Andrew Abraham

andy-0101 My name in Andrew Abraham. I have been investing in commodities and managed futures since 1994. I adhere to the philosophy of trend following. Trend following stresses a disciplined approach to commodity/ futures trading. Successful trend following and commodity futures investing requires patience, discipline and actively managing the risk. What sets me apart from other traders is that I am not only concerned about the return on investment but how much risk I will have to tolerate to achieve my goals.

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If you are interested in contacting for speaking engagements. Please email me at Andrabr9@gmail.com or call 954 903 0638.

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Futures and commodity trading involve substantial risk. The evaluations of futures and commodities may fluctuate and as a result, clients may lose more than their original investment. In no event should the content of this website be construed as an express or an implied promise, guarantee or implication by, that you will profit, or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Information provided on this website is intended solely for informative purposes and is obtained from sources believed to be reliable. Information is in no way guaranteed. No guarantee of any kind is implied or possible, where projections of future conditions are attempted.

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The Devil Is In The Details: An Important Limitation In Back Testing

The Devil Is In The Details: An Important Limitation In Back Testing

It seems to me that back testing trading strategies before trading them is becoming increasingly more popular these days. The evolution of the “sophisticated” trading platform now offers investors access to “back testing strategies” as well as fast and cost effective execution. The “do-it-yourself” fad is on the rise, and who can cast blame when financial advisors in general have not lived up to expectation. I guess that’s putting it mildly for some of them.

Unfortunately the “do it yourself” approach is no guaranteed success either. The problem lies in the ability for the investor to maximize on his do-it-yourself approach. You can have the fastest execution at the lowest cost available and still consistently lose money. You can back test until your blue in the face only to find the “real world” upsetting your back tested strategy.

I hear traders all the time use the term “statistically significant”, when in fact it is nothing more than an illusion of certainty. There is uncertainty in all statistical suggestions, but some are more like intellectual fraud. These TV advertised platforms are particularly dangerous in their limitations.

There are countless obstacles to overcome when building dependable quantified trading strategies, but one limitation in quantified trading will never be resolved, and must be addressed through proper risk management strategies.

Let’s focus on that one.

In his book The Black Swan, author Nassim NicholasTaleb coins the phrases Mediocristan and Extremistan to distinguish between two types of randomness. All randomness is not created equal if you will.

In Mediocristan, everything has boundaries and limits that can be easily measured. Things like IQ scores, height, and weight, and how much people smoke would be examples of Mediocristan. If we were to randomly select 1000 people and calculate the mean weight, we can be reasonably assured that no one sample will dominate the distribution. In other words, you may find the average weight of 1000 men to be 200 lbs, but you won’t find a man weighing in at 200,000 lbs. Even the heaviest man in the sample will not materially affect the mean value of a distribution.

In Extremistan, the variation within distributions is quite different. In Extremistan, one sample can affect the entire distribution. Let’s say that instead of weighing the 1000 men we find out their incomes. Now, even though the mean income might be $75,000 for 999 men, what if the final entry made 75 million a year? Well, that would mean we can legitimately see a single event that’s 1000x the mean (there are people who make 75 mill), and also double the mean value.

This one sample (event) can change the entire distribution and in fact in some ways make it meaningless to depend on. After all, if I am trying to get some idea of what to expect from sampling, and one event can ruin the whole thing, what good is it?

In this case, it misleads me into thinking that the mean income of the 1000 men is $150,000 per year, twice as much as the 999 men actually make. So, if I had a product that was dependent on the fact that the 1000 men made $150,000 with little variation, I would be quite surprised when my product only sold to the rich guy.

Now, let’s say the income examples above are trades. That extreme entry could be the event that sends us to the financial graveyard. We are at risk of pulling a sample that excludes the extreme event when back testing, fooling us into thinking that the distribution we have is dependable enough to trade. Then we are likely to build an approach based on this sample and these assumptions. When we finally are confident enough to trade the strategy, we are unaware of the extreme, and therefore unprepared and eventually surprised.

In the trading world we have a duel edged sword. On one hand we are unfortunately held hostage to the same extremistan surprises that could blow us up. On the other hand these are the events that can make us wealthy. In trading, it is the same extreme moves that make the effort worthwhile. It is one of those businesses that one or two big events (trades) can make your whole year. Just like authors or rock stars where a handful of stars generate most of the revenues, a handful of trades do the same thing. The trick is staying alive long enough to be there when the come.

Quantified trading systems and strategies, like randomness, are not created equal, and therefore should be scrutinized to see how they will handle the adverse extremes. Constant risk monitoring is the key.

Charles Maley
Viewpointsofacommoditytrader.com

Futures trading involves risk. People can and do lose money


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