Are you Swimming Naked?

As you all know when you trade with QiT you don’t have to waste a lot of your brain neurons trying to figure out the market.

You exorcize the demons that creep into your trading and lead you down paths you should not go.

You catapult yourself into the realm of “I don’t care what the market is going to do, I’ll let the algorithms worry about it.”

But that does not mean from time to time we all find ourselves at the bottom of that pit when we’re “trying to figure out the markets.”

Even though you don’t have to concern yourself with the day to day craziness, it does behoove members to fully acknowledge the volatility that will accompany a market drop. So here is a newsletter dissecting what life may look like if we undergo a comprehensive market downdraft. Since I’m always on the lookout for topics that tickle your fancy, I thought his suggestion was excellent and timely.

Your mission, should you choose to accept it, … is to understand and navigate the volatility that separates the men from the boys. The wheat from the chaff. The traders from the wanna-be’s once we hit a market top. This newsletter will self-destruct in five seconds.

The Sage of Omaha

Warren Buffet once said, “Only when the tide goes out do you discover who’s been swimming naked.” It was a reference to if you don’t have your ducks in a row when the markets start to fall or when the tide reverses and goes out, you will be in a lot of hurt. I want to make sure you are not left naked went the tide recedes. So I went looking for a metric you could use to understand what it will be like to live through an unpredictable and capricious period. Lo and behold, I had one all along in Amibroker, the software I use to develop my algorithms. 

I need to warn you, you are now entering the “Geek Zone.” You’ll have read two definitions of terms you have probably never heard of. You can read both definitions in their entirety or just their headings. I have a pretty good idea as to who will devour it all though.

Maximum Adverse Excursion

The MAE measures the largest loss suffered by a single trade while it is open. For example, a trade may end up closing at a profit of (say) 5%. But while that trade was open, at one time, the trade was down 4% thus -4% would be the MAE.

The MAE is also called the Most Adverse Excursion (read heartburn). In this context Most and Maximum mean the same thing and can be used interchangeably.

Maximum Favorable Excursion

The MFE measures the largest profit gained by a single trade while it is open. For example, a trade may end up closing at a profit of (say) 5% but while that trade was open, at one time, the trade was at a profit of 10% thus 10% would be the MFE.

The MFE is also called the Most Favorable Excursion (read euphoria). In this context Most and Maximum mean the same thing and can be used interchangeably.

Let’s put it to work

Now we will squirrel away the geekiness and see if we can put it to work but before we do that we have to do a “back story.” This entails a look at the Monthly Profit table for S&P 500 Margin.

 

Let’s concentrate on the years:
2007 that ended the year with a 74% Compounded Annual Return (CAR),
2008 that ended the year with a 105% CAR and
2009 that ended the year with a 66% CAR.

Those were some wildly volatile years but the S&P 500 Margin did a stellar job.

Now drill baby drill to 2008, one of the worst years in the history of the US Stock Market. In 2008, the S&P tumbled 38% and the Russell 2000 almost as far with a 34% loss. I won’t ask you to recall what your individual accounts lost – I don’t want you to relive that again – but I know my accounts took a beating.

If you were looking for a strategy to trade and found one that had a yearly CAR of 105% you’d be all over it like a wasp to your dinner in the backyard, at least you should be. But – oh, oh here comes the great big fat “but” – in order to have completed the year with a jaw dropping CAR of 105.70% for 2008, you had to live through some pretty darn rough times.

Will this metric help me?

This is where I segue into the MAE and MFE. We need to explore this metric to see if it can help us negotiate the inevitable rapids our inflatable raft has to withstand.

This spreadsheet shows the top 50 MAE’s (Maximum Adverse Excursion) for the SP500 Margin back to January 1, 2007. These are the top 50 trades that had, at one point while the trade was open, experienced the largest trade drawdown. These are the trades that would have given you the tingle down the spine, the sweat on the brow, or/and the desire to put your fist through the monitor.

Of the 50 top largest MAE’s, 26 were in 2008. That’s a little over 50%. In other words, from 2007 to 2017, 10 ½ years, 26 of all the trades that would have given you the most heartburn were in 2008. And of those 26, 16 took place August through December. That’s a lot of indigestion to deal with in a few short months.

Interestingly 25 of those top MAE’s were long and 25 were short.

Now let’s look at the top 50 MFE, Most Favorable Excursion. 25 of those trades were in 2008.

These were the euphoria type of trades. However, because our brain is wired the way it is they would have given you the same rollercoaster ride as the MAE’s. If you’re like me, even though you know you should not, you still look at your trades throughout the day. When you saw a trade up (say) 10% the adrenaline rush would have you dreaming of a vacation in Tahiti. Then at the end of the day if you ended up with “only” a 5% profit dejection sets in. You are disappointed at a 5% profit! Isn’t the human brain a wonderment?

Are you getting an idea of what it would have been like to trade through 2008?

Unless you had someone trading your account AND you didn’t look at it daily these were rough waters to navigate.

Here’s some of the metrics for the MAE’s of the QiT portfolios that trade equities.

By the way, the stock symbols you see in the previous spreadsheets with a date beside them are the stocks that have been delisted, the date was the delisted date. This is why you should always trade with a service that uses data with no survivorship bias.(my paid political announcement.)

We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie

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