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This weekend I was looking at some SP systems on the web. A few of the most
attractive ones were daily systems - with backtest results going back 10
years. One in particular showed a max dd of $14,000 with a total profit of
over $200K. Note that all the backtests used a single contract for each trade.
Sounds good. Let's say you actually trade the system. You're expecting to
have a max dd of around 14K on one contract. OK maybe double that, since
you want to look at a worst-case situation. You set up an account with
$50,000 - that should be enough to handle a $28,000 drawdown. Worst case!
What's to worry about!!
But WAIT! Can you really trust that simulation? Is it even in the ballpark
as far as the realistic drawdown expectation? I think NOT!!!!!
You decided to buy one contract - today's Average True Range is about 23
bigpoints. So that's one contract per 23 points of truerange. You're
figuring your max dd should be around $14,000 * 2 (doubling it to be
conservative).
But now let's say you're back in the 80's. It's not a backtest anymore, now
you're really trading the system. The Average True Range then was about 3
bigpoints. So all things being equal you'd have traded (23/3) contracts -
that's about 8 contracts traded then for every one today (actually you'd
have traded just 4, since the point value was 2 times what it is today -
but the example works out the same anyway).
Here's the problem - what if the max dd in the backtest occured way back
when. Trading one contract, as i the backtest, you would have drawn down by
about 14K. But IF the test reflected a realistic position size (it doesn't)
your drawdown would have been 8 times that big, a whopping $112,000.
Remember that 8 contracts back in the 80's is equivalent to just 1 now. So
who's to say you won't draw down AGAIN by $112,000??? Or $224,000, since we
wanted to double things just to be on the safe side. Your $50,000 account
is going to have a problem!
Sincerely, and I hope this is not totally confusing,
Phil
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