Quantitative Trading: Part 4 - Development Philosophies

As I move along in describing my current trading strategy I will walk you through the process I used when developing my system. During the walk-through I will get to the cool stuff - like backtesting, optimization, RESULTS, etc. - but that's not where it started. Before I wrote down a single entry or exit rule I first had to figure out what I was trying to accomplish.

Of course I wanted profits, but that wasn't my only goal. I also wanted to account for risk and drawdowns... so.... I started with an understanding of what I wanted in the system. After a lot of thought I realized there were two simple things that summarized my trading objectives in the system:

1. "We're here to make money!" That's right... let's not kid ourselves. I wanted the system to be profitable. And that doesn't mean I want to "beat the major indices". That's not good enough. Believe me, if I handed my money over to some fund manager and he told me in 2008 that he ONLY lost 30% of my money, I wouldn't be too thrilled. Absolute returns, rather than relative returns, is what I'm after.
2. "I never want to be more than a few days away from a record high in my account." You read that right... I can't stomach long drawdowns. A "drawdown" happens when your account reaches a new high and then falls back below that for some period of time. For example, in 2007 the SP500 reached a high of $1561. 18 months later it was less than half that number, and today it closed at $1062... still down more than 30% from it's all time high. When with the DD be over? Not until it exceeds it's previous high. If your 401k was in a nice safe index fund, it's still down significantly, nearly THREE YEARS LATER! That's not for me. My bar is "never more than a few days from a new high..."

That's it! Pretty simple, eh? Make money, and make money consistently. Those are my objectives, and that's why I developed the system I did. That, by the way, is why I'm not a trend trader (see my last post). Trend trading will frequently make money, but drawdowns can be significant.

In future posts I will share more results with you, but for now let me describe what I mean when I talk about the two objectives above. First, with regard to returns, my system backtests show NO losing years in the past 12 years. Further, 91% of months are winners.

Second, regarding consistency, my longest drawdown in the past 12 years of backtests is 54 days. Is that more than a few days? I'd say yes. It's a LOT better than three years, but it's still more than a few days. Truthfully, I don't always meet objective number two in the strictest sense, but I'm pretty close. In the past 12 years of backtesting there have been only a handful of drawdowns more than 10 days.

You might design a system with completely different objectives... this is just what I've come up with that meets my requirements and fits my trading style and preferences. By the way, this idea of fitting your trading style is important. As a working stiff, I don't have a lot of time to spend trading, and I certainly can't sit and look at a monitor all day. With that in mind, I designed my systems to trade accordingly.

Good Trading...