Why The Small System Trader Fails
Friday, January 8th, 2010Wisdom is meaningless until your own experience has given it meaning and there is wisdom in the selection of wisdom – BERGEN EVANS Author and Professor
Those of you that follow this blog know that I am a big fan of a definitive trading plan. Having a plan however, does not equate to success, there are still limitations. One limitation is the small account. Unfortunately, the small account has many more obstacles to overcome to be successful than the large account. Let’s take a look at why that is the case.
Most commodity futures have underlying collateral value in the tens or hundreds of thousands of dollars. A gold contract for example is worth $113,000 today and crude oil is $82,000. When you add low margin requirements and increased volatility into the equation, you have a recipe for small speculation disaster.
So, what makes the larger account fair better in the long run?
Well, to name a few reasons, large accounts can afford to trade virtually any opportunity, at any time. There are 75 to 100 or so liquid commodity markets worldwide, and should buy or sell opportunities emerge, a large account can easily afford the margin and risk to trade them all. In addition, they can scale into and out of positions. This is in stark contrast to the small account where prudence dictates only having exposure in a limited number of markets with one contract.
Also, large accounts are not restricted from trading contracts whose volatility is relatively high. For example, a gold trade today with a 5% cash stop would translate into over $5600.00. That happens to be a little over one half of 1% of a million dollar account, yet over 11% of a 50K account.
Now, the devils advocate would say that “I wouldn’t use such a wide stop”, but it’s necessary to use expanded stops in expanded volatility to avoid being stopped out by “noise”. Also, as the contract becomes more valuable, the risk to trade it increases. Gold is not $400.00 anymore it’s $1130.00 per ounce. A 10% move now is close to three times the dollar risk of $400.00 gold.
To stay with the gold example, we run an in-house volatility filter that is currently suggesting that gold has $1238.00 of daily noise (around 12 dollars). So, if you are trading gold and would like to be “outside the noise”, 3 standard deviations would suggest a stop at $3714.00 (around 37 dollars). Even this wider stop does not insure anything, as we all know markets frequently make 3+ standard deviation moves on a routine basis.
So, in a nut shell the 50k account trading gold would have to risk close to 7.5% of his account (per trade) to hopefully stay in the game of trading gold. Good luck with that.
So, how can we trade a smaller account that has the probability of success equal to the large account?
One approach we have explored, and now successfully trade, is the concept of building a model that employs multiple systems, and multiple markets, along with an effective filtering process and risk management controls.
Let’s elaborate.
The process of running multiple systems over many markets will generate a fair amount of trades (like the large account). The filtering process, and the risk controls however, allowed us to filter down the many trades to a few “higher probability” trades. Since the small account cannot take on all the trades, it is the next best approach. This strategy attempts to identify a limited percentile of all the markets it tracks as being the best candidates, using a systematic process to select the few that the small account can handle in terms of volatility and risk.
The portfolio selection process is dynamic as opposed to static (like the small account). This means that from day to day the basket of markets we would trade can change due to strength, weakness and/or volatility changes. We feel this keeps our trades limited to only those markets with the best risk adjusted potential. This allows us to evaluate a very large portfolio (like the large account) while still keeping the number of trades and margin requirements very low to address the small account.
Monitoring a very large portfolio is critically important because if you initially limit yourself to a predetermined small portfolio, how do you know that those markets will be the best markets in the future? (Hindsight bias portfolio selection is a form of curve fitting and is a major downfall of many traders). If an exceptional opportunity develops in a market outside of your predetermined portfolio wouldn’t you want to take advantage of it? By trading with this type of strategy you don’t arbitrarily rule out any market that may perform well in the future and you have eliminated the tendency to pick a portfolio based merely on past performance (curve fit) considerations. See related post
If anyone would like to see more detailed research, feel free to contact me.
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on January 21st, 2010 at 1:36 PM Said:
[...] “Experience helps in developing a successful trading system. The most common and most dangerous error made in system development is curve fitting. One thing we have learned over the last 15 years is that curve fitting cannot be understood by theory alone. There are many statistical traps that can only be learned by trading systems real-time.” Read related post [...]