Perspective

The Bane of a Trader’s Existence: Asset Volatility and Drawdowns

February 14, 2011

Summary

Wouldn’t it be nice if speculative trading had a performance profile similar to an annuity? The same
profit, day after day, week after week, year after year! Wishful thinking! The reality of speculative
trading is that there are winning trades and losing trades, winning days and losing days, winning
weeks and months and losing weeks and months, and, unfortunately, even losing years (at least for
those honest enough to admit it).

Historically, Factor LLC has been profitable in about 35% to 40% of trades (although during any brief
series of trades the figure might range from 10% to 70%). Based on history, the odds favor that each
new trade I enter will be closed as a loser. My trading plan is based on the expectation of losses.

I know traders who claim to have never had a losing year. I don’t want to by cynical, so I will take
these people at their word and admit that they have achieved what I have not. If you are one of these
people, all the more power to you! You are a gorilla trader. The fact is, I have been unprofitable in four
years since 1981 – the worst year, 1992, experienced a loss of (5.2%).

But losing year or profitable year, asset volatility is the bane of a trader’s world. Asset volatility can be
positive and be represented by a profitable run, but at its worst it is best defined as a capital
drawdown. Drawdowns can be expressed in several ways:
• Drawdown as a percent of assets employed in a trading operation
• Drawdown in relationship to an average rate-of-return (see Wikipedia for the definitions of the
Calmar ratio, Sortino ratio and MAR ratio)
• Drawdown, peak to valley to new peak, in terms of duration measured in days, weeks or
months

It is possible that a novice trader adopts a trading approach that will never be profitable, in which case
the subjects of asset volatility and drawdowns are beside the point. My guess (it is only a guess) is
that 50% of novice traders enter into futures and forex speculation with great hope and enthusiasm,
try one approach after another, but never find a consistently profitable operation. Such an experience
does not represent a character flaw – trading is tough work.

But, assuming a trader has an approach that provides long-term, multi-year profitability, asset volatility
is a subject of real interest and concern. The obvious goal of a trader is to achieve superior
performance (however defined) with a minimum of asset volatility.

The subject of drawdowns is never really applicable to a trader during a hot streak. When one is
running the table, a losing period is the furthest thing from a trader’s mind. When a trader is winning,
he or she assumes winning will be perpetual. When in a losing period, a trader can reach the point of
wondering whether he or she can even buy a profitable trade.

I am in a trading drawdown right now (it started last May), so the subject is very pertinent to me. I
want to discuss the general topic of asset volatility and the specific topic of my current drawdown from
three angles – asset volatility, drawdown measured as a percent of assets and drawdown measured
by duration of peak-to-valley-to-new peak. By the way, I measure drawdown on a month-ending basis

Perspective_Drawdowns_Feb8 1
because I am a position trader. Others might measure it on a weekly or even daily basis. I even know
traders who measure it with a five- or ten-day moving average of trading assets.

Asset volatility

Traders experience drawdowns and asset volatility. In my way of thinking (which tends to be
sequential and linear), there are three components of asset volatility.

1. The amount of leverage being employed during any time period, especially if leverage varies from
trade to trade. Too much leverage at the wrong time, and, ouch!
2. Whether a trader’s approach is in or out of synch with market behavior – this is equally true for
systematic and discretionary traders.
3. Whether a trader is in or out of synch with his or her trading plan – this is far more applicable to a
discretionary trader, but has some truth for both groups.

At all times – good or bad – a trader needs to logically think through all three components. Traders
need to be very attentive to the nature and cause of drawdown periods as they seek, over time, to
modify their trading plans (design and execution) in an attempt to maximize return and minimize asset
volatility. In my mind, the evolution of a plan is VERY different from optimization. I do not believe in
optimization. It is a fool’s dream.

Over the years I have become attached to thinking about asset volatility through the lens of a modified
Calmar ratio. I modify the Calmar ratio to divide average annual return by the average of the worst
annual drawdowns (month-ending basis) over one, three and ten years and since program inception.
The data for my proprietary trading (through January 2011) look like this:

Period Avg. ROR (non- Avg. of Worst Modified

compounded) Annual Drawdowns Calmar
Last 12 months 3.5% (7.8%) -.45
Last 3 years 47.7% (15.7%) 3.04
Last 10 years 28.9% (12.6%) 2.29
Since inception 101.0% (16.2%) 6.23
(1981)

It would be wonderful to think that I would never have a drawdown – wonderfully idiotic that is!
Drawdowns and capital volatility do occur in my trading and the trading of every professional trader I
know.

My trading goal is to achieve a modified Calmar of at least 2.0 over any rolling three or more year
period of time. In my way of thinking, absolute rates-of-return must be understood in relationship to
the asset volatility required to achieve those rates-of-return. An average annual ROR of 21% with an
average worst annual drawdown of (7%), or a modified Calmar of 3.0, is FAR, FAR, FAR superior to
an average annual ROR of 45% with an average worst annual drawdown of 30%, or a modified
Calmar of 1.5%. In fact, in my opinion, the former performance profile is twice as attractive as the later
performance profile statistically, and three times better emotionally. Of course, a fuller examination of
the performance profile for each duration period would include a look at the worst single drawdown,
providing another important angle in understanding risk-adjusted performance.

By the way, I am not a fan of the Sharpe ratio for futures and forex trading because it penalizes
traders that achieve their gains in a small proportion of months, guarding their capital in other months.

Perspective_Drawdowns_Feb8 2
Drawdowns

The profile of profitability in futures and forex trading is as important as the size of the profitability.
There is an old trading adage with great wisdom: “It is easy to make money in the markets, just try to
keep it.” So true!

I have no interest in an approach to speculation that gains 100% in one time period only to lose 50%
in the next time period. In my opinion, risk and money management are far more important than
signal generation. Novice traders place priority on signal generation. Seasoned pros place their
priority on risk and trade management. The performance profile of any trading program must include
both profit achievement and asset volatility.

Drawdowns can be measured in two ways – as a percent of the underlying capital base and in terms
of duration. As I mentioned earlier in this communications, I am in a drawdown presently, so I will
focus on this present drawdown to generate some metrics in comparison to previous drawdowns.

Since 1981 the proprietary trading of Factor LLC has generated an approximate cumulative ROR of
something north of 31,500%, or an approximate 41% annual compounded ROR. Each $1,000 of initial
trading capital has produced actual profits of $315,000, not counting interest income. The two graphs
below show the exact same NAV per initial $1,000 – the graph on right with a numeric scale, the
graph on the left with a semi-log scale. [Elliott wavers, please do not label this graph and send it to
me!]

Factor Trading LLC Proprietary Performance Factor Trading LLC Proprietary Performance
October 1981 through January 2011 October 1981 through January 2011
$1,000,000 $401,000

$351,000
NAV per initial $1,000

NAV per initial $1,000

Value per Intial $301,000 Value per Intial

$1,000 $1,000
$100,000
$251,000

$201,000

$151,000
$10,000
$101,000

$51,000

$1,000 $1,000
1981 Year 2010 1981 Year 2010
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
Actual performance based on attestation of federal tax returns and brokerage statements Actual performance based on attestation of federal tax returns and brokerage statements

The graph on the right does a better job of graphically showing the drawdowns, including the present
drawdown. Since 1981 I have experienced 15 drawdowns exceeding 8%.

The scatter graph on the following page shows the size of the drawdowns and the duration of each
from asset peak-to-valley-to-new-high peak. The red box is the current drawdown which is around 8%
deep and eight months in duration.

Perspective_Drawdowns_Feb8 3
 Factor LLC Proprietary Trading
Drawdowns 1980 to present
12

Duration (# of months)
10
8
6
4
2
0
0% 10% 20% 30% 40%
% Peak to valley drawdown (month end basis)
PAST PERFORMANCE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

[Note: the performance data herein reflect proprietary trading from 1981 through 2008. I stopped trading the Factor
Trading Plan with pure proprietary funding in 2008 and merged proprietary funds into an exempt pool that I control.
The performance data starting in 2009 reflect the pool. Because my leverage was greater prior to 2009, my analysis
has also adjusted the scatter table to normalize leverage (not shown). The scatter table shown here does not
attempt to normalize leverage.]

The current drawdown is at risk of becoming my longest drawdown ever, but the magnitude is quite
mild by historic standards.

The point is this – all trading programs experience capital drawdowns and asset volatility. Welcome to
the real world. Traders who win online trading contests with a 6-month performance of 500% and
think they are untouchable are in for a very rude awakening. Traders who expect annual returns of
100% or 200% are in for a rude awaking. Do the math – a trader who makes 200% per year without
withdrawing a penny is worth $3 billion in ten years. You and I both know this is not going to happen –
not to you and not to me.

I am in the process of evaluating other traders for some IRA funds – under law I cannot self direct my
own IRA futures/forex account. Ideally, I would like to employ from eight to 12 CTAs with a proven
ability to limit drawdowns during their tough periods. Of the 12 CTAs on my current “A” list, the
average of their worst drawdowns during the past 6 years has been (13.3%). The average of their
longest peak-to-valley-to-new peak drawdowns has been 13 months, ranging from six to 23 months.

Having a goal of high performance is wonderful. But traders must be equally concerned about
managing and understanding their risk-adjusted performance.

The wrong time to become concerned with drawdowns is when an account is down 50%. Risk-control
protocols need to be given as much thought at the front end of developing a trading plan as is given to
signal generation, trade management, leverage and other factors.

I hate drawdowns. I have never developed a taste for humble pie. When in a drawdown it is easy for a
trader to start thinking the drawdown will never end. But I have been through so many drawdowns that
I have learned the importance of maintaining the overall trading plan. Critical analysis of drawdowns is
important in real time. Equally important is the confidence that a trading plan with a history of
overcoming drawdowns will once again prevail. This is not the last drawdown I will conquer and it will
not be the last drawdown I will experience.
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