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Dear valued client,
I thought you might enjoy reading a feature recently written by Jack
Schwager.
A SYSTEM TOO GOOD TO BE TRUE?
By Jack Schwager
Imagine a trading system that often generates sell signals near relative
highs and buy signals near relative lows, and also has more winning
trades than losing trades. Interested? Chart 1 illustrates the SRD
system (I'll explain the name momentarily), which exhibits these
characteristics. During the period shown, the system provided four
signals in the corn market, all of which were profitable, with an
average per trade gain of $1,031. Chart 2 is even more impressive. All
five of the signals generated for the British pound during the period
depicted were profitable, with a whopping average gain per trade of
$4,662.
Of course, you are probably curious to know the details of the system
that generated these series of impressive trade signals. However, I'm
sure you will agree that it is unreasonable to expect me to divulge this
information for free in a magazine article. Certainly, it would make
more sense to market this system at several hundred dollars a copy, or
more, providing only a very general description in this article.
Well, I'm actually going to reveal the specifics of the SRD system in
this article. What possible motivation could I have for disclosing this
information for free? That will soon become clear. The great trading
signals illustrated in Charts 1 and 2 were generated by an actual
system. The rules of this system are as follows:
Buy Signal-Whenever the market closes below the lowest
low of the past 90 days, go long.
Sell Signal-Whenever the market closes above the highest
high of the past 90 days, go short.
It's that simple. And yes, this very basic system generated the
excellent signals indicated in our examples. However, before you rush
out to trade this system, let me provide you with a few more
illustrations of the SRD system in action.
Chart 3 depicts the same system applied to the Japanese yen market. In
this instance, 3 out of 5 trades were losers. However, the real problem
is that one of the losing trades was for a staggering $39,062 per
contract, resulting in an average per trade loss of $7,017 over the five
trades combined. In Chart 4, for the period illustrated, the SRD system
started off promisingly enough with four straight wins in the coffee
market, with an average per trade gain of $2,250. The next two trades,
however, were mammoth losers, with an average loss of $25,047 per trade!
For the six trades combined, the average per trade result was a loss of
$9,849 per contract. As one final example, Chart 5 shows the SRD system
applied to the gold market. Here the system generated four consecutive
winning trades, followed by a fifth trade, which lost more than three
times the gain of the first four trades combined.
So what happened to our great system? The truth is that although the SRD
system will work great in wide-swinging trading range markets, it will
get massacred in strongly trending markets. The problem is that although
you can easily identify trading range and trending markets in the past,
it is virtually impossible to predict whether a market will be in a
trading range or trend in the future. In fact, generally speaking, you
are likely to do far better by fading the SRD system-that is, taking
trades in the opposite direction of the signals-than trading the system
as proposed. The system only seems to do spectacularly well because the
examples were carefully selected to make the system look good. (By the
way, the SRD name of our system stands for Super-Razzle-Dazzle.)
Well chosen examples are pervasive, appearing in books, articles,
advertisements, direct mail, and seminar presentations. Accepting well
chosen examples at face value is one of the most common and critical
blunders made by traders. Our mock presentation of a "super" trading
system was intended to highlight three critical points:
1. Any, repeat any, system can be made to look great using a few
well chosen examples. In fact, I believe it is virtually impossible to
devise a system that can't be made to look great on some segment of
market price history.
2. Therefore, never, repeat never, judge a system based on a few
examples.
3. When it comes to trading systems, what works well in one case,
may kill you in the next.
As another illustration of the well chosen example, let me tell you a
true story. Back in 1983, when I had only been working on trading
systems for a couple of years, I read an article in a trade magazine
that presented the following very simple trading system:
1. If the six-day moving average is higher than the
previous day's corresponding value, cover short and go long.
2. If the six-day moving average is lower than the previous
day's corresponding value, cover long and go short.
The article used the Swiss franc in 1980 as an illustration. Without
going into the details, suffice it to say that applying this system to
the Swiss franc in 1980 would have resulted in a profit of $17,235 per
contract (assuming an average round-turn transaction cost of $80). Even
allowing for a conservative fund allocation of $6,000 per contract, this
implied an annual gain of 287 percent! Not bad for a system that can be
summarized in two sentences. It is easy to see how traders, presented
with such an example, might eagerly abandon their other trading
approaches for this apparent money machine.
I couldn't believe such a simple system could do so well. So I decided
to test the system over a broader period-1976 to mid-1983 (the time of
my test)-and a wide group of markets. Beginning with the Swiss franc, I
found that the total profit during this period was $20,473. In other
words, excluding 1980, the system made only $3,238 during the remaining
6½ years. Thus, assuming that you allocated $6,000 to trade this
approach, the average annual percent return for those years was a meager
8 percent-quite a comedown from 287 percent in 1980.
But wait. It gets worse. Much worse. When I applied the system to a
group of 25 markets from 1976 through mid-1983, the system lost money in
19 of the 25 markets. In 13 of the markets-more than half of the total
survey-the loss exceeded $22,500 or $3,000 per year, per contract! In
five markets, the loss exceeded $45,000, equivalent to $6,000 per year,
per contract! Also, it should be noted that, even in the markets where
the system was profitable, its performance was well below gains
exhibited for these markets during the same period by most other
trend-following systems.
There was no question about it. This was truly a bad system. Yet, if you
looked only at the well-chosen example, you might think you had stumbled
upon the trading system Jesse Livermore used in his good years. Talk
about a gap between perception and reality.
This system witnessed such large, broadly based losses that you may well
wonder why fading the signals of such a system might not provide an
attractive trading strategy. The reason is that most of the losses are
the result of the system being so sensitive that it generates large
transaction costs. (Transaction costs include commission costs plus
slippage.) This sensitivity of the system occasionally is beneficial, as
was the case for the Swiss franc in 1980. However, on balance, it is the
system's major weakness. Losses due to transaction costs would not be
realized as gains by fading the system. Moreover, doing the opposite of
all signals would generate equivalent transaction costs. Thus, once
transaction costs are incorporated, the apparent attractiveness of a
contrarian approach to using the system evaporates.
It should be emphasized that the foregoing is not merely intended as a
cautionary tale to purchasers of trading systems and readers of articles
on trading systems. The points made are equally relevant to traders who
design their own trading systems. Traders need to be wary of the
potential of well chosen examples cropping up in their own system
testing. Don't jump to conclusions based on a few test cases-they may
simply be chance occurrences of well chosen examples. Always do
sufficient testing before assuming the efficacy of a trading system.
The moral is simple: Don't draw any conclusions about a system (or
indicator) on the basis of isolated examples. The only way you can
determine if a system has any value is by testing it (without benefit of
hindsight) over an extended time period for a broad range of markets.
Kindest regards,
Janette Perez
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