September 12, 2007

Book notes – Way of the Turtle - IV

My notes on the previous chapters of the book here, here and here.

The ninth chapter discusses about the building blocks of trading such as breakouts, moving averages, volatility channels, time based exits and simple look backs in detail. The next chapter follows with a detailed discussion on various systems such as the ATR channel breakout, Bollinger breakout and Donchian trend etc. This chapter also gives the performance data for all these systems based on the historical data. For ex: donchian trend has a 10 year return of 30% p.a with a max drawdown of 38.7%.

The important point in this chapter is the author’s emphasis on backtesting. Backtesting means that every system should be evaluated with respect historical data for returns and maximum drawdown. Backtesting may not help predict the future or ensure that the system will always work, but it would help to determine which system could be profitable in the future and what conditions are needed for the success of the system.

My comment: The same approach should be applied by investors too. For ex: value investing has almost a 50 year history of performance over varying periods and business conditions. So this approach to investing has proven its ‘fitness’ over a long period of time and in varying conditions. I would say that any other approach such as momentum investing should also be evaluated in a similar manner.

The next chapter discusses in detail the pitfalls of backtesting. The key reasons why the historical test results differ from actual trading are as follows
- trader effects : As more traders use the system, the effectiveness of the system is lost
- Random effects
- Overoptimization paradox:
- Curve fitting: Fitting the system to data

The chapter then discusses how these distortions can be resolved and backtesting results improved.

The next chapter discusses how one can get better results from backtesting. One approach is by using better measures such as RAR (regressed annual return), R-cubed and a robust sharpe ratio. In addition a representative sample and appropriate sample size can help to get better results. The author also discusses about monte-carlo simulations to analyse the various systems based on historical data.

3 comments:

Senthil said...

I think that this is not a good book. A reviewer in Amazon had ranked it low.

The review doesn't have a disparaging tone. It lists five reasons why it isn't a good book. You might want to check it out.

Rohit Chauhan said...

Hi senthil
i think the key point is whether you are an experienced trader or a complete novice on trading like me.
if you are like me, then this is a good introductory book. ofcourse this book will not help you to learn how to trade. at best it gives a few basics on trading and what it takes to be a good trader
i agree to a few points by the reviewer like lack of details on the trading system, but not with some others like on the cliches ...those cliches are precisely the reason people fail in trading and investing.they are cliches because they are well know and still not followed
i agree that there must be really better books on trading (how tos ?), but this is a decent book for a total novice like me
who wanted an initial primer on trading and has no plans on reading on trading further :)
so this book may not help you if you already know a lot about trading.
finally, as reviwer says that title is misleading and most probably a marketing ploy by the publisher.
also have a look at the author's blog, it is decent

Senthil said...

So may be it depends on what one has read or come across earlier. I think that if someone had read about behavioural finance the points which are cliche and which most people don't follow should feel repetitive. They, I think, are common to both investing and speculation.

I think you can read more on trading, if only to make sure we know we aren't doing it :)

Speculation, though considered bad isn't necessarily so.

You might want to read this lecture where Graham differentiates between intelligent and unintelligent specualation. The other lectures are also good, in case you haven't read them.

Also check this link on risk by Seykota. It's got a nice explanation on how the Kelly's criterion helps.