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Re: A SYSTEM TOO GOOD TO BE TRUE?



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Hi
Thought you might find this interesting.
Ben


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
 > 
 >     -----------------------------------------------------------