20,000 drawdown
now only represents a 10% decrease of your capital.
It ends up telling you more about how early in
the testing period a drawdown occurred than how
large it was.
Personally, I'd rather see this percentage refer
to the same maximum closed trade drawdown period
which the dollar figure drawdown refers to. My
own spreadsheet calculations, if correct, indicates
a closed trade max drawdown will often be much
less than open trade max drawdown.
One system I compared had an open trade maximum
portfolio drawdown of approximately $47,000 and
a maximum closed trade portfolio drawdown of approximately
$39,000 or 17% less. Another system had a open
trade maximum portfolio drawdown of approximately
$36,000 and a closed trade maximum portfolio drawdown
of approximately $16,000 and represented a drawdown
which was 56% less.
The difference in these numbers could make the
difference in a trader deciding whether or not
to purchase or trade a system. Also, the method
of calculation of maximum drawdown based on open
trade equity might tend to encourage system developers
to design long-term systems to exit trades quicker
in order to limit open trade drawdowns which may
ultimately be to the detriment of overall profitability.
There are obviously benefits in knowing maximum
drawdown based on both open equity and on closed
equity only. So, why shouldn't both be reported
by testing software.
Numerous figures of performance evaluation are
normally included in testing summaries and it
would not seem hard to include one more that is
particularly important. That way you would know
both the greatest decrease in open trade equity
at any time during the testing time frame and
you would know the greatest decrease in actual
money lost in closed trades.
reprint permission from webtrading.com
