If you put in stops and run your profits and trade randomly you make money; and if you put in targets and no stops, and you trade randomly you lose money. So the old saw about cutting losses and running profits has some truth to it.
The quote was used to illustrate a post stating that a large driver of Trend Following returns is based on the mechanics of those systems (“cut your losses short, let your winners run“) which therefore benefit from the right tail of market return distributions – which are “fatter” than the usually assumed normal distribution – and avoid the left tail.
“Trade randomly”? Like the proverbial dart-throwing monkey? It seems so…
In effect, Harding is saying that entry points do not matter so much: a random entry coupled with a smart exit strategy would make money.
Random Trading To the Test
I once met with a fund manager, who described his strategy as very similar to that random system in the Harding quote. What was really important to them was the position sizing for each new signal, as well as the exit strategy. The entry signal direction was “irrelevant”.
I found this puzzling at the time and have been wanting to test this idea since then, to verify whether a “random trading” system could indeed be profitable.
The system tested here is composed of random entries with additional “classic” components: a volatility-based fixed fractional money management and volatility-based trailing stop exits.
- The system first “tosses a coin” to decide whether to go long or short the market.
- An initial stop is set below/above the entry price at a distance equal to a fixed multiple of the volatility measure.
- That entry-stop distance is used to calculate the position size, so that the risk per trade (amount lost if trade gets stopped out) is equal to the fixed percentage of account equity.
- Every day, the trailing stop is adjused so that it is never further than the fixed multiple of the volatility measure. The stop always gets closer to the market and never gets adjusted further away from the market (i.e. if the market turns back toward the stop, the stop level does not change).
- When the position hits the trailing stop level, it gets closed and a new position is open. The direction of that new position is again determined by a new coin-toss.
Test Parameters and Results
For this test, I used fairly standard parameter values:
- Volatility Measure: 39-day (exponential) ATR
- Stop Distance: 2 ATR
- Risk per Trade: 1% of Account Equity
The portfolio used for this test is a subset of the one used in the State of Trend Following report, basically all those instruments that I have data for going back to the start of the test: in January 1990 (click for the exact list).
Since this is a random experiment, I generated multiple test outputs (200), all based on the same parameters, and averaged their monthly returns to create a composite equity curve, which performance summary statistics can be seen below:
|Monthly Std Dev||
|Average Monthly Rtn||
The 2-ATR stop level is somehow an arbitrary choice and I wanted to check whether this bore an impact on the test results.
I ran a further test, stepping the ATR-multiple for stop calculation from 2 to 10. Each ATR-multiple set was run 200 times again and averaged to give a composite equity curve.
Normalizing these 9 composite equity curves (for equal monthly standard deviation) and averaging them produced a “super-composite” equity curve composed of 2000 random tests (equally split between ATR-multiples ranging from 2 to 10).
The performance summary statistics of this “super-random-composite” equity curve are below:
|Monthly Std Dev||
|Average Monthly Rtn||
Note how the diversification and rebalancing over several ATR-multiple stop levels have a substantial impact on the Max Drawdown and volatility.
Both equity curves are charted below:
All in all, not too bad for “monkey-style” trading! It goes to show that signal entries, which most beginning traders/system developers focus so much on, are not so important after all…
Update: follow-up post tackling other aspects of randomness in trading systems and clarifying subjects such as averaging and commissions/slippage: Further Musings on Randomness
Credits/Additional Reading: The concept of random entries with trailing stops has actually been discussed before. It seems like it was introduced by Van Tharp in his Trade your Way to Financial Freedom book, and mentioned on this article by Chuck Le Beau, where he expands on the concept of “Chandelier Exit” (name for volatility-based trailing stops).
Thanks and credits also to user “sluggo” on the Trading Blox forum, who published a similar study four years ago, and some code which I reused most of for this study. Note that his study found an opposite result, showing a turn in profitability (downwards) of random systems after 1997 (portfolio and parameter values are different though), so you might want to run your own test to verify this concept for yourself…