The Well-Chosen Example

You’ve plunked down your $895 to attend the 10th annual “Secret of the Millionaires” futures trading seminar. At that price, you figure the speakers will be revealing some very valuable information.

The current speaker is explaining the Super-Razzle-Dazzle (SRD) futures trading system. The slide on the huge screen reveals a price chart with “B” and “S” symbols representing buy and sell points. The slide is impressive: All of the buys seem to be lower than the sells.

This point is brought home even more dramatically in the next slide, which reveals the equity stream that would have been realized trading this system—a near-perfect uptrend. Not only that but the system is also very easy to keep up.

As the speaker says, “All it takes is 10 minutes a day and a knowledge of simple arithmetic.”

You never realized making money in futures could be so simple. You could kick yourself for not having attended the first through ninth annual seminars.

Once you get home, you select 10 diversified markets and begin trading the SRD system. Each day you plot your equity. As the months go by, you notice a strange development. Although the equity in your account exhibits a very steady trend, just as the seminar example did, there is one small difference: The trend on your equity chart is down. What went wrong?

The fact is you can find a favorable illustration for almost any trading system. The mistake is in extrapolating probable future performance on the basis of an isolated and well-chosen example from the past.

A true-life example may help illustrate this point. Back in 1983, when I had been working on trading systems for only 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 after transaction costs. 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—and a wide group of markets. The start date was chosen to avoid the distortion of the extreme trends witnessed by many commodity markets during 1973–1975. The end date merely reflected the date on which I tested this particular system.

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 6 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—i.e., the bid/asked spread). This sensitivity of the system occasionally is beneficial, as was the case for the Swiss franc in1980. 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.

Because the related episode and the system testing it inspired occurred many years ago, some readers might justifiably wonder whether the system has been a viable strategy in more recent years. To answer this question, we tested the same system on a portfolio of 31 U.S. futures contracts for the 10 years ending November 30, 2015, and produced similar results: Only 12 of the 31 markets generated a net gross profit—that is, a profit before accounting for commissions or slippage. Incorporating a $25 commission and slippage assessment reduced the number of profitable markets to nine, and the total losses of the unprofitable markets outweighed the profits of the winning markets by a factor of more than 4 to 1, with a total cumulative loss of −$940,612 for the entire 10-year period (assuming a trade size of one contract per market).

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.

This is the first in a series of articles that will be released approximately weekly that are based on extracts from the recently published A Complete Guide to the Futures Market.