Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article Searching for Returns in a Yield Starved, Sideways Market by D.R. Barton, Jr.
• Trading Education Gain Peak Performance in Your Trading
• Trading Tip The Ups and Downs of Backtesting by Ken Long
• Workshops Two Events Added in July
• Mailbag Accurate Analysis of Strenghts and Challenges

by D.R. Barton, Jr.

My dad is the best fisherman I know. While I grew up in a small college town in the southwest part of Virginia, my dad was raised almost an hour way in what we call “the country”—a tiny town of a few hundred people, nestled in the Blue Ridge Mountains.

Dad grew up hunting and fishing and helping out my grandpa and grandma in the family store, called a Five and Dime back then. Fun for my dad was packing a lunch, grabbing a fishing pole, and heading into the woods for a day of fishing.

When we were kids, my dad loved to take me and my brother out to lakes, rivers and streams around my home. My guess is that his patience as a fisherman helped immensely with his patience as a parent, and goodness knows, he needed it while raising me!

I vividly remember two particular fishing trips from my youth for very different reasons. The first was a day when were going fishing with my best friend and his dad. It rained pretty hard that morning and we weren’t sure whether we’d get to go fishing at all. When the weather broke and we finally got to the lake, the fish were really biting; they were practically jumping in the boat! We caught dozens of fish between the four of us in a few short hours, with my dad, of course, catching the most. That was probably the best time I ever had fishing.

The other trip I clearly remember was just a short time later. That summer morning was hot, steamy, and beautiful but not a fish was biting. After awhile, I became irritable because I kept thinking about that recent big haul of fish and because of my childlike lack of patience (okay, my lack of patience that has carried over into my adult years).

Trying to keep a fidgeting son on task while teaching me patience in a lighthearted way, my dad told me something that morning that I’ll never forget, “Sometimes you just have to be glad that you don’t have to give any fish back.”

The financial markets recently have reminded me how trading tends to be like fishing: sometimes the big returns just seem to “jump into the boat” and at other times, like the markets so far this year, patience is called for.

Taking What the Market Gives You

When the real estate bubble burst in 2007, we had an 18 month period in which the financial markets left nowhere to hide essentially. Practically every asset class got hammered.

That’s when my best friend, business partner, and true market maven, Christopher Castroviejo reminded me of an old British banker’s saying: “Sometimes the return OF your money is more important that the return ON your money.”

Even though 2011 has not been a down year for the equities markets, it again poses some unique difficulties because those seeking returns are finding very little to choose from.

Low Yields, Sideways Volatile Markets

The first half of 2011 has been a trying time for those seeking either returns or “alpha” (outperformance vs. the S&P 500 or other benchmark). The themes this year so far have been sideways and volatile for equity markets and sideways or down for most everything else.

Hedge fund returns on average are as flat as the major indexes. In fact some of the biggest names have struggled. John Paulson, known for placing large directional bets, has had multiple, double-digit down months trying to catch the next up leg of the commodity move.

Let’s take a quick look at a fairly a broad swatch of asset classes.

Here we see the S&P 500 within a few percent of its 2010 close, but it took a volatile up and down path to get there.

Gold is up a moderate 6% and may have at least short to intermediate term difficulty pushing through its recent double top.

Crude oil made a strong top in April and has had nothing but downside since then, including the excess supply added when the US tapped into the strategic oil reserve just days ago.

The long term US Treasury bond ETF is up less than 2% for the year. In this yield-starved world, the current benchmark US 10-year note hit low yields for the year last Friday—below 2.9%. With stated inflation in the US at around 3% (while the real inflation is much higher), locking up money for 10 years and making less than the rate of inflation makes little sense. This is one of the reasons for the market’s volatility. As the last of the QE2 money flooded the financial markets buyers were not heading to low-yielding treasuries but looking for returns in the stock market, driving prices up. They were only to be answered by consistently negative news: the Japanese natural disaster, the Greek debt crisis, a flagging economy and more.

The CRB Index shows how flat commodity prices have been, especially given the strong run-up that commodities saw from the summer of 2010 until April of this year.

In short, historically-low yields in the fixed income world and a dearth of returns across a broad list of other assets make this year a challenging time for longer term traders to find any satisfaction. We might be well advised to take my dad’s sage fishing advice: be satisfied, at least in current market conditions, not to have to throw any back.

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "iitm.com".

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Trading Tip

by Ken Long

Back testing is a crucially important way of understanding a trading system and the process is an essential part of a complete trading plan. That being said, too much back testing can lead to learning the wrong lessons if you’re not careful.

Traders should respect the synergy between professionalism and experience in their level of backtesting.  Even an experienced trader should carefully consider the results of a detailed back test when taking on a new strategy or operating in a new time frame so that his experience provides proper expectations rather than blinds him to some new aspect of the system. 

Traders can back test to various degrees depending on their experience, beliefs, and objectives. In some cases an experienced trader who is considering an idea that is similar to previously reliable systems may only need minimal back testing to be convinced that the idea is worth trading with live money at a reduced risk level. For others, the validity of a trading idea may not be convincing until they see it work over multiple time frames, in multiple markets and in all different market conditions.

The type and level of backtesting is largely a matter of personal taste; it comes down to personal choices about the risk of capital rather than a theoretical exercise in the pursuit of absolute truth. Leave that for the academics. We want to make money. 

Benefits of Back Testing

Properly constructed back testing will identify whether or not an idea has a persistent edge and under what conditions it will manifest. By properly controlling for different parameters, we can isolate those which add the most value to a particular proposition. We can test for robustness and measure the sensitivity of the edge to changing parameters. From that, we may be able to identify specific market conditions where the edge is significant and tradable or identify a subset of the total market trading targets in which this idea works best. 

Back testing should reveal the likely win rate percentage, the importance of slippage and commissions, the trading frequency, the maximum adverse excursion, the longest normal winning and losing streaks, and both the maximum and average figures for wins and losses. 

One of the most important result sets for analysis is the distribution of R-multiple results in the form of a frequency histogram. We would like to see a somewhat normal distribution that has most of the trades clustered around the mean and with an orderly profit tail to the right.  A tail of some high, positive R-multiples suggests we have the possibility of large winning trades. We would also like to see a carefully-controlled left tail of losses that suggests we are able to engineer our risk with some confidence. 

Having this kind of data in hand allows us to determine where, when and under what conditions this idea is tradable and the expected results. When we proceed into live market trading the prototype system with minimal risk, we can then compare actual results to backtest results to see if the trades can be managed as intended. 

Under these kinds of conditions and looking for this kind of information, back testing is an important part of the trader’s repertoire.

Limitations of Backtesting

One of the primary downsides of back testing is that it can lure the trader into overconfidence about a system based on how it performed in the past.

There is always a real danger of curve fitting and data mining to find a perfect system that worked with a set of past market conditions in the past but will never occur again in the future. The market is a complex, adaptive system that never shows traders the same face twice. 

Even when traders perform a backtest rigorously and with full knowledge of the limits of its ability to forecast into the future, they will commonly see a large discrepancy between backtest results and actual results from live trading. 

There are several potential causes for this discrepancy.  Sometimes, traders will backtest a system in isolation and not as part of a full portfolio of strategies. Often back tests may use unrealistic values for slippage and commissions. Many times the backtest will not take into account the human dimension of executing a set of trading rules. Experience shows that this is one of the most overlooked aspects in back testing. 

Backtesting specifically, and any forecasting method in general, has limits and that’s perhaps the biggest challenge for traders to understand. Some traders place so much reliance on their back testing that the evidence of divergent actual results will not convince them that they missed something important. They might persist in trading a system that will simply not work in the real world. (Attribute this to the overconfidence bias combined with the need to be right.) 

Professional engineers and doctors are especially prone to this common problem because of their ingrained belief systems from their professions. Those professions in particular place a premium on being right to be successful, yet in the trading profession, the ability to act with incomplete knowledge and a willingness to be wrong often leads to the best results. 

While back testing offers many powerful advantages, the professional trader concurrently recognizes the limits of its usefulness. The professional trader should take back testing results into consideration as a way to select a system to prototype with real money, in real markets with the human factors fully engaged to see what the real world results look like before committing to full production system risk.

About the Author: Ken Long is a retired Lieutenant Colonel in the U.S. Army with a Master's Degree in Systems Management. He is a doctoral candidate researching the management of uncertainty and an active trader. He is a proud father of 3, a husband, teacher, student and martial artist. Ken is also a dynamic workshop instructor for the Van Tharp Institute. The above article was reprinted from Ken's blog. Read more of Ken's essays at http://kansasreflections.wordpress.com.

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Workshop

Two Events Added in July

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Mailbag

Thank you for the information in my Investment Psychology Inventory Profile Report. While I should probably not be surprised that you are able to so accurately analyze my trading strengths and challenges on the basis of a questionnaire, I find it quite encouraging that this is the case. For this means that I am no different than anyone else; therefore, by applying the correct principles, I will make the necessary changes to achieve success. I am eagerly awaiting the Peak Performance Course and can’t wait to get into it.

I also want to thank you for your recent series of articles. While I had heard about the Peak Performance Course from a friend of mine who has it, it was the first of these articles that made me determined to do it myself. But the one I loved the most was the third article, on Raising Your Consciousness. I have read Dr. Hawkins’ Power vs Force and I love it. I would say that my ambition in life is very similar to yours in terms of achieving Awakening. I am now determined to get the money together to join your Super Trader Program and attend all of the workshops that you talk about.

Thank you very much,
T.W.

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