Systematic Trading research and development, with a flavour of Trend Following
Au.Tra.Sy blog – Automated trading System header image 2

How to Start Trading a New System?

February 3rd, 2011 · 6 Comments · Strategies

start

Today is the big day…

After months or years of research, your trading system is finally deemed ready for production, and the latest back-test shows open trades as of yesterday (from earlier signals). How do you handle these positions in your new system today?

You have two basic options:

  1. Skip these positions and only enter as and when new signals arise.
  2. Enter the positions today, as if your system had taken the entry signals in its past, back-tested life.

The back-test did not skip any signals, as option 1 would, but neither did it enter trades in the middle of their life, as with option 2. How to decide which option to pick?
You could take a “middle-of-the-road” approach and decide to take the positions at only half their normal size, effectively mixing options 1 and 2, but let’s consider both options individually.

Option 1 takes the risk of “missing the boat” on big winners, whereas option 2 might get you in the trades at a point where heat is running at a much higher level than at typical entries.

With regards to this last point, please consider an extract from “A trick to reduce Drawdowns” where I expanded on the concept of lifecycle of a Trend Following trade, heat, open equity risk vs. closed equity risk:

By nature, Trend Following is a strategy prone to drawdowns because of the way it waits for the trend to reverse before closing the position. On any winning Trend Following trade, there is often a lot of open equity “given back” to the market.

Below is an equity graph of the life of a hypothetical Trend Following trade:

EquityCurves

Entering a trade “half-way” carries the risk of being directly exposed to a large trade heat. What this would do is transform a potential open equity drawdown, after a profitable run, into a closed equity drawdown directly from the start of trading. Instead of having a good performance followed by a bad performance, the system would potentially suffer from negative performance from the start.

Testing Both Options

Apart from the starting point of the back-test, all trades are usually taken as soon as entry signals are triggered. No skipped trades and no late entries. Ideally, you would want to run tests to show where the system would stand now if you had started live trading some time ago (let’s say one year ago for example) with either option. Where would the system stand at the end of last year if you had started trading with either option two years ago, and so on.

In order to test this and cover a wide array of possible start dates, I ran a stepped parameter back-test with staggered testing periods, covering 1990 to 2010.

The system used for this test was the 20-50 Moving Average Cross-Over system featured in the State of Trend Following report.

About 850 tests were run, with each test starting 5 days later than the previous test and covering 1250 trading days (to allow for long running trades to complete from the start).
Each test is run twice, covering options 1 and 2 for the trade start methodology.

The results of all tests allow for a performance comparison to try and understand which option performs better on average. Below is chart of the difference in CAGR for each test:

CAGR-Difference

The difference plotted above is absolute (a 5% absolute difference does not have the same significance if the CAGR is 10% or 100%). The average difference is -5.05% for an average CAGR of 29.9%, which gives us a better idea of the relative difference. Note that the difference is also a function of the length of the test.

The results seem fairly biased towards option 2 (enter all positions as soon as the system goes live), which can seem counter-intuitive from some point of view.
Below is an additional chart plotting the difference in Sharpe ratio:

Sharpe-Difference

Some traders might still not enjoy the idea of idea of jumping on-board trades with higher heat levels. A fairly obvious solution to this would be to add stops to initial entry points only in order to reduce system heat at the start of trading. Trading a system with stops and volatility-based position sizing would also do this naturally. Either way, this could possibly represent a third option, combining the best of both worlds. Something else to test…

Related Posts with Thumbnails

Tags:

6 Comments so far ↓

  • Pretorian

    Hi Jez,

    This is a topic that I have been thinking about to, in my case it doesn’t seem to be much of a difference. However I think that there might be a mistake in one of the graphs, because it says CAGR 2 – 1, in order to have so many negative months option 1 must be larger, so it should be a better option, at least this is how I interpret the graph. Thanks

  • Jez Liberty

    Pretorian – thanks for both feedbacks!
    And apologies, there is indeed a typo in the chart title, which should read Option 1 – Option 2. And therefore option 2 has a higher number of higher CAGR.
    I’ll update the post (and charts later). Thanks for letting me know.

  • RiskCog

    One thing I have learned from my experience when starting a trading system out is that – for the sake of your equity curve – you don’t want to turn down the volatility/return of the strategy after starting out. If you have initial losses and then decrease your volatility it will take you a lot longer to make up the losses. OTOH if you have gains and decrease the volatility then it could look like your returns are rolling off to someone who just glances at your curve. So make sure you like the volatility level you plan to start with! Just a marketing thought that might become important if you have a system that turns out to do well.

  • John Hall

    Let’s say you have some optimal weights for your whole portfolio determined along with a risk appetite and covariance matrix. With reverse optimization, you can back out the expected returns that a mean-variance optimization would require to produce that portfolio. You could then run a mean-variance optimization incorporating transaction costs (ie. your current weights are an input) with these weights and you will have the new portfolio that you should invest in given your current position, your ideal position, and your costs.

  • William F.

    Regarding starting a new strategy in the middle……
    As you said a person can wait for the next signal, or just enter with the proper risk management in place.

    To Quote a trader friend of mine here is some food for thought. (a bit paraphrased though)

    If you buy new highs or sell new lows you will own all the winners and only some of the losers.
    If you buy/sell retracements you will own all of the losers and only some of the winners.

    Like I said a bit paraphrased but I hope you get the gist of the message.

  • Jez Liberty

    Thanks William – I like the quote, a bit over-simplifying, but still gets a good point across (about buying into strength, selling into weakness)…
    I think this does not only apply on starting a system but an the overall system concept (ie MR vs TF)

Leave a Comment