Today is the big day…
After months or years of research, your trading system is finally deemed ready for production, and the latest back-test shows open trades as of yesterday (from earlier signals). How do you handle these positions in your new system today?
You have two basic options:
- Skip these positions and only enter as and when new signals arise.
- Enter the positions today, as if your system had taken the entry signals in its past, back-tested life.
The back-test did not skip any signals, as option 1 would, but neither did it enter trades in the middle of their life, as with option 2. How to decide which option to pick?
You could take a “middle-of-the-road” approach and decide to take the positions at only half their normal size, effectively mixing options 1 and 2, but let’s consider both options individually.
Option 1 takes the risk of “missing the boat” on big winners, whereas option 2 might get you in the trades at a point where heat is running at a much higher level than at typical entries.
With regards to this last point, please consider an extract from “A trick to reduce Drawdowns” where I expanded on the concept of lifecycle of a Trend Following trade, heat, open equity risk vs. closed equity risk:
By nature, Trend Following is a strategy prone to drawdowns because of the way it waits for the trend to reverse before closing the position. On any winning Trend Following trade, there is often a lot of open equity “given back” to the market.
Below is an equity graph of the life of a hypothetical Trend Following trade:
Entering a trade “half-way” carries the risk of being directly exposed to a large trade heat. What this would do is transform a potential open equity drawdown, after a profitable run, into a closed equity drawdown directly from the start of trading. Instead of having a good performance followed by a bad performance, the system would potentially suffer from negative performance from the start.
Testing Both Options
Apart from the starting point of the back-test, all trades are usually taken as soon as entry signals are triggered. No skipped trades and no late entries. Ideally, you would want to run tests to show where the system would stand now if you had started live trading some time ago (let’s say one year ago for example) with either option. Where would the system stand at the end of last year if you had started trading with either option two years ago, and so on.
In order to test this and cover a wide array of possible start dates, I ran a stepped parameter back-test with staggered testing periods, covering 1990 to 2010.
The system used for this test was the 20-50 Moving Average Cross-Over system featured in the State of Trend Following report.
About 850 tests were run, with each test starting 5 days later than the previous test and covering 1250 trading days (to allow for long running trades to complete from the start).
Each test is run twice, covering options 1 and 2 for the trade start methodology.
The results of all tests allow for a performance comparison to try and understand which option performs better on average. Below is chart of the difference in CAGR for each test:
The difference plotted above is absolute (a 5% absolute difference does not have the same significance if the CAGR is 10% or 100%). The average difference is -5.05% for an average CAGR of 29.9%, which gives us a better idea of the relative difference. Note that the difference is also a function of the length of the test.
The results seem fairly biased towards option 2 (enter all positions as soon as the system goes live), which can seem counter-intuitive from some point of view.
Below is an additional chart plotting the difference in Sharpe ratio:
Some traders might still not enjoy the idea of idea of jumping on-board trades with higher heat levels. A fairly obvious solution to this would be to add stops to initial entry points only in order to reduce system heat at the start of trading. Trading a system with stops and volatility-based position sizing would also do this naturally. Either way, this could possibly represent a third option, combining the best of both worlds. Something else to test…