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David Druz: Robustness

Posted on by Michael Covel

David Druz, a trend follower with a lengthy track record, offered this tidbit on his web site:

“The robustness of a trading system is proportional to its volatility. This is the no-free-lunch part. A robust system is one which works and is stable over many types of market conditions and over many timeframes. It works in German Bund futures and it works in Wheat. It works when tested over 1950-1960 or over 1990-2000. Robust systems tend to be designed around successful trading tactics (origin of our “Tactical” name), classical money management techniques, and universal principles of market behavior. These systems are not designed around specific types of markets or market action. And here is the amazing thing about robust systems: The more robust a system, the more volatile it tends to be! This is because robust systems are not optimized to particular markets or market conditions. The converse is also true. You can design systems with excellent returns and low volatility on historical testing, but which work only for given periods in given markets. These systems tend to be curve-fit or market-fit and are not robust. For a system to have the highest odds of profitability over time and markets, the inescapable tradeoff is volatility. Diversification is used of course, but it will only dampen the volatility so much.”

Trend followers put out publicly available documents listing their backgrounds and performance. These are usually interesting to read even if not making an investment with that particular trader. These “disclosure documents” are freely available from the government via Freedom of Information requests and or directly from the trader. Here is one from David Druz.

Disclaimer: I have no business relationship with Druz. I write about what interests me. If you have a good idea for a blog entry here, drop me an email.

Volatility, Leverage and Returns

Posted on by Michael Covel

Investment banks spend millions upon millions to produce research. J.P. Morgan Securities Ltd. recently produced “Volatility, Leverage and Returns”. Read PDF. An excerpt:

“We find, though, that active managers of bond and hedge funds earn lower alpha when volatility rises unexpectedly. This is because many are structurally long risky assets that get hurt when volatility rises. Alpha returns when volatility stops rising and becomes high only when volatility starts falling again.”

Of course, much of this report is the opposite of a trend following thought process.

Reminiscences of a Stock Operator: Trend Following Power

Posted on by Michael Covel

An excerpt from Reminiscences of a Stock Operator:

“My losses have taught me that I must not begin to advance until I am sure I shall not have to retreat. But if I cannot advance I do not move at all. I do not mean by this that a man should not limit his losses when he is wrong. He should. But that should not breed indecision. All my life I have made mistakes, but in losing money I have gained experience and accumulated a lot of valuable don’ts. I have been flat broke several times, but my loss has never been a total loss. Otherwise, I wouldn’t be here now. I always knew I would have another chance and that I would not make the same mistake a second time. I believed in myself. A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip I must sell those same stocks on Smith’s tip. I am depending on him. Suppose Smith is away on a holiday when the selling time comes around? No, sir, nobody can make big money on what someone else tells him to do. I know from experience that nobody can give me a tip or a series of tips that will make more money for me than my own judgment. It took me five years to learn to play the game intelligently enough to make big money when I was right.”

Jesse Livermore Books:

• How to Trade in Stocks (PDF)
• Reminiscences of a Stock Operator (PDF)

Ten Rules for Position Sizing

Posted on by Michael Covel

Ed Seykota was recently asked:

“If you could give me ten rules to consider with respect to position sizing what would they be?”

He responded:

“Ten rules for position sizing:

1. Bet high enough to make meaningful profits when you win.
2. Bet low enough so you are ok financially and psychologically when you lose.
3. If (1) and (2) don’t overlap, don’t trade.
4. Don’t go adding a bunch of rules that don’t work, just so you have ten rules.”

Of course, Seykota and others will use detailed rules for risk management, that’s not the point with his answer. I liked his #4 answer.