Very near the bottom of the equity drawdown, I decided to segregate some of my trading money into a living expense account so that I would feel less pressure from the day to day moves in the market.  I looked at the distribution of gains and losses for the prior year, and established a knee-jerk rule to add money to the living expense account whenever I experienced a “large” gain. 

In retrospect, this strategy amounts to a dynamic cash hedge, meaning that my total risk level fluctuates with the percentage of the total account that is held out in the living expense, or “hedge” account.  In truth, establishing the hedge at the equity trough was exactly the wrong thing to do, and it delayed my recovery from the drawdown.

From June to September, I blissfully ignored my hedge % as the Cable Glider posted gains in each of those months.  A losing October, however, has caused me to re-evaluate how I hedge my risk, and it’s led me to an interesting discovery that will affect how I handle money management with my systems going forward.

I have found that by picking a fixed hedge percent, say 25%, and resetting it to 25% at the end of each subsequent month, I can achieve better returns than by simply reducing my risk on each trade by 25%. 

Essentially, I’ve discovered the position sizing method that chaffcombe (http://www.futurestech.com.au/MonthlyReport_Sep2007.htm) refers to as Variable Fractional Position Sizing. (VFP).

Rather than re-invent the wheel, I’ll quote his comments on the subject below:

”

Although the drawdown was lengthy, it was extremely shallow – something that I am particularly pleased about considering the earlier major gains.   I largely attribute this to tight risk management and, specifically,  the variable fractional position sizing methodology (VFP) that I employ.  VFP increases or decreases the risk taken for each system in proportion to the realtime P/L  for the calendar month, thus allowing increased leverage during profitably months, without taking undue risks with what I consider to be ‘capital’ ie NAV booked at the end of the previous month.   VFP can make a lot of money very quickly in good trading conditions, while limiting losses very quickly in bad…

”

Armed with VFP, we can re-think the subject of drawdowns.  Traders will first and foremost consider the maximum peak to valley drawdown in their trading, but may not pay any attention to the timespan that those drawdowns cover.  Indeed, visualizing a drawdown as a lake whose volume is measured on the vertical axis by % drawdown and whose horizontal axis is measured by time, we can work on decreasing the pain of drawdowns by attacking both the vertical and the horizontal dimensions.

Most of the vertical value of a hedge is accomplished in the first down month.  If we reset the hedge to a fixed percent after a down month, we are effectively adding money to the trading account.  This is an anti-hedging technique meant to decrease the time taken to recover the drawdown.  With this methodology, we do risk a deeper drawdown if we experience consecutive losing months, but we retain the majority of the vertical value of the original hedge.

So, VFP has the potential to outperform fixed fractional in a drawdown.  What about in a run up to new equity peaks?  The beauty of VFP is its ability to lock in more of the gains from a positive outlier.  If we are happily moving along making 5% per month with no variation, VFP will reduce our total return by hedging out a portion of the gain each month.  If however, as has been the case with the Cable Glider, it is true that large positive and negative outliers are clustered together in time, VFP will outperform fixed fractional.  If we have a big gain followed by a big loss, VFP locks in more of the first month’s gain and reduces the subsequent drawdown. 

If we have a big loss followed by a big gain, the anti-hedging ability of VFP shines again by adding more capital to the system at the equity curve trough and speeding us out of the drawdown.

As with many other trading system parameters, the optimal (defined here as maximum net profit for any given level of risk) hedge percent is a moving target, and so this is not a simple topic.  For the Cable Glider in 2006, the optimal hedge % would have been in the 40′s, but this is because there were two cases of big run ups followed by drawdowns.  In 2007, the optimal hedge percent is much lower, because overall the equity curve has been much more flat.  When I combine the two years, 25% is the optimal hedge.  Over the past five months, my original dynamic hedge was moving in the 22% to 31% range.  Even though the length of this post and my long-winded explanation might suggest otherwise, the new method is simpler, cleaner, and easier to verify.

I started using Tradestation to trade British Pound futures just two months ago.  The power and flexibility of Tradestation has really impressed me and allowed me to improve my trading model.

Today, I begin trading the 3rd generation of the Cable Glider system.  A summary of changes follows.

1) I will be trading British Pound futures at the CME alongside British Pound spot.  I started this side by side testing in August with the idea that I would like to have the systems synchronized and measure the relative costs of slippage and commission in each market.  One of the main things that drove me to the futures market in the first place was the idea that my trading costs might be reduced.  My current opinion is that this seems to be true at my current trading size, which to date has not exceeded 20 contracts on any single trade.

2) I will be using a different parameter set for each market, as determined by the ongoing optimization in both markets.  I’m currently using a genetic optimizer to periodically re-optimize the systems with a fitness function that uses net profit, gross profit, gross loss, and maximum intraday drawdown. 

3) Entry signals for both markets will be driven from the futures price chart.  Since the futures market is a true transparent market, I believe it gives me a cleaner picture to set up entries.  I never liked the fact that in the cash market, I’m getting a stream of bid prices rather than a stream of actual transaction prices.

4) Cross-market MACD confirmation will be used in both markets.  That is, I will require that a price breakout be confirmed by MACD in both markets.  This little tweak has already saved me from entering what would have been a losing trade in the futures market on the very first day of trading.

5) Exits will be managed by the optimized exit parameters in each respective market.  Once I’m in a trade, I don’t want to fool around with setting exits that rely on more than one data stream.

6) I will not attempt to synchronize trades in both markets.  The expectation of synchronized trades drove me crazy in the month of September.  By trading two different parameter sets, I gain a measure of diversification that is not possible otherwise.  This system diversification gives me a second level of equity curve buffering in addition to the smoothing effect of keeping a living expense capital reserve account.

Cable Glider II had a lifespan of only 4 months.  All months showed a profit, and the total compounded return on risk capital was just above 125%.  No, that is not an annualized figure.  It is a 125% return in four months.  I’m much happier putting CG II to rest this way;  the first Cable Glider system was suspended at the end of May after a large drawdown.

I’m still on the lookout for improved execution and reduced trading costs.  My next move on that front will be to investigate API trading with Interactive Brokers.  Their commissions appear to be identical to Tradestation, but the cash forex spreads look tighter, they pay interest on cash balances, and their unique umbrella account allows for cash balances to be SIPC insured.  The programming involved to trade at IB is a whole new ballgame, so I don’t expect I’ll be making the move anytime soon.

24 hour market : Forex, check.  Futures, check…almost. The futures trade 23 hours a day.  The market is closed for maintenance between 5 and 6 PM Eastern time.  Although some might argue that 23 hours is practically the same as 24, I disagree.  I hope that some day the CME will have the technology to keep the market open 24 hours a day.  From a practical standpoint, however, this would not deter me from trading the futures.

Availability of leverage: There is a high availability of leverage in both markets, and although forex affords access to greater leverage, I can say from experience that trading beyond the maximum leverage levels allowed in the futures market is really a recipe for disaster anyway.

Availability of free software for automated trading:  Okay, this is where I sang the praises of Metatrader, because it is free and widely available.  I still believe that this is a big deal.  In the futures market, I am experimenting with TradeStation.  This platform is also free if one trades a sufficiently large volume, and the hurdles aren’t that high.  Real-time data for the CME electronic contracts also carries a monthly fee.  At this point in my trading career, these costs are not a deterrent, and at first glance, the power of TradeStation’s platform absolutely dwarfs MetaTrader.

Easy Access to Paper Trading :  There is also easy access to paper trading in the futures market, although I don’t know for sure whether or not there is easy access to free paper trading on a platform that allows for automated execution of user-defined strategies. 

Low start up capital requirement: This absolutely still holds as a benefit for the retail forex market.  Again, at this point in my trading career, it is not an issue.

Depth of liquidity:  This point is really a tricky one.  The liquidity in the futures market is TRANSPARENT.  Although it may certainly be less liquid than the OPAQUE OTC forex market, I’ll simply say that the liquidity is ample for me at this time, and the benefits of a central exchange with transparent pricing is huge.

So that covers the original points.  Now I’d like to add some benefits of trading in the futures markets.

Safety of Funds on Deposit — Regulation and truly segregated customer accounts are a stand out benefit.  Some forex dealers claim to have segregated customer accounts, but lack of regulation means that in a pinch, anything can happen…think Refco and the relative agony experienced by its forex customers vs. it’s futures customers.

Cost – I’ve often seen “zero commission” and “tight spreads” being listed as a benefit of trading forex.  This is really just a fancy way of saying “obscured compensation” and “dealer-controlled spreads”.  Now, I’ve yet to trade in the futures markets, so I can’t really comment on total costs of one market against the other.  The spreads in the futures market appear to be 1 to 2 ticks in a quiet market.  Unless the slippage is excessive in futures, I believe that the total transactions cost of trading in the futures market will be lower than trading in the retail forex market.  I’ll have more to say on this when I have some live trading experience under my belt.

Swaps are “on the chart” — Let me explain.  In the cash forex market, there is a rollover (“swap”) that occurs every day.  While some carry traders must surely enjoy getting large cash swaps on a daily basis, this is really analogous to preferring to receive cash dividends as opposed to capital gains.  In a properly functioning futures market, the difference between the spot price and the futures price represents the cumulative value of expected swap payments until the contract’s expiration.  In other words, as the time to expiration decreases, the futures and spot price must converge.  Although no swaps are paid out on a daily basis, interest rate differentials show up on the futures charts as a time-decaying swap premium or discount that converges to zero as expiration approaches.

Okay, that explanation is long-winded, nerdy, and perhaps unreadable.  The short version is that swaps are something that are outside of the chart, and as a technical trader, I’ve always hated that.  I want to trade the chart and have all the information that will affect my trading performance be represented on the chart.  I give futures the edge here.

Unambiguous taxation — Due to retail forex trading’s rising popularity and relative novelty, the taxation of spot forex gains is a little bit cloudy.  As I understand it IRC 988 and IRC 1256 are overlapping and conflicting, and subject to interpretation.  Please go elsewhere for forex tax advice, as I do not provide those services.  The taxation of futures contracts is covered entirely by IRC 1256, and while such taxation is not beneficial for losing traders, it is beneficial for winning traders and it is unambiguous.

So there you have it.  I will write up my thoughts about TradeStation after I have more experience with it.

So when I get right down to it, my feeling today is that futures will provide a superior experience for me.  Forex certainly is better for traders with small accounts (<5K USD), and perhaps for super large traders, where depth of liquidity again becomes an issue.  Folks who love the carry trade may also prefer the spot market, but even this preference is subjective.

 

 

 

 

At any rate, the Bank of England left interest rates unchanged this morning, which caused a downward spike and upward retracement in the Cable, with the pair currently drifting lower.  The Cable Glider is idle until after tomorrow’s US Employment number.  Tomorrow is Good Friday…holiday week weirdness abounds!

As of right now, we’re still sitting on 1 win and 1 loss for April with a gain of 4.1%

 This also marks a new equity peak in the Cable Glider account, and the second $10,000 + single trade profit.

Oh, and for the love of God, please don’t use my site to time entries in your own accounts!  I keep my current position in the “Snapshot” section of the sidebar, but I update this manually, and NOT in real time…I’m not running a signal service here.

My system is NOT the Turtle System.  I think that the Turtle Rules are valuable because they get us thinking about a “complete” trading system.  Lots of traders think a “system” is a set of entry criteria…well, that’s just part of it, and perhaps the least important part!

On page 2 of the Turtle Rules, there is a section called “The Ugly Truth about the System Sellers” I don’t know the whole story;  they are making some references to people selling the Turtle System, and they have a problem with it.  I guess if some 3rd party were selling something called “Ed Mamula’s REAL ORIGINAL CABLE GLIDER” for $995, I’d be just a bit upset too! For this reason, I don’t intend to get any more specific about the Cable Glider other than what was posted when the blog was first launched in January.  My purpose here is not to sell the reader anything;  it’s only to document my own experience.

The reason why I recommend that every aspiring mechanical trader read Van Tharp’s “Trade Your Way to Financial Freedom” is because it gets us in the mindset of developing our OWN systems, systems that will work for us as individuals.  Once we mentally graduate from looking for a system to buy and use to looking at other systems for insight on how to enhance our own systems, I believe we’ve made a giant leap forward toward success.  Black box systems (ones that can be purchased but whose rules are unknown to the buyer) tend only to cause us frustration in the long run, because even if they are “successful”, we are ill-equipped to follow the rules.

 

 

 

I’m ready for next week…Happy St. Patricks day to all and happy March Madness viewing.

Enjoy!

—–

UPDATE : 3/17/2007 — I added the Metatrader Expert Advisor Backtest to the performance chart as well;  this shows how far the system development has come over the past 5 months.  I can confidently say that the rules in the newest Cable Glider are not “curve fit” to the data;  there are two out of time samples in which the new version validates well.  What I’m saying here is that my actual experience has been about a 130% return over the past 5 months but if I had known then what I know now, I may very well have been up 1300% … well, I’ll believe it when I see it, and I’ll be here to tell you all about it!

 # closed winning trades : 2

# closed losing trades : 0

 Net monthly profit (loss)% :  43.4%

Current drawdown : 0% (at new equity peak)

 With the help of equity curve timing and one favorable manual override, the Cable Glider has reached a new equity peak as of 10 AM EST.  Without the timing and front-running, the system itself is still in a 7% drawdown.  Needless to say, I am very pleased with how quickly the system recovered, given the relatively steep and sharp drawdown it experienced just two weeks ago. 

 a) Cut losses

b) Ride winners

c) Keep bets small

d) Follow the rules without question

e) Know when to break the rules

Part of my motivation for starting this website was the idea that if the system’s results were made public, I’d be more likely to let the system run without manual overrides.  For the most part, this has been true.  Tonight, I overrode, or rather front ran, a signal on the Cable Glider. 

  (The 2nd cliff the GBP/USD has fallen off of in the last 2 days)

The net result? 

31 extra pips or $2480 profit by front-running the signal.  I *am* less inclined to break the rules today than I was a few months ago, and most times when I break the rules I actually come out ahead. 

In fact, this may be the only time where I can successfully break the rules.  The GBP/USD started a sharp down movement last Thursday night, and I closed the position so that I would not hold over the weekend.  When the market opened tonight, the continuation of the down move happened before 6:30 PM EST, which is usually the earliest that I’ll take a signal.  I’ve yet to figure out how to modify the Cable Glider to accept such “continuation trades”.  Until I do, I guess I’ll be here on Sunday nights to watch the market manually until I can code this as a rule.