Combining Money Management, Portfolio Metrics, and Strategies for Investing and Trading Discussed by: Paul Grems Duncan Leader, Tri-State Investors Group July 16, 2001 1
Today’s Topics Metrics – a few that will help your trading/investing Three strategies that appear to be working right now Effective Volume Overview and a review of some candidate stocks 2
Admin Example files are located in my forum at http://forums.effectivevolume.com Directions on how to access these files are at the end of the presentation. 3
Portfolio Metrics: Do We Care? Yes! Portfolio Metrics help us understand whether the changes we make to a portfolio are beneficial. To use metrics though, you have to keep some form of log… (which I will provide an example… ) 4
My Favorite Portfolio Metrics Calmar Ratio Mathematical Expectation Pessimistic Return Ratio There are others (Sharpe Ratio, Sortino Ratio, Upside Potential Ratio, etc.) but they are more difficult to understand and apply consistently (in my opinion). 5
The Concept of Drawdown What is Drawdown (DD)? Drawdown is the measurement from the maximum (equity, price) peak to the lowest value AFTER the peak. Perceived Drawdown is: • the mechanism that causes us to sell a stock in a decline, resulting in us locking in losses rather than having confidence in our mechanical systems. • the enemy of mechanical trading. There IS a distinction between intra-trade DD and end- of-trade DD – end-of-trade is far more important! 6
7 Daily Russell 2K Since 1987 Drawdown Example:
Calmar Ratio What is the Calmar Ratio? CR is a very simple metric that relates return to drawdown . Easy to remember: ���������� ������ ������ ����� �� � ������� �������� ����� If CR < 0, your CAR is negative, and you’re losing money. This is a bad system. If CR ~ 1, Reward to Risk is 1:1. In general, you lose a dollar for every dollar gained, but time frame is important . If CR = 2, for every dollar lost, you gain 2 dollars. Good system. If CR = 3, for every dollar lost, you gain 3 dollars. Great system! Practical, winning systems generally have a CR > 1.50
Example of CR = 0.82 (CRR = 30.5%, MDD = 37.4%), 12/2/08 to 12/2/09 AAII Accelerated EPS Strategy (Modified Shadow Stock Portfolio Criteria) 9
Example of CR = 5.07 (CRR = 41.6%, MDD = 8.20%), 5/4/09 to 5/4/10 AAII Accelerated EPS Strategy (Modified Shadow Stock Portfolio Criteria) 10
Steps to Track Calmar Ratio 1) You need your equity curve, either real or backtested. 2) Download CR-CalculationExample.xls at my forum at Effective Volume (once you’ve registered, of course). 11
CR Moves with Time! (Thankfully, Not Fast) 1996 – 2010, AAII Accelerated EPS Strategy (Modified Shadow Stock Portfolio Criteria) We’ll discuss how to use CR Average = 2.02 and timers to improve a strategy +/- 1.31 Stdev later in the presentation Ugliness Ugliness Ugliness 12
Criticisms of CR The definition uses the compounded annual return (CAR); this isn’t practical for short bursts of trades as the time frames do not align. Trades occurring in a 4-week burst do not extrapolate to 12 months very well. Correspondingly, many people simply use total return (if less than 1 year) and the actual MDD. The purists will shutter, but this latter method works until a solid history per strategy is developed. 13
Mathematical Expectation What is Mathematical Expectation (ME)? ME is the “average take-home” amount in a trade scaled by the % of winning trades for the strategy (you have a strategy, right?) All you need is: • Average winning trade amount • Average losing trade amount • % winning trades for the strategy In the long haul, ME MUST BE > 0.
ME Example A strategy has demonstrated a record of only 20% winning trades. The average profit per trade is $10K The average loss per trade is $2K Is this a winning strategy? 1 � �� �� � ∗ �� � 1 �� • Where: AW = average winning trade amount • AL = average losing trade amount • PW is the % winning trades 15
ME Example (con’t) In the long run, this example should be profitable, as the ME is shown to be > 0. 16
Steps to Track ME 1) You need to start tracking your trades with a log. 2) You need to track what strategy is being used for a specific trade (you DO have (a) strategy(ies), right?) 3) Download “ME-PRR- CalculationExample.xls” from my forum at Effective Volume – this is a log that auto- calculates ME. 17
Example Trade Log for Autocalculating ME Worksheet Auto- calc’s Various Parameters Enter Trades by Strategy ME-PRR-CalculationExample.xls 18
Pessimistic Return Ratio (PRR) Pessimistic WHAT? Created by Ralph Vince and published in “Portfolio Management Formulas” (ISBN 0- 471-52756-4), this is a REALLY good method to understand your profitability and whether your methods will work in the longer haul. PRR is like ME but it gets better as the number of trades increases.
Pessimistic Return Ratio Here’s how PRR is defined: ��� � � � � ∗ �� � � � ∗ �� • W is the number of winning trades • L is the number of losing trades • AW is the average winning trade amount • AL is the average losing trade amount Per Vince: PRR > 2.0 are good systems. PRR > 2.5 are excellent systems. Also per Vince: We need at least 24-28 trades in a system to know whether it’s a viable system 20
PRR Example Suppose we have a system with 13 winning trades, 5 losing trades, with $288 taken home on each trade that is won, and with ($33) lost on each trade that goes against our methods. 21
Steps to Track PRR 1) Download “ME-PRR- CalculationExample.xls” from my forum at Effective Volume – this is a log that auto- calculates PRR (yes, this is the same file that also calculates ME). 22
Review of Metrics Calmar Ratio: Compares gain to drawdown. Tells you if you’re taking too much risk (DD > gain is bad) Mathematical Expectation: The “edge” of a strategy – we want positive numbers only here. Pessimistic Return Ratio: the best of the three, it tells us how good a strategy is, and it improves as the number of trades goes up 23
24 Strategies
AAII Shadow Stock Portfolio Standard AAII portfolio: http://www.aaii.com/model- portfolios/stock-rules Focuses on Small Cap stocks between $17 and $200M in size Performance over last year has been quite good, but historically?
AAII MSSP Performance Actual vs. Modeled, 1997-2010, corr = 0.816 Avg CR = 3.49 +/- 5.14 MDD = ~49% 26
AAII MSSP Performance The assumption here is that the modeled performance is “adequate” at corr = 0.816 (1.0 = perfect, 0.0 = no correlation) The drawdown of 49% would most likely have caused most to bail long before this occurred, then losing out to subsequent gains in 2009 and 2010. The average CR of 3.50 is very, very good, but, the standard deviation of +/- 5.14 suggests major losses (3.5 – 5.1 CR < 0 – BIG PROBLEM ) How to stabilize CR by reducing MDD? 27
Improving AAII MSSP Performance “Market Cap Favoritism” – There are certain periods in the cycle that Small Caps underperform Favor Small Caps 1/03 – 9/08 Favor Large Favor Small Caps Caps 6/08 – 9/08 6/06 – 5/08 4/09 - Present 10/08 – 3/09 Chart is the RATIO of Russell 1000 (Large Caps) to Russell 2000 (Small Caps) – R2K is in the Denominator 28
AAII MSSP Performance Gated w/ Russell 1K/2K Favoritism Avg CR = 4.59 +/- 5.76 MDD = ~28% 29
Stockcharts can Assist in Analysis http://stockcharts.com/h-sc/ui?s=IWB:IWM&p=D&yr=3&mn=0&dy=0&id=p46574665355 Ratio is below trend – Small caps are looking better, so watch for it Green = Small Cap Favoritism 30
AAII MSSP Conclusions It’s possible to use CR (as well as other metrics) to quantify adjustments to a strategy. The AAII MSSP strategy is a good strategy, but management of the drawdown must occur or we’ll lose confidence in the system. The general trend of favoring large caps or small caps certainly helps to provide confidence that we’re not running with small caps when the large caps are dominating. Right now it appears that small caps are just coming into favor again 31
Mean Reversion Strategies What is Mean Reversion? Mean reversion is when a stock or ETF gets overbought or oversold to the extent that after some period of time, buyers/sellers converge and move the price to the mean. Markets generally are in a trend or are mean- reverting. It’s important to have tools for each market. Larry Connors and Cesar Alvarez have developed a number of strategies to take advantage of this phenomenon
A Comment on Mean Reversion Strategies The psychology of mean reversion is opposite to that of trend trading. • In trend trading, you add to your position as it increases. • In mean-reversion trading, you add to your position as it falls If you are not prepared to see negative numbers, then in trendless markets, you may be better suited to sit on the sidelines. 33
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