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

Trading

Discussed by:Paul Grems Duncan

Leader, Tri-State Investors Group

July 16, 2001 1

Today’s Topics 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

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Admin 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.

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Portfolio Metrics: Do We Care? 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 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 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 end-

of-trade DD – end-of-trade is far more important!

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Drawdown Example:Daily Russell 2K Since 1987

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Calmar Ratio What is the Calmar Ratio? CR is a very simple metric that relates return

to drawdown. Easy to remember:

If CR < 0, your CAR is negative, and you’re losing money. This is a bad system.

If CR ~ 1, Reward to Risk is 1:1. In general, you lose a dollar for every dollar gained, but time frame is important.

If CR = 2, for every dollar lost, you gain 2 dollars. Good system. If CR = 3, for every dollar lost, you gain 3 dollars. Great system! Practical, winning systems generally have a CR > 1.50

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

9AAII 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

10AAII Accelerated EPS Strategy (Modified Shadow Stock Portfolio Criteria)

Steps to Track Calmar Ratio 1) You need your equity curve, either real or

backtested. 2) Download CR-CalculationExample.xls at

my forum at Effective Volume (once you’ve registered, of course).

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CR Moves with Time!(Thankfully, Not Fast)

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1996 – 2010, AAII Accelerated EPS Strategy (Modified Shadow Stock Portfolio Criteria)

Average = 2.02+/- 1.31 Stdev

UglinessUglinessUgliness

We’ll discuss how to use CR and timers to improve a strategy later in the presentation

Criticisms of CR The definition uses the compounded annual return

(CAR); this isn’t 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 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 A strategy has demonstrated a record of only 20% winning

trades. The average profit per trade is $10K The average loss per trade is $2K Is this a winning strategy?

• Where: AW = average winning trade amount• AL = average losing trade amount• PW is the % winning trades

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ME Example (con’t)

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 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-PRR-CalculationExample.xls” from my forum at Effective Volume – this is a log that auto-calculates ME.

Example Trade Log for Autocalculating ME

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Enter Tradesby Strategy

Worksheet Auto-calc’s VariousParameters

ME-PRR-CalculationExample.xls

Pessimistic Return Ratio (PRR) Pessimistic WHAT? Created by Ralph Vince and published in

“Portfolio Management Formulas” (ISBN 0-471-52756-4), 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 Here’s how PRR is defined:

• W is the number of winning trades• L is the number of losing trades• AW is the average winning trade amount• AL is the average losing trade amount

Per Vince: PRR > 2.0 are good systems. PRR > 2.5 are excellent systems.

Also per Vince: We need at least 24-28 trades in a system to know whether it’s a viable system

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PRR Example Suppose we have a system with 13 winning

trades, 5 losing trades, with $288 taken home on each trade that is won, and with ($33) lost on each trade that goes against our methods.

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Steps to Track PRR 1) Download “

ME-PRR-CalculationExample.xls” from my forum at Effective Volume – this is a log that auto-calculates PRR (yes, this is the same file that also calculates ME).

Review of Metrics Calmar Ratio: Compares gain to drawdown.

Tells you if you’re 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 Standard AAII portfolio:

http://www.aaii.com/model-portfolios/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 PerformanceActual vs. Modeled, 1997-2010, corr = 0.816

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Avg CR = 3.49 +/- 5.14

MDD = ~49%

AAII MSSP Performance 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?27

Improving AAII MSSP Performance

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“Market Cap Favoritism” – There are certain periods in the cycle that Small Caps underperform

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

Favor Small Caps1/03 – 9/08

Favor Small Caps 6/08 – 9/084/09 - Present

Favor Large Caps6/06 – 5/0810/08 – 3/09

AAII MSSP PerformanceGated w/ Russell 1K/2K Favoritism

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Avg CR = 4.59 +/- 5.76

MDD = ~28%

Stockcharts can Assist in Analysis

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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

AAII MSSP Conclusions It’s 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 we’ll lose confidence in the system.

The general trend of favoring large caps or small caps certainly helps to provide confidence that we’re 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

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 mean-reverting. It’s 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

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

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?34

Connors’ TPS Strategy (Long) 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 Connor’s 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 1159 Trades Average % P/L = 1.45% Average Holding Time = 6d % Number Winners = 89%

20 ETF from 1/1/09 to 7/15/11 405 Trades Average % P/L = 1.67% Average Holding Time = 5d % Number Winners = 93% ME: 0.203

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Connor’s TPS Strategy (Long)Equity Curve, 1/1/09 to 7/15/11

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Connor’s TPS Strategy (Long)Trade Distribution, 1/1/09 to 7/15/11

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

Connors’ TPS Strategy (Short)20 ETF Inception to 12/31/08 648 Trades Average % P/L = 1.97% Average Holding Time = 6d % Number Winners = 81%

20 ETF from 1/1/09 to 7/15/11 59 Trades Average % P/L = 1.39% Average Holding Time = 6d % Number Winners = 75% ME: 0.163

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Connor’s TPS Strategy (Short)Equity Curve, 1/1/09 to 7/15/11

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Connor’s TPS Strategy (Short)Trade Distribution, 1/1/09 to 7/15/11

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

Optimizing Connor’s TPS Strategy 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 non-leveraged 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 7/15/11 405 Trades Average % P/L = 1.67% Average Holding Time = 5d % Number Winners = 93% ME: 0.203

3x ETF from 1/1/09 to 7/15/11 163 Trades Average % P/L = 4.33% Average Holding Time = 5d % Number Winners = 89% ME: 0.492

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

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Note that there is 1 trade that fell >60%

Connors’ TPS Strategy (-3x Short)1x 20 Short ETF 1/1/09 to 7/15/11 59 Trades Average % P/L = 1.39% Average Holding Time = 6d % Number Winners = 75% ME: 0.163

-3x ETF from 1/1/09 to 7/15/11 70 Trades Average % P/L = 1.53% Average Holding Time = 8d % Number Winners = 74% ME: 0.091

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

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Note that there is 1 trade that fell >30%

Connors’ TPS Strategy Conclusions TPS has a positive ME in all 4 cases (non-

leveraged, 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

Pascal Willain and Billy O’Nair 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 Pascal’s Effective Volume tools, as well as precise entries/exits using pivot levels, statistics, and risk/reward ratios. This is a combination mean-reversion and trend-following 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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Paul’s IWM Robot Performance 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

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, mean-reversion via Connor strategies can keep some income moving in.

Pascal’s and Billy’s 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”

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 Let’s 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.

There is a movie posted EV site that I created and which shows how I navigate the different information.

GGT (Paul’s system) and EV work together nicely to identify early breakouts; here’s 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. Let’s look at the first 3:

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VNR

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

Group just issued a “buy” signal because large player strength has jumped above 0%

CL

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Upward trending average line shows constant accumulation

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

MDVN

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

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

The Day’s Summary We covered three relevant metrics to assist you with your portfolio:

• CR, ME, and PRR 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 Connor’s 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:

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 you’re an AAII member and attended this presentation, you’ll 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 you’re interested in the IWM and GDX robots, let me (Paul) know, and I’ll see what I can do for a free trial. 60

Registering for Access to Presentation Files (and Paul’s Forum)

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Step 1: Registration Page at Effective Volume

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http://forums.effectivevolume.com/register.php?

In the Registration QuestionPlease state “Registering perPaul Duncan / AAII Wash DCMeeting”

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:

Step 3: Registering for Paul’s GGT Forum

Step 3: After you receive the previous screen, you’ll 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 Paul’s GGT Forum

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Click this First

Click this 2nd

See if this says “LeaveGroup” or “Join Group”Feel free to join the othergroups – it is free.

Paul’s is theGGT Group

Access to AAII Presentation Files

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

File Location w/in Thread

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The Excel files will be located under this header

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

Paul Duncan(703) 509-5332

grems8544@gmail.com

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