Combining Money Management, Portfolio Metrics, and Strategies for Investing and Trading

Discussed by: Paul Grems Duncan Leader, Tri-State Investors Group July 16, 2001
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Todays Topics
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Metrics a few that will help your trading/investing Three strategies that appear to be working right now Effective Volume Overview and a review of some candidate stocks

Admin
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Example files are located in my forum at http://forums.effectivevolume.com Directions on how to access these files are at the end of the presentation.

Portfolio Metrics: Do We Care?

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Yes! Portfolio Metrics help us understand whether the changes we make to a portfolio are beneficial. To use metrics though, you have to keep some form of log (which I will provide an example )
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My Favorite Portfolio Metrics

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Calmar Ratio Mathematical Expectation Pessimistic Return Ratio There are others (Sharpe Ratio, Sortino Ratio, Upside Potential Ratio, etc.) but they are more difficult to understand and apply consistently (in my opinion).
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The Concept of Drawdown

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What is Drawdown (DD)? Drawdown is the measurement from the maximum (equity, price) peak to the lowest value AFTER the peak. Perceived Drawdown is:
the mechanism that causes us to sell a stock in a decline, resulting in us locking in losses rather than having confidence in our mechanical systems. the enemy of mechanical trading.

There IS a distinction between intra-trade DD and endof-trade DD end-of-trade is far more important!
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Drawdown Example:
Daily Russell 2K Since 1987

Calmar Ratio

Example of CR = 0.82
(CRR = 30.5%, MDD = 37.4%), 12/2/08 to 12/2/09

AAII Accelerated EPS Strategy (Modified Shadow Stock Portfolio Criteria)

Example of CR = 5.07
(CRR = 41.6%, MDD = 8.20%), 5/4/09 to 5/4/10

AAII Accelerated EPS Strategy (Modified Shadow Stock Portfolio Criteria)

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Steps to Track Calmar Ratio

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1) You need your equity curve, either real or backtested. 2) Download CR-CalculationExample.xls at my forum at Effective Volume (once youve registered, of course).

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CR Moves with Time!

(Thankfully, Not Fast)
1996 2010, AAII Accelerated EPS Strategy (Modified Shadow Stock Portfolio Criteria) Average = 2.02 +/- 1.31 Stdev
Well discuss how to use CR and timers to improve a strategy later in the presentation

Ugliness
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Criticisms of CR
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The definition uses the compounded annual return (CAR); this isnt practical for short bursts of trades as the time frames do not align. Trades occurring in a 4-week burst do not extrapolate to 12 months very well. Correspondingly, many people simply use total return (if less than 1 year) and the actual MDD. The purists will shutter, but this latter method works until a solid history per strategy is developed.
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Mathematical Expectation
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What is Mathematical Expectation (ME)? ME is the average take-home amount in a trade scaled by the % of winning trades for the strategy (you have a strategy, right?) All you need is:
Average winning trade amount Average losing trade amount % winning trades for the strategy

In the long haul, ME MUST BE > 0.

ME Example

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ME Example (cont)

In the long run, this example should be profitable, as the ME is shown to be > 0.

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Steps to Track ME
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1) You need to start tracking your trades with a log. 2) You need to track what strategy is being used for a specific trade (you DO have (a) strategy(ies), right?) 3) Download ME-PRRCalculationExample.xls from my forum at Effective Volume this is a log that autocalculates ME.
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Example Trade Log for Autocalculating ME

Worksheet Autocalcs Various Parameters Enter Trades by Strategy

ME-PRR-CalculationExample.xls

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Pessimistic Return Ratio (PRR)

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Pessimistic WHAT? Created by Ralph Vince and published in Portfolio Management Formulas (ISBN 0471-52756-4), this is a REALLY good method to understand your profitability and whether your methods will work in the longer haul. PRR is like ME but it gets better as the number of trades increases.

Pessimistic Return Ratio

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PRR Example

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Steps to Track PRR

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1) Download ME-PRRCalculationExample.xls from my forum at Effective Volume this is a log that autocalculates PRR (yes, this is the same file that also calculates ME).

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Review of Metrics
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Calmar Ratio: Compares gain to drawdown. Tells you if youre taking too much risk (DD > gain is bad) Mathematical Expectation: The edge of a strategy we want positive numbers only here. Pessimistic Return Ratio: the best of the three, it tells us how good a strategy is, and it improves as the number of trades goes up
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Strategies

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AAII Shadow Stock Portfolio

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Standard AAII portfolio: http://www.aaii.com/modelportfolios/stock-rules Focuses on Small Cap stocks between $17 and $200M in size Performance over last year has been quite good, but historically?

AAII MSSP Performance

Actual vs. Modeled, 1997-2010, corr = 0.816
Avg CR = 3.49 +/- 5.14

MDD = ~49%
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AAII MSSP Performance

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The assumption here is that the modeled performance is adequate at corr = 0.816 (1.0 = perfect, 0.0 = no correlation) The drawdown of 49% would most likely have caused most to bail long before this occurred, then losing out to subsequent gains in 2009 and 2010. The average CR of 3.50 is very, very good, but, the standard deviation of +/- 5.14 suggests major losses (3.5 5.1 CR < 0 BIG PROBLEM) How to stabilize CR by reducing MDD?
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Improving AAII MSSP Performance

Market Cap Favoritism There are certain periods in the cycle that Small Caps underperform
Favor Small Caps 1/03 9/08 Favor Large Caps 6/06 5/08 10/08 3/09 Favor Small Caps 6/08 9/08 4/09 - Present

Chart is the RATIO of Russell 1000 (Large Caps) to Russell 2000 (Small Caps) R2K is in the Denominator
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AAII MSSP Performance

Gated w/ Russell 1K/2K Favoritism
Avg CR = 4.59 +/- 5.76

MDD = ~28%
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Stockcharts can Assist in Analysis

http://stockcharts.com/h-sc/ui?s=IWB:IWM&p=D&yr=3&mn=0&dy=0&id=p46574665355

Green = Small Cap Favoritism

Ratio is below trend Small caps are looking better, so watch for it

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AAII MSSP Conclusions

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Its possible to use CR (as well as other metrics) to quantify adjustments to a strategy. The AAII MSSP strategy is a good strategy, but management of the drawdown must occur or well lose confidence in the system. The general trend of favoring large caps or small caps certainly helps to provide confidence that were not running with small caps when the large caps are dominating. Right now it appears that small caps are just coming into favor again
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Mean Reversion Strategies

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What is Mean Reversion? Mean reversion is when a stock or ETF gets overbought or oversold to the extent that after some period of time, buyers/sellers converge and move the price to the mean. Markets generally are in a trend or are meanreverting. Its important to have tools for each market. Larry Connors and Cesar Alvarez have developed a number of strategies to take advantage of this phenomenon

A Comment on Mean Reversion Strategies

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The psychology of mean reversion is opposite to that of trend trading.

In trend trading, you add to your position as it increases. In mean-reversion trading, you add to your position as it falls

If you are not prepared to see negative numbers, then in trendless markets, you may be better suited to sit on the sidelines.
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Favorite Connors Mean Reversion Strategy

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Connors calls it TPS for Time-Price-Scale In This is an aggressive strategy Focused on ETFs You scale-in to a position as the price drops on the long side in a 10%-20%-30%-40% fashion (which equals a 100% position when all done) Connors has conducted much of his work using 20, non-leveraged, highly-liquid ETFs What are the specific rules of this strategy?
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Connors TPS Strategy (Long)

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1) ETF is above the 200d MA 2) RSI(2) is below 25 for two days in a row. Buy 10% at the close. 3) If prices are lower on the close than your previous entry, buy 20% at the close 4) Repeat #3 until you attain 40% Exit on the close when the 2-period RSI closes above 70 A PDF copy of Connors book has been uploaded into the Effective Volume forum; there are more details there. How has the strategy performed?
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Connors TPS Strategy (Long)

20 ETF Inception to 12/31/08
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20 ETF from 1/1/09 to 7/15/11

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1159 Trades Average % P/L = 1.45% Average Holding Time = 6d % Number Winners = 89%

405 Trades Average % P/L = 1.67% Average Holding Time = 5d % Number Winners = 93% ME: 0.203

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Connors TPS Strategy (Long) Equity Curve, 1/1/09 to 7/15/11

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Connors TPS Strategy (Long) Trade Distribution, 1/1/09 to 7/15/11

Note that there are a few trades that fell -14%

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Connors TPS Strategy (Short)

20 ETF Inception to 12/31/08
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20 ETF from 1/1/09 to 7/15/11

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648 Trades Average % P/L = 1.97% Average Holding Time = 6d % Number Winners = 81%

59 Trades Average % P/L = 1.39% Average Holding Time = 6d % Number Winners = 75% ME: 0.163

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Connors TPS Strategy (Short) Equity Curve, 1/1/09 to 7/15/11

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Connors TPS Strategy (Short) Trade Distribution, 1/1/09 to 7/15/11

Note that there are a few trades that fell -12%

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Optimizing Connors TPS Strategy

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One criticism that I have of this strategy is that it can tie up capital. On the bottom of the previous equity graphs there is a graph to the Number of Open Positions. For the nonleveraged ETFs, this could be close to all 20 positions. What about using leveraged ETFs, and simply reduce the position size? This next test uses the Direxion +/- 3x Leveraged ETFs
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Connors TPS Strategy (3x Long)

1x 20 Long ETF 1/1/09 to 7/15/11
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3x ETF from 1/1/09 to 7/15/11

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405 Trades Average % P/L = 1.67% Average Holding Time = 5d % Number Winners = 93% ME: 0.203

163 Trades Average % P/L = 4.33% Average Holding Time = 5d % Number Winners = 89% ME: 0.492

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Connors TPS Strategy (3x Long) Trade Distribution, 1/1/09 to 7/15/11

Note that there is 1 trade that fell >60%

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Connors TPS Strategy (-3x Short)

1x 20 Short ETF 1/1/09 to 7/15/11
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-3x ETF from 1/1/09 to 7/15/11

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59 Trades Average % P/L = 1.39% Average Holding Time = 6d % Number Winners = 75% ME: 0.163

70 Trades Average % P/L = 1.53% Average Holding Time = 8d % Number Winners = 74% ME: 0.091

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Connors TPS Strategy (-3x Short) Trade Distribution, 1/1/09 to 7/15/11

Note that there is 1 trade that fell >30%

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Connors TPS Strategy Conclusions

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TPS has a positive ME in all 4 cases (nonleveraged, leveraged, long, short). The greatest edge (ME) is going long with the +3x Leveraged Direxion ETFs, followed by going long with the +1x original ETFs that Connor tested. The greatest net gain per trade is long with the +3x Leveraged ETFs ( +4.33%/trade), followed by long the +1x original ETFs (+1.67%/trade)
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The IWM and GDX Robots

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Pascal Willain and Billy ONair have created two very focused, mechanical trading systems that are available at the Effective Volume web site which are profitable. The first system, which uses IWM and related ETFs, is based upon the 20d Money Flow, established using Pascals Effective Volume tools, as well as precise entries/exits using pivot levels, statistics, and risk/reward ratios. This is a combination mean-reversion and trendfollowing system. The second system, which uses GDX, is based upon money flow, looking specifically for extremes, then fades these situations. This is a mean reversion system. These two instruments were chosen because they are not highly correlated. Detailed FAQs can be found on the Effective Volume site, under the heading Robots. You must be a registered member to view.
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Theoretical Equity Curve for IWM Robot

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Theoretical Equity Curve for GDX Robot

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Pauls IWM Robot Performance

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Just started getting really serious with the IWM Robot. 15 total trades, 10 long, 5 short. ME: 4.58 PRR: 1.08 (but only have 15 trades)
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Summary of Strategies
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The AAII MSSP strategy is a good strategy which can be improved upon by incorporating a larger signal which kicks you out when small caps are out of favor. When trend-following does not work, meanreversion via Connor strategies can keep some income moving in. Pascals and Billys robots are proving their worth, and a forward test of the IWM robot is very profitable.
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Effective Volume aka Follow the Whales

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Effective Volume, developed by Pascal Willain, separates minute-by-minute volume and price movements, resulting in assigning volume movement to two groups:
Large Effective Volume (LEV): volume attributed to institutionals and other big players. Occurs because once the bid/ask is satisfied, the price must move up if the bid is unsatisfied, else the price must drop if the ask is unsatisfied Small Effective Volume (SmEV): volume attributed to retail buying and selling of an equity. Typically, small selling does not move the price a significant amount over extended periods of time.

EV money flow, which is determined by buying/selling of institutional investors by averaging individual money flow within ~92 industry groups, can tell us what the markets are doing overall and whether we should be long, cash, or short.

How I (Paul) Use EV

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Lets say that I have a stock candidate. Since 30% of the price movement is historically related to institutional buying, I check the EV site to see if
1) the industry group/sector that the stock belongs to has accumulation across many stocks in the group. Institutionals typically buy multiple stocks in a hot sector 2) if the stock is showing a positive divergence in large effective volume compared to small EV.

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There is a movie posted EV site that I created and which shows how I navigate the different information. GGT (Pauls system) and EV work together nicely to identify early breakouts; heres an example:
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GGT + EV Stocks

These are favorable EV stocks for Monday (VNR, CL, MDVN, DVN, and CDE). Two are showing EV buying: CL and CDE. VNR just turned into a GGT New Long, which is favorable. Lets look at the first 3:
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VNR
Group just issued a buy signal because large player strength has jumped above 0%

Notice how Total EV is converging on trendline stock is being accumulated

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CL
Group recently signaled a buy but has dropped back below 0 and the trend line. CL is a wait

Upward trending average line shows constant accumulation

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MDVN
Group recently signaled a buy and trendline is just crossing 0 from below very bullish for group.

Weaker TEV trend line but the fact that TEV has crossed above is very positive
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The Days Summary

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We covered three relevant metrics to assist you with your portfolio:

CR, ME, and PRR

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We looked at the AAII MSSP performance, and then suggested a method to improve drawdown which will help CR in the long run. The method is not related to the strategy at all (What was it? Hint: Russell 1K vs. Russell 2K) We looked at Connors TPS Mean Reversion Strategy and found a strategy that slowly, but with a positive edge, generates profits. We concluded that the 3x leveraged ETFs have a better edge and better gain than their 1x counterparts. We looked at two mechanical strategies that have phenomenal backtesting performance and the initial forward test is going very well. We looked briefly at how I evaluate GGT + EV stocks, specifically using the EV web site after I have candidates. There are files to download at the Effective Volume site. You must register to view these files; directions follow on the remaining slides.
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From Pascal Willian, Creator of Effective Volume:

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If you are interested in becoming a member at the Effective Volume site and accessing the EV data, there is a special offer for AAII participants: Go to http://www.effectivevolume.eu/EV_Subscribe_Special.html and if you mention that youre an AAII member and attended this presentation, youll get $10 off the yearly subscription of $149 (most of which goes to charity see the web page). This will give you daily access to EV data on over 1000 stocks and 200 ETFs. It is an eye opening experience to your investing/trading. Further, if youre interested in the IWM and GDX robots, let me (Paul) know, and Ill see what I can do for a free trial.
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Registering for Access to Presentation Files (and Pauls Forum)

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Step 1: Registration Page at Effective Volume

http://forums.effectivevolume.com/register.php?
In the Registration Question Please state Registering per Paul Duncan / AAII Wash DC Meeting

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Step 2: Confirmation of Registration

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Step 2: When you receive an email confirming your registration, click on the link in the email. You will receive the following screen:

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Step 3: Registering for Pauls GGT Forum

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Step 3: After you receive the previous screen, youll have to wait for an admin-type to approve you into the forum. You will receive an email when this is completed. IF you specified that you were from the AAII Wash DC group, you should be automatically added to the GGT Forum. Here is how you check: 1) Log In to http://forums.effectivevolume.com 2) (next slide)
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Step 3: Checking/Registering for Click this First Pauls GGT Forum

Pauls is the GGT Group

See if this says Leave Group or Join Group Feel free to join the other groups it is free.

Click this 2nd

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Access to AAII Presentation Files

This thread Links contains the links to the files; They are at the BOTTOM of the thread.

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File Location w/in Thread

Note: this is message 1 of the thread it is at the BOTTOM of all the messages

The Excel files will be located under this header

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Paul Duncan (703) 509-5332 grems8544@gmail.com

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