Trading thunderdome member Grants' monthly letter

If you've been with me for a while you've seen me showcase some of Grant's work. Grant is a team mate in the Trading Thunderdome and continues to generate great research and insights. He started writing a monthly letter summarizing his thoughts and keeping his investors updated along the way. 

You will recognize the heavy focus on market regimes in his writings but you will also notice that he has taken the work he did in the Systems Mastery Course and ran off in his own direction with it. 

THAT IS EXACTLY HOW IT SHOULD BE DONE!

If you did the Systems Mastery Course you should have a lot of your own ideas and now have a framework for how to turn that into a trading business. 

In other news, the new direction that we will be taking the Thunderdome idea will go live this week. Currently the things we are looking to offer are:

• Private Slack Channel
• Access to the long term ETF Global Macro Portfolio
• Daily Swing setups in FX and Futures
• Access to backtests of strategies and rules
• Zoom sessions

But what else would you all be interested in? Reply to this email and let me know

----------------

And without further delay, heeeeeeere's Grant!

----------------

6/28/2020

Second Sight Capital June 2020 Monthly Report

Portfolio Overview

First full month of trading is in the books. As I am writing this it looks like our portfolio will be down just over -3% in total. This provides me a great opportunity to talk about important performance metrics that we will be tracking.

I use software called Edgewonk as one of my trading journals. It is nice and convenient for daily, weekly, and monthly journaling of personal thoughts and has a clean dashboard function. Overall, it is a useful tool that I will be sharing screenshots from and filling in gaps when needed.

As you can see, it provides a fair amount of information. Do not be overwhelmed, we will go through line by line. The more we go over this information monthly the more familiar it will become.

• Win Rate: Winning Trades/Total Number of Trades 

• RRR (Risk Reward Ratio) Planned: (Target Price – Entry Price)/(Entry Price – Stop Loss Price)
  
• Sum R-Multiple: SUM of (Exit Price – Entry Price)/(Entry Price – Stop Loss Price)
  1. Sum of Realized RRR
• Expectancy: Total Profit or Loss/Total Number of Trades
• Profit Factor: (Average Winning R-Multiple/Average Losing R-Multiple)
• Average Winner Performance
• Average Loser Performance
• Volatility
• Sortino Ratio: (Average Portfolio Return – Risk Free Rate)/(Standard Deviation of Loses)
  1. Does not penalize upside volatility of a portfolio which makes it superior to the Sharpe Ratio
  2. We want upside volatility in our portfolio, we are concerned with downside volatility (aka losing money!)
• Sharpe Ratio: (Average Portfolio Return – Risk Free Rate)/(Standard Deviation of Portfolio Returns)
• Total BE (Breakeven)
• Win Rate without BE

It is lacking some information and its focus, win rate, is a flawed metric to measure performance. I would like to provide a list of metrics I will be following and sharing as our business progresses:

• Profit Factor (>1.5 is Good, >2.5 Excellent, >3.5 is World Class)
  2. This gives us insight to our average winning trade versus our average losing trade. So, the higher the profit factor of a strategy the less win rate plays a role in profitably. My goal is to run a portfolio of strategies that averages a Profit Factor above 2. For every 1% we risk in our portfolio we make 2% when we win. If our win rate is 40% one year our average win would be .2%. This is enough to cover costs and breakeven for the year.
  3. A question might arise, why aren’t we striving to have a profit factor above 3.5? This is because mean reversion and trend following systems have different acceptable Profit Factor ranges. Our trend following strategies we will be looking for Profit Factors greater than 3. Our Mean Reverting systems I wand t profit factor greater than 1.2.
  4. Final note, trend following opportunities are less prevalent than mean reversion opportunities. Therefore, we will have more mean reversion trades a year than trend following trades driving down our average Profit Factor.
• Gain-To-Pain Ratio (>1 is Good, >2 is Excellent, >3 is World Class)
  1. This is calculated by dividing the sum of monthly portfolio gains by the absolute value of monthly portfolio losses
  2. We care about this on a:
     1. Rolling 1 Year
     2. Rolling 3 Year

• Rolling 5 Year

1. All Time

3. This metric is important because we want to have more winning months than losing months and we want out winning months to be larger than our losing months. There is no context need to use this metric. We will be looking to have a Gain-To-Pain Ratio greater than 3.

• Calmer Ratio (>2)
  1. The Calmer Ratio is your Average Annual Return/Absolute Value of Drawdown
     1. 3 Year
     2. 5 Year

• 10 Year

1. I only care about our returns with respect to the risks that we take. Let us look at two Portfolio Mangers and determine who has been a better manager:
   1. Manager 1 has returned 22% Compounded Annual Returns for the last 25 years. Manager 2 has returned 6% Compounded Annual Returns for the last 25 years.
      1. By purely looking at Compounded annual returns everyone would choose Manager 1 as the superior manager. But, now let us add in their drawdowns.
   2. Manager 1 has had drawdown as deep as -50% lasting 3 years and his average drawdown is -25% and lasts on average 18 months.

• Manager 2 has had a drawdown of -5% lasting 6 months and his average drawdown is -2% and lasts on average 2 months.
  1. Manager 1 Calmar Ratios
     1. 25%/50% = .5
     2. 25%/25% = 1
  2. Manger 2 Calmar Ratios
     1. 6%/5% = 1.2
     2. 6%/2% = 3
  3. We can see that Manager 2 is a far superior manager. It could be that he has mandates that restrict his allowed drawdown and therefore his compounded annual return will be lower. This is not a completely random example. I would say that Manager 1 is Warren Buffett and Manager 2 is a firm like Prerequisite Capital 

1. Buffett

1. Prerequisite Capital

• Close Trade Net Asset Value
  1. This is for simplicity and it smooths out our equity curve. Our Belief is that profit is not achieved until the trade is closed. Therefore, looking at a trading profit in an open trade is not important. We have not banked our earnings yet therefore they are not ours.
• R-Multiples
  1. Tracking R-Multiples allow me to calculate Profit Factor, Expectancy, and SQN
• Expectancy
  1. Sum of R Multiples/Number of Trades
  2. We need to know one average how much we expect to make when we put our money to risk.
• System Quality Number (SQN) (>2.5 Good, >3.5 Great, >4.5 World Class, >7 Holy Grail)
  1. SQRT(100)*(Expectancy/Standard Deviation of R Multiples)
  2. This should remind you of the Sharpe Ratio, which I said is not a great performance metric.
  3. The SQN is important because it is measured using trade expectancy not a returns-based calculation. It provides insight to how easy the strategy is to trade. If a strategy is too reliant on one big trade a year it will not be easy to trade. The strategy will have a low SQN because the standard deviation of R Multiples will be very high. We would expect a high variance of results year over year.
  4. The SQN does not penalize upside volatility as much as the Sharpe Ratio because it uses expectancy in the numerator. Also, a popular approach is to remove the top 5% of winning trades to see if your system will still have a reasonable SQN. Again, constantly testing for robust results.

Metrics provide some level of benchmark where we can gain an understanding of how we have performed in the past. Notice how we mention the past not the future. The only constant in markets is that they change. By tracking metrics, we might be able to see when a system is broken, therefore robustness in system development reigns supreme. Fragility is an enemy, so we choose metrics that prioritize robustness. Also, I want to note the metrics that are missing from my list:

• Win Rate
  1. Win Rate is a byproduct of the type of system you are trading. Mean Reversion will have higher win rates of 60%+ and Trend Following will have win rates of 40% and less
• Compound Annual Return
  1. This is subject to the position sizing strategy one chooses to implement. It has no real meaning to determine if a system is good or not.
• Drawdown
  1. Same issue as Compound Annual Return
• Sharpe Ratio
  1. This calculates the standard deviation of returns. So, it does not like any volatility, even when our firm is making money. This metric clearly favors mean reversion strategies over trend following.
• .
  1. The list of bad metrics goes on and one. Remember, focus on robust metrics that you understand the context of the strategy you are implementing.

If you have questions or want me to write more about a subject email:

[email protected]

Chart Book

S&P 500 Index

We care about the 2948 Level and 2551 Level in the S&P 500 Index. We are clearly in a sideways regime with a bullish bias. There can be a nice bear trap setting up when price dives below 2948.80 and then reverses. This is the type of trade we will be looking to take. If you ask me if stocks are going higher or lower over the next year, we will have to say higher. But this is not because we have faith in the fundamentals or think the market is at a fair valuation. It is simply because stocks on average go up and governments have every incentive to keep the tide rising. We will be able to see clearly when stock move into a bear market and act accordingly. Below the 2551 Level can be devastating and if we do trade lower it will act as a magnet.

Nasdaq 100 Index

Last week we were able to make new all-time highs in the Nasdaq. This is an impressive move. When we look to own stocks, we do look to own relative strength. Look at NDX/SPX from 1985 to Present:

The Nasdaq has massively outperformed the S&P 500 over this period. Why? Do you even need to know? Just recognize the regime using price and go with it. No need to predict, react to the real time changes. With price you can see when the regime changes and you can change your strategy. Being flexible and admitting when one is wrong are important to superior returns.

US Stocks vs. Rest of World

We are comparing two Vangaurd ETF’s here. VTI is US Total Stock Market ETF and VEU is the All World ex-US ETF. Again, we want to be long US Stocks right now. When the trend changes, we will be able to capitalize and change our opinion. I will compare some individual cases. When price is moving higher the Nasdaq is outperforming. When price is moving lower the other asset is outperforming: 

QQQ (Nasdaq)/EWG (German Stocks)

QQQ (Nasdaq)/EWJ (Japanese Stocks)

QQQ (Nasdaq)/RSX (Russian Stocks)

QQQ (Nasdaq)/EWW (Mexican Stocks) 

QQQ (Nasdaq)/GLD (Gold)

QQQ (Nasdaq)/TLT (20 Year Treasuries)

This all goes to show that we want to understand what assets are over performing and which are under performing. This provides us insight where we want to put risk capital to work. As you can see, we would want to be invested in Mexican Stocks over Nasdaq Stocks between 2000 and 2012. Assets around the world are competing for capital flows. We can recognize where the long-term flows are moving and capitalize on those trends. Regime Recognition makes up 80% of the returns will see as a firm, Risk Management makes up 15%, and Trading Tactics contribute only 5% to our results! Let that sink in. How you identify a trade or investment does not matter if capital flows are moving away from your idea driving the prices lower. Simple supply and demand. Focus on the major trends and be quick to change your position when the facts change.