Turtle Trading Rules

Chapter 13 How to Measure Risk (1)
Understanding risk and respecting risk are the hallmarks of top traders.They know that if you don't pay attention to risk, risk will come to you.

When you are considering a trading strategy based on a mechanical trading system, or looking for an investment advisor to use such a strategy, one of the key questions (perhaps the only one) to ask is: "How do you know if a system or Is an investment advisor good or bad?" Generally speaking, although the answers given by the industry are varied, they are essentially the same: whoever has the highest risk-reward ratio is the best.

Everyone wants to make as much money as possible for a certain level of risk, or take as little risk as possible for a certain level of expected return.On this point, almost everyone agrees, whether they are traders, investors, fund managers, or others.Unfortunately, there are still many differing views on what is the best measure of the two elements of the risk-reward ratio, risk and reward.Sometimes the financial industry defines risk so narrowly that it completely ignores certain risks that are just as damaging as the ones it cares about.

Speaking of these risks that fall outside the traditional measure, the debacle of LTCM [6] (Long Term Capital Management) is a good example.This chapter explores these risks and how to measure them, then presents some general techniques for assessing the risk and reward levels of a trading system based on historical data.

Rich and Bill were very concerned about our position size because they knew that if we took too large a position in an adverse trend, they could even be in danger of going bankrupt.In the years before Project Turtle began, they had experienced a period when the silver market set a limit down.Comex has set a limit on the maximum daily move in silver, which means that if no traders are willing to buy within the limit, sellers have no chance of getting out.This is a futures trader's worst nightmare.Your losses magnify day by day, but there is nothing you can do about it.

Fortunately, Rich cut his position before the nightmare occurred, which may have saved him tens of millions of dollars in losses.If he doesn't act fast enough, he could lose it all.I believe that this terrible memory lingered in his mind all the time that the Turtle Project was going on.

Rich kept an eye on the Turtles' positions and would trim his own if he felt the overall risk was too great.The common perception is that Rich is a daring gambler, but in my opinion the opposite is true and he is very mindful of his level of risk.

Four Risks
There are many types of risk, and therefore many ways to measure risk.Some big risks arise from relatively rare events that happen only a few times in 10 years; some risks are more common and always happen a few times in a year.There are 4 main trading risks that most traders worry about:

Decay: A string of losses shrinks your account.

Low Returns: The returns are so low that you earn negligible money.

Price volatility: Sudden price movements in one or more markets, resulting in significant and irreparable losses.

System Death: The state of the market changes such that a once efficient system suddenly fails.

Let's look at each of these 4 risks one by one, and then consider how they can be measured - methods that can be combined to assess the risk-reward ratio of a trader and a trading system.

Fading
衰落风险可能就是交易者们放弃交易或是以失败收场的主要原因。请看图7–1中的净值曲线，它代表一个使用唐奇安趋势系统的10万美元的账户从1996年1月到2006年5月的交易结果。

It can be seen from the figure that the net value of this account grew at an average annual compound interest rate of 10% during the test period of more than 43.7 years, but there was also a period of decline of 38% during the period.

Many beginners will be attracted by this kind of excellent performance system, thinking: "the profit is so much, of course I can bear the 38% loss".Sadly, it has been proven time and time again that people are not all that aware of their own capacity to sustain these types of losses.That's not to mention, since the graph is on a logarithmic scale, the magnitude of the fading appears to be much smaller than it would be on the standard scale.

新手约翰对这个系统充满信心，而且相信自己有能力熬过那种衰落期，于是他在6月1日投入10万美元开始交易。图7–2包含了图7–1的内容，只是更新到了2006年10月末，而且用一个线性刻度展示了历史上的衰落期。

Shortly after John entered the market, the system entered a period of decline, and this time the decline was a bit higher than any of the previous ones: 42%.What would John be thinking at this moment?
1996年1月~2006年5月图7–2唐奇安趋势系统交易结果：1996年1月~2006年10月“万一这个系统不再管用了，怎么办？”

"What if this is just the beginning of a big landslide?"

"What if there is a problem with my previous test method?"

"What if...how?"

These doubts often prompt a novice to abandon the system, or start trading selectively in an attempt to "de-risk".This often results in traders missing out on opportunities that could have made money.Frustrated, after seeing 1/2 or even more losses on the initial account, the trader finally couldn't bear it and quit.This is the reason novices fail to make money even with effective strategies: they overestimate their ability to withstand large swings at high risk levels.

From what I have observed, most people cannot afford to decline like this.A successful trader who is confident in his trading abilities, system, and testing results can probably afford a large drawdown, but a prudent novice should adjust his risk level accordingly to reduce the magnitude of the drawdown.Of course, this also means reducing the return level of the system.This is a sensible compromise.

Luckily for the Turtles, our boss, Richard Dennis, knows that a decline in a market correction is not the same as a decline in a string of bad deals.He knows that returning some profits is only part of the game for trend followers.

Because of this, managing money for this boss is a relaxing thing.Some of the big downturns we have experienced at times are enough to scare most investors.Some of the Turtles are now masters at raising outside capital, but if you look at their performance, they are not as bold as they were in the Turtle days.Caution is actually a prerequisite if you want to raise institutional investment.

Unfortunately, if you want to earn 100%+ returns like the Turtles did, you also have to be prepared to take these kinds of big drawdowns.I estimate that my biggest decline was about 70%. I am afraid that not many people can bear this kind of ups and downs.For most people's psychological world, this is a very difficult level to get through.

low return

If a trader wants to earn an average annual return of 30%, he can do it in two ways: use a system that can consistently earn 30% annual returns, or use another system that is less stable - the first year Earn 5%, earn 5% in the second year, and earn 100% in the third year. After 3 years, the average compound growth rate (CAGR) for both systems is 30%.However, most traders prefer a stable system earning 30% per annum because it makes the equity curve smoother.

We found that, other things being equal, a system that consistently generates high returns is more likely to generate desirable returns over any period of time in the future.Thus, in any given year, the risk of such a system misbehaving is lower than that of a system with a less stable track record.

price volatility
Price volatility refers to sudden and rapid price changes, typically caused by natural disasters, unexpected political events, or economic disasters.Since I entered the trading world, the United States has experienced two severe price fluctuations, one was the stock market crash and subsequent rebound in 1987, and the other was after the terrorist attack on the World Trade Center in New York on September 2001, 9.

I was trading a $2000 million account for Richard Dennis when the first turmoil broke out.I still have vivid memories of this disaster.I actually made a little money the day the stock market crashed, but the next day, it was a completely different story.

On October 1987, 10, known as "Black Monday," Eurodollars closed at $19 per share, near the low of $90.64 per share reached two days earlier.That low was tested that morning, when the market fell as low as $90.15 per share.I was short about 90.18 December Eurodollars and 1200 T-bills.At the same time, I was also heavily long in gold, silver and several foreign currencies.

Early the next morning, Eurodollars opened higher at $92.85 a share, jumping more than two points to $5500 per contract.I have no chance of getting out at all, this is the highest price in 8 months.On the other hand, gold opened below $25 and silver opened below $1.Figure 7-3 shows the dramatic changes in the Eurodollar market on this turbulent day.

Doing the math, I lost about $2000 million on the $1100 million account I traded for Richard Dennis.Basically, my entire year's profits have been wiped out overnight.

What makes me laugh and cry is that I actually gained something on the day of the stock market crash. It was the crazy move of the government to cut interest rates overnight without warning that hurt me.Price volatility came unexpectedly.

Here's a $10 account using the Donchian Trend System from 1984 when the Turtles started playing until late 1987.

You can clearly see that huge gap representing a 65% drop.It's important to remember that this decline happened overnight.There is no chance of getting out of the market.Note also that the one-day drop was twice as large as any historical test of the system.In other words, systematic historical testing will underestimate the risk of decline by a factor of two.

All traders who want to survive will carefully consider the reality of price volatility when setting the level of risk for their account.Anyone looking for a high return bears an equally high downside risk—even the possibility of losing it all in a huge price swing.

system death
The so-called system death refers to a system that was effective or seemed to be effective in the historical test suddenly no longer effective and began to lose money.This risk does not come from the market itself, but from poor testing methods.This risk is even greater for short-term systems that optimize based on recent price fluctuations.

Is an underperforming system just in a normal period of decline, or is it really no longer effective?This is often difficult for a novice to judge.Dare I say, this is probably one of the most frustrating things for novices.When they experience a downturn, they start to doubt their approach: Is there something wrong with my test?Has something changed in the market that makes my approach useless?Will this continue?
We will discuss ways to reduce the risk of systemic mortality in later chapters.However, the reality is helpless.Because the market is dynamic and includes many other players, it is an unalterable reality that the market will change, and this will affect the systems and methods that have worked in the past.Sometimes these changes are permanent.One of the things that separates great traders from average traders is their ability to stick with and succeed at methods that others have grown tired of and abandoned.

Some traders will stop using it because they are suspicious of a method, which has an interesting side effect for trend followers as well.Every few years, trend-followers experience a period of losses, and at this time, some experts must jump out and declare that the trend-following strategy has come to an end.As a result, funds using trend-following strategies often face the dilemma of large-scale redemptions.However, when more and more funds withdrew from the trend-following strategy camp, this type of strategy began to regain its glory and show its power.Since Project Turtle, I have heard at least three or four times that trend following is dead.I usually laugh it off, because I know it means that the gold market is not far away.

quantification of risk

The quantification of risk is one way to take that into account the painful periods of adversity that come with using any system.There are many ways to quantify risk, here are a few common ones that I find effective:

1. Maximum Drawdown: This is a number representing the percentage decline from the highest point to the subsequent lowest point in a test period.In Figure 7, this figure equals 4%, the result of the 65 price turmoil.

2. Longest decline period: The longest period from one peak to the next new peak.It measures recovery speed, or how long it takes to regain new highs after a period of loss.

3. Standard deviation of returns: This is a measure of the dispersion of returns.A low standard deviation indicates that returns are close to the mean most of the time, and a high standard deviation indicates that returns vary widely from month to month.

4. R squared value: This indicator measures the degree of agreement between the actual return on investment and the average compound growth rate.For fixed income investments such as interest-bearing accounts, the R-squared value is equal to 1.0, and if the rate of return is unstable, the R-squared value will be less than 1.0.

(End of this chapter)