The Future of System Development – Part 2

Rank and Filter to Adjust Position Size

The higher the likelihood for a trade to go your way the more contracts you would like to buy. By ranking and filtering all trade signals for
a portfolio on any given trading day you can achieve this. For this to work your system needs to keep track of all markets simultaneously.
For a broad futures-markets portfolio measuring and ranking the most recent trends strength is one way to do it.

TRADERS´ insights
Thomas Stridsman
Mr Thomas Stridsman is a
partner of Alfakraft Fonder,
where he manages two
funds (Alfa Commodity and
Alfa Energy). He has been
developing strategies for
model-based investing since
the early 1990s. Prior to joining
Alfakraft Fonder, Mr Stridsman
managed client money in
the FX markets. He also is a
freelance analyst and author
of the two books Trading
Systems That Work (2000) and
Trading Systems and Money
Management (2003).
07/2011 www.tradersonline-mag.com
One feature that has been lacking
for many years in most trading-
system platforms is the possibility
to test a system incorporating
ranking and filtering functions.
Sure, many testing and trading
platforms offer these possibilities
as stand-alone features, but very
few if any offer the possibility to
incorporate them into a system.
This is because old trading-
system platforms operate under
the old paradigm of testing one
market at a time from the start
of the data to the end of the
data, before they combine the
performance for each market
tested into a portfolio report. With
the old-school way of testing
there is no way to compare the
markets and their respective
indicator values mid-test. Newer
platforms, on the other hand,
offer this feature, because their
way of testing things are not one
market at a time, but rather one
day (bar) at a time, simultaneously
across all markets in the portfolio.
One of the platforms offering
ranking and filtering for systems
is Trading Blox, which is used in
this article on a portfolio of 49
commodity futures markets in an
effort to improve a basic volatility-
breakout system. The system
is a standard Bollinger-band
type system with a 40-day look-
back period for its calculations.
18
The markets tested are listed at F1) Original 40-day Volatility Breakout System
the end of this article. Figure 1
shows the performance for this
system since 1990. An average
of $5 and $10 was deducted for
commission and slippage for all
contracts traded. The risk per
trade was set to 0.2 per cent of
total equity. You can see that the
average annual return comes out
to 19.08 per cent with a maximum
drawdown of 22 per cent, over
8869 trades.
The Ranking Functions The performance of the original system indicates the system works
well over time. A steady equity growth generates an annual return of
Two different ranking and filter more than 19% over 8869 trades.
functions are added to the above Source: TradingBlox
system. They are based on a
simple momentum calculation
(Close today minus Close n
days ago) and the Average F2) Filtering out the Worst Trades
True Range (ATR) indicator. For
the momentum ranking, a high
positive value means the market
has been trending higher and is
expected to continue to do so.
A high negative value means the
market has been trending lower.
For the ATR ranking a high value
means low intra-day volatility,
which is considered a good thing
for both long and short trades.
Using the ranking and filtering
techniques you can test the
performance of all markets based Reducing the number of trades based on a filtering function would be
a bad idea for this system. Getting rid of potentially profitable trades
on their relative strength in the is seldom a good idea.
portfolio for each day, provided Source: TradingBlox
that they also signaled a trade
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TRADERS´ insights

that day in accordance with the much higher for the sum of all trade more contracts while those
original breakout rules. Table 1 percentiles than they are for the that rank the lowest trade as few
shows the performance of each unconstrained system in Figure contracts as possible? In this F3) Ranking the Momentum
percentile, using the momentum 1. This is because a filter like this case we will alter the original 0.2
filter. For example, the row for the can in fact, offer more trading per cent risked per trade with the
top-10 percentile shows those opportunities per market over a following simple formula:
markets that were among the longer test period, the narrower New Risk = Original Risk * ((1 -
highest ranked markets according the ranking bins are. Figure 2, Rank / 49 - 0.5) * 2 + 1), with the
to the momentum filter, and also which shows the performance of number 49 representing the total
signaled a trade that day which trading only the top-60 percent number of markets.
produced 2068 trades for a total trades, confirms that this would This way we double the risk
annual return of 3.13 per cent. be a bad conclusion. Filtering out for the highest ranked markets
Now, not knowing any positive trades always lead to while decreasing the risk for the
better, we could just add all lower performance. lowest ranked markets all the way
the percentile returns together down to zero. For all trades, the
and might conclude something Testing Money Management average risk per trade will still be
like, “Trading only the top-60 So, in this case filtering out 0.2 per cent or close to it. Figures
percentile markets will produce a trades is not the way to do it. 3 and 4 show the performance of Ranking the markets in the portfolio according to their relative market
momentum before modifying the position sizing algorithm incorporating
return of close to 35 per cent, so But is there another way? How such tests with our filters. Figure the ranking, generates higher returns, but also higher drawdowns.
let us settle for that”. about altering the positions size 3 shows the performance for the Source: TradingBlox
However, this the wrong based on the ranking so that momentum filter. With this filter,
conclusion as both the sum those markets that are ranked the the annual return came out to
of all returns and trades are highest according to the ATR filter 23.62 per cent, an increase of F4) Ranking the Average True Range (ATR)
approximately four percentage
points. The modified Sharpe ratio
T1) Percentile Performance (not including the interest rate)
also increased somewhat, but
Percentile Return Sharpe Trades the bad news is that both the
- 10 3.13 0.62 2068 magnitude and the length of the
10 - 20 5.40 0.72 3299 maximum drawdown are also
20 - 30 6.23 0.80 3688 increased.
30 - 40 7.82 0.96 3462 Figure 4 shows the
40 - 50 5.53 0.81 2926 performance for the ATR filter.
50 - 60 6.20 0.98 2314 Now the annual return comes
60 - 70 2.72 0.54 1772 out to 21.38, an increase of
70 - 80 1.00 0.28 1331 2.3 percentage points. Again,
80 - 90 0.75 0.07 893
the modified Sharpe ratio also
90 - 100 0.45 0.22 426
increased somewhat, which is In this case, ranking the markets in the portfolio according to their
relative ATR before modifying the position sizing algorithm based on the
Here we see the performance of each percentile, using the momentum filter. For example, the row for the top-10
percentile shows those markets that were among the highest ranked markets according to the momentum filter
an improvement. Again, though, ranking turned out not as profitable as the momentum-based ranking.
and also signaled a trade that day produced 2068 trades for a total annual return of 3.13%. the bad news is that both the Source: TradingBlox
magnitude and the length of

07/2011 www.tradersonline-mag.com

TRADERS´ insights
the maximum drawdown also
increased considerably. Overall,
the momentum filter did a slightly
better job than the ATR filter.
Analysing the Results
The reason why we were not
able to increase the performance
more than this can be deducted
from Table 1. First, take look at
the values for each percentile’s
Sharpe ratio. Notice that there
is little order to how the values
change from one percentile to
the next. Sometimes it is higher,
sometimes it is lower. This means
the filter is doing a poor job in
sorting out risk-adjusted trading
opportunities.
For the system to do a good
job we would have liked for the
Sharpe ratio to be consistently
lower. (A consistently higher
Sharpe ratio would also have
been a good thing, although in
that case our reasoning for how
the filter was supposed to work
would have been completely
backwards.)
Second, if we divide the annual
return for each percentile with
the number of trades for that
percentile we come to a number
indicating the performance per
trade for that percentile. Again,
for the system to do a good job
we would have liked for this ratio
to be consistently lower or higher.
Figure 5 shows this ratio for our
two filters, with the momentum
filter in blue and the ATR filter in
07/2011 www.tradersonline-mag.com
red. As you can see, both lines
are rather unstructured with no
clear trend from high to low or
vice versa. This indicates that
the trades for each percentile are
producing profits similar to the
trades for all other percentiles,
which makes the use of these two
ranking techniques for adjusting
the position size for this particular
system fruitless.
Another Example
As is likely to be pointed out
more with some frequency in this
article series: The purpose of this
article is not to provide you with
any turn-key trading systems,
but rather to present, state-of-
the-art research concepts while
inspiring you to conduct your
own research. Therefore, so that
you do not feel left in the dark
thinking this was a bad trading
idea and article let us take a
look at another system with an
accompanying ranking function
which considers adjusting the
position size.
Figure 6 shows the
performance of a basic volatility-
breakout system, also tested on
the same portfolio of markets,
risking 0.2 per cent of equity
per trade. This system has an
annual return of 20.27 per cent, a
modified Sharpe ratio of 1.2 and a
maximum drawdown of 22.9 per
cent. Figure 7 shows the Sharpe
ratio (in blue) and the profit ratio
(in red) for each percentile for this
20
system after the ranking process.
Notice how both the Sharpe
ratio and the profit ratio become F5) Profit per Trade for Each Percentile of Trades
increasingly lower for each
percentile. This is exactly what we
want to see for the ranking based
money management to work the
most effectively.
If we base the position sizing
of each trade on the ranking, the
annual return increases by close
to nine percentage points, which
is very good; the modified Sharpe
ratio increases by 0.27 points,
which is phenomenally good; the
drawdown increases by close to The profit per trade for each percentile of trades for the ranking
functions. There really are no distinct trends from high to low values
seven percentage points, which for either of the two ranking functions. The momentum function in blue
and the ATR function in red.
is bad. The most important point
here is the large increase for the Source: TradingBlox
modified Sharpe ratio, while the
drawdown increases less than the
annual return. This is super good
news, because now what we can F6) Performance of a Proprietary Breakout System
do is to lower the average amount
risked per trade from 0.2 per cent
to look for a target return close
to the original 20 per cent which
will lower the drawdown even
more while maintaining a very
competitive Sharpe ratio.
Figure 8 shows what happens
with the performance, if we
keep the ranking based money
management, while lowering the
average risk per trade to 0.14 per
cent. With both the return and the
drawdown back to their original
readings, the modified Sharpe The performance of a short-term volatility breakout system without
any filtering or ranking. Note that the annual return is accompanied by
ratio remains at 1.47, which a modified Sharpe ratio of 1.2.
indicates that the day-to-day and Source: TradingBlox
month-to-month volatility of the
 21
TRADERS´ insights

account equity has decreased builders and technical traders. markets were then allowed only
significantly, making this version First we tried using them as a small risk per trade, all the way
of the system both safer and filters, filtering away the least down to no risk (= no contracts F7) Profit per Trade and Sharpe Ratios
more enjoyable to trade than the profitable trades, which did not traded) at all.
original version. work that well in our case. This, This way of doing things turned
however, has more to do with out much better, and in one
Conclusion the underlying system than the case we increased the average
Both ranking and filtering has filters themselves. Because if annual return by more than four
been around for many years, the system is good, generating percentage points from 19.08
but not as features to be added profitable trades even during per cent to 23.62 per cent. This
into a trading system. Being most circumstances, then the in itself is very good, but we also
able to do so, represents filters do nothing but lower the took a closer look at why we did
a huge leap forward in the profit. Had the system itself been not manage to increase the profit
systems development process, better, then even these simple even more.
which opens up the doors filters would have done a good To maximise the total profit
for a completely new set of job. increase, the ranking process Both the profit per trade and the Sharpe ratio trends nicely from high
to low values for this system with the modified filtering function in
automatised trading strategies When the filtering process did needs to be constructed so that place. This indicates that the performance could increase significantly
with the position sizing altered by the ranking.
and completely new ways of not work we tried to rank only the average profit per trade and/
thinking. The sky is truly the limit the systems and then adjust the or the Sharpe ratio decreases Source: TradingBlox
in this area. money management function at a steady pace, the worse the
For this article we looked at based on the ranking so that upcoming trades are expected
two very simple ranking and the highest ranked markets at to perform. That is, in a backtest, F8) Ranking Increases Performance
filtering techniques, using nothing each day were allowed to take the highest ranked markets
but the simple momentum and on a larger position than the should have a much higher
ATR indicators. Both techniques original 0.2 per cent per trade. average profit per trade than
are well known to most systems Consequently, the worst ranked the worst ranked markets. To
show this, a final example with a
proprietary breakout system and
Markets used in these tests a proprietary ranking managed
to increase the annual return by
close to nine percentage points,
Currencies: Australian dollar, British pound, Canadian dollar, Euro, Japanese yen,
Mexican peso, Swiss franc
from 20.27 per cent to 29.06
Energies: EUA emission rights, Crude oil, Heating oil, Brent oil, Gas oil, Natural gas, per cent, indicating that a well-
Gasoline functioning ranking and filtering
Equity indices: SP 400, CAC 40, Dax, FTSE 100, Hang seng, Nikkei, Russell 2000 function will increase a system’s
Grains: Corn, Rice, Soybeans, Soybean meal, Soybean oil, Wheat, Kansas wheat performance significantly.
Interest rates: Australian bonds, British long gilt, Canadian bonds, German bund, The performance of a short-term volatility breakout system with a
Japanese bonds, US 10-year notes, US 30-year bonds proprietary ranking function affecting the position size. Note especially the
large increase in the modified Sharpe ratio, from 1.2 to 1.47, even after the
Metals: Aluminum, Copper, Gold, Nickel, Palladium, Platinum, Silver average risk per trade has been reduced from 0.2% to 0.14% per trade.
Misc: Feeder cattle, Live cattle, Lean hogs, Coffee, Lumber, Orange juice, Sugar
Source: TradingBlox

07/2011 www.tradersonline-mag.com