Just as beer is proof that God loves us, drawdowns are proof that no single strategy works in all environments.
A mean reversion strategy does not perform well in a trending market, whereas a trend following strategy underperforms in a choppy market. And since markets go through periods of sideways price action and trends, it is impossible for either strategy to always work.
So what is so hard for people to understand that drawdowns are a natural process. They are not a reflection of your inability to trade. They are not a declaration that you are inferior. Nor are run ups a reflection of how smart you are. Or how you’ve mastered the art of trading. But for today let’s focus on drawdowns.
Whether you are quantitative or discretionary you cannot hide from reversion to the mean. Price, your performance, everything in life oscillates around a mean. A player with a 300 batting average will go through periods of hitting perhaps 200 and then periods of maybe 400. During the 200 period they should not be traded for an inability to hit the ball. Nor should they be given a new contract when hitting 400.
Our brains are not wired to think in terms of probability or reversion to the mean. Nor are we able to process historical data without bias. In other words, our brains take the most recent data points and apply extra weight versus older data points. So if you are experiencing a period of underperformance, your brain is putting more emphasis on those data points and less on the prior period when you were outperforming.
So you need some method of taking data and seeing it within the bigger picture. Outside of your brain’s inability to process such data. The simplest tool can be an Excel spreadsheet plotting your net profit over time. What you’ll see is something that looks like a stock chart. Normal oscillations. Normal cycles. Periods of higher highs and higher lows. Or at least that’s what you want to see.
If you can graphically look at a drawdown you’ll be able to understand its context. In the late fall my ZB system went through a period of drawdown. And having this ability to graphically see its context made it more palpable. Not enjoyable but at least more palpable. Prior to that period of drawdown there was a very big run up. A two standard deviation move that lasted a few months.
So it was not only normal, but necessary that a drawdown would follow. I hated going through it and fortunately found a method through use of my equity curve to turn the system off during the drawdown. But it was a natural process that I had to endure. And if I opted not to turn my system back on when the equity curve said to do so, then I was a fool. A person who contributed to another’s positive alpha.
The bottom line is drawdowns are natural. You need to find a way to understand their context. And you need to have confidence in your strategy to trade through them.
This article was sponsored by Advanced Futures
Headquartered in Chicago, Advanced Futures was founded in 2002, by traders and investors with an extensive history in the industry.
Our experience includes brokerage and clearing services, systematic development and programming, trading all asset classes as independent traders and with prop firms, career placement and capital matching.
We help traders and investors build and grow computer based systems through education, placement and consulting.