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The Future of System Development Part 4

Martingale Bet Sizing in Drawdowns

A small Martingale bet-size strategy could improve the performance of a trading system, especially when it comes to the frequency and length of its drawdowns. But it also comes with a few negative aspects worth considering before it is added to the overall strategy.

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F1) Drawdown Analysis i

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).

Do you believe in your trading system? if so, how do you handle its drawdowns? At least among the trend-following traders within the managed-futures world it has been a long-time truth that the time to invest is when things are looking the worst and the system actually is losing money. The reasoning has been that the equity stream of a trend-following system follows a so-called mean-reversion pattern, which stipulates that after bad times, good times always follow. Another way to put this would be: The worse things look the better they actually are, if you can only overcome your fears of investing with a strategy that currently is doing poorly. if you subscribe to the above as true, and you really want to put your money where your mouth is, the thing to do in a drawdown would be to increase your position size for all upcoming trades instead of scaling back, as you normally would. The most extreme of such strategies is often referred to as a Martingale

betting strategy. Using a true Martingale strategy you would double your bet size after every losing bet, so that when you finally have a winner you would end up with a net profit equal to the initial bet. however, if that winner fails to materialise within a few trades you will quickly go broke. it follows then that using a Martingale bet-sizing strategy, you have to be careful. Remember such trading debacles as Long Term Capital in the 90s, or, for that matter, every rogue trader that has been in the news over the last several years. What they all did was to go from bad to worse by increasing their bet sizes too aggressively, which they tried too hard to get back to even after a losing streak. in this process they all shifted their trading goals from maximising profits in the long run to showing any type of profit as soon as possible preferably already by the next period or trade. That said, another mistake they probably all did was to

Figure 1 shows the development of all drawdowns over time together with the development of the average drawdown. Source: Traders Studio

F2) Drawdown Analysis ii

Figure 2 shows the amount of time spent in drawdown for all drawdowns, together with the development of the average time in drawdown. Source: Traders Studio

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would fluctuate around its longterm average growth rate.) According to Vince a small Martingale betting strategy should be psychologically easier to implement as it would decrease the amount of time spent in a drawdown. That is, the ebbs and flows of your systems equity stream would repeat themselves quicker and more frequently. The flip side to that coin, according to Vince, is that the drawdowns when using a Martingale-type strategy are likely to become larger. The question then is: how much shorter and/or larger will the drawdowns become when using a Martingale-type strategy? Luckily for us this can be tested, using a modern systemtesting platform, such as TradersStudio or Trading Blox, which both allow us to test dynamic money management principles on a larger portfolio. For this test we will be using TradersStudio and a basic trend-following strategy applied to a basket of 20 commodity futures markets. The actual entry/exit strategy is not of interest here, so it will not be discussed. instead, what we will look at is how to make simple alterations to the bet-sizing formula in the TradePlan module of the software to see what we can learn about Martingale betting. The Code in his book, Ralph Vince used a rather complicated formula for his small-Martingale strategy. For our purposes we will keep things a bit simpler. First, we need to keep track of our latest equity peak with the help of a max function: HighEquity = Max (HighEquity[1], SummEquity) Second, we need to calculate the current drawdown in per cent from this peak: HighEquity / SummEquity - 1 With these steps done we will go on and introduce a drawdown factor (DDFactor) and apply it as indicated in the fully coded TradePlan script (see info box). Running a Few Tests From the script it follows that a DDFactor of zero will keep the bet size constant relative to the current equity at all times, while a DDFactor of 1 will keep the bet size constant relative the amount as it were at the equity high. Thus, as the drawdown increases in depth the bet size will grow relative to the amount of remaining account equity. increasing the DDFactor to 2 and 3 will accelerate the growth of the bet size further as the drawdown increases in depth. A DDFactor of 3 would then mean that the
Markets Used in these Tests
Currencies: Energies: grains: interest rates: Metals: Misc: indexes: Australian Dollar, Euro, Japanese Yen Crude Oil, natural gas, gasoline, heating Oil Corn, Soybeans, Soybean Oil german Bund, US 10-year Bond gold, Silver, Palladium, Copper Coffee, Cotton DAX, DJ Euro Top-50

act in panic, without a thought out and tested strategy. As with everything else in trading, Martingale betting does not have to be all black or white. There still are several shades of grey in between the extremes and using a systematic trading approach this can be fine-tuned to increase your systems performance or at least create a performance pattern better suited to your trading style and psychological makeup. The Theory in his book The Leverage Space Trading Model (Wiley Trading, 2009), the famous money manager and author Ralph Vince discusses such a grey-area model for Martingale betting within a systematic trading strategy, which he calls a small Martingale betting approach. He does so after first concluding that most traders or investors do not primarily concern themselves with maximising profits in the long run, but rather first and foremost strive to show any profit at all over the next trading period. in doing so, ordinary fixed-fractional or optimal f type betting strategies will fail them as such strategies tend to produce long periods of modest negative returns, followed by quick and huge positive returns. (i.e. the return stream would follow a slow mean-reversion pattern as it
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best size would increase at twice the pace it normally would have decreased, so that at a drawdown of ten per cent the best size will be 20 per cent larger than it was at the equity high or over 30 per cent larger than it should have been for the current equity. To start testing we need to set some benchmark values. Setting the DDFactor at zero, the

constant risk per trade at 0.19 per cent of the current equity and running the strategy on 20 markets over a 21 year time period, we get the following test statistics: Average Annual Return (AAR): 23.65% Sharpe Ratio: 1.1671 Max Drawdown (DD): 22.77%

T1) Drawdown Factors and Base Risk per Trade

Test Statistic AAR Sharpe ratio Max DD Longest DD Avg. DD depth Avg. DD time Tot. DDs # Tot. Peaks # 0 (0.190%) 23.65% 1.1671 22.77% 321 days 3.68% 26 days 188 423 1 (0.176%) 23.56% 1.1762 23.57% 321 days 3.61% 25 days 194 433 2 (0.163%) 23.23 1.1810 24.14% 249 days 3.53% 25 days 199 444 3 (0.151%) 22.69% 1.1820 24.79% 248 days 3.35% 24 days 205 456 -1 (0.210%) 23.83% 1.1328 22.46% 322 days 3.81% 27 days 181 411

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speaks for using a small (yet aggressive) Martingale strategy. The development of the average drawdown depth also speaks for using the Martingale strategy as it surprisingly decreases with the aggressiveness of the betting. The bottom two rows confirm the theory that Martingale betting will increase the frequency with which the account equity will ebb and flow around the systems long-term average growth rate. Lastly, the Sharpe Ratio also increases as we increase the Martingale aggression, which has to be considered another positive. in total, and so far, everything seems to be speaking for using a Martingale betting strategy. To somehow verify that these results are no fluke we also reverse the reasoning for the drawdown bet size and test how the strategy will perform if we decrease the bet size in a drawdown more than what would have been the case for a static fixed-fractional betting model. in this case we will decrease the position size with twice the normal speed. To do so, we simply alter one line of code in the TradePlan script to: DDWeight = (SummEquity / HighEquity - 1) * DDFactor + 1 Where: DDFactor = 1 The results are shown in the rightmost column (with a DDFactor of -1) in Table 1. They in this case the changes to most of the measured results were rather small, which would lead us to decide the changes are not worth it. however, keeping in mind the primary reason for why we did this might sway our minds. We did this to show more frequent profits and having decreased the length of the longest drawdown from more than 300 days to less than 250 days is quite a significant change, worth considering. Adding a smallMartingale bet-size strategy to a trading system could decrease the amount of time spent in drawdowns and help the system be profitable more often. The negative side of that strategy is that the drawdowns might become slightly deeper. For our trend-following system a significant decrease of the length of our longest drawdown, combined with more frequent equity highs, indicates we should include this bet-size strategy to the system for improved overall performance. however for any other trading system this has to be analysed and decided on a case-by-case basis.

Longest DD: 321 days Average DD depth: 3.68% Average DD time: 26 days Total number of DDs: 188 Total number of Peaks: 423

with a DDFactor of -1 will be commented later in the article). The first thing we notice is that the largest drawdown increases from 22.8 per cent without Martingale betting to 24.8 per now, we will test for different cent with the most aggressive DDFactors, which means we Martingale betting, while the need to lower the base risk longest drawdown period per trade so that we aim for a decreases from 321 days to 248 similar average annual return. days. Both these observations The base risk per trade is are in accordance with Ralph simply the smallest percentage Vinces theory. What is surprising amount of equity we will risk is that the largest drawdown per trade, which we will do at increases with a relatively the equity peaks. Table 1 gives modest amount while the longest us some interesting statistics to drawdown period decreases analyse (the rightmost column, significantly. note that for the most aggressive Sub SizeRunningEQ (PercentRisk as Double) Martingale strategy, with a largest drawdown of 25 per Drawdown Martingale Weight cent the bet size will Dim ThisBar As integer be twice the size it Dim DDFactor, DDWeight As Double should have been or Dim highEquity As BarArray ThisBar = Barnumber - FirstBar 50 per cent larger than if ThisBar > 0 Then it was at the equity highEquity = Max(highEquity[1], SummEquity) peak, so that the risk DDFactor = 0 per trade would be DDWeight = (highEquity / SummEquity - 1) approximately 0.3 * DDFactor + 1 per cent (0.151 * 2) of Else equity. however, this DDWeight = 1 End if is still only 50 per cent larger than the original Adjusted Risk per Trade bet size of 0.19 per PercentRisk = PercentRisk * DDWeight cent of equity that SizeUsingTradeRisk(SummEquity, PercentRisk, -1) we would have kept SizeForTotalExits constant in a normal End Sub non-Martingale betting strategy. Clearly this

Adding a smallMartingale bet-size strategy to a trading system could decrease the amount of time spent in drawdowns.
basically show the opposite results of the other columns, confirming the validity of the Martingale strategy. Conclusion Whenever we alter or add complexity to a trading system be it in the execution code or in the money management code it is important to remember we are also increasing the curve fitting of the model. Therefore we need to always keep in mind why we do the alterations and be careful in deciding whether each change is worth it or not.

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