MARKET WEIGHTING

The discussion of portfolios in the previous chapter is a great leadoffinto the subject matter of this chapter. What if the two markets inquestion were the corn and S&P markets? Would each market trade28 contracts then? Or would the markets be weighted with three orfour corn contracts for every S&P contract? Every time I bring thissubject up at a seminar, the question is always answered with a resounding“absolutely.1” Some participants are determined that it isnot even possible to trade the same number of contracts for these twomarkets. They will argue until their face is blue against all mathematicalproof.The fact of the matter is that we can call the two markets anythingwe want. From Mars rocks to escargot. If these are the twomarkets being traded and they produce these kinds of numbers, thenthe math is the same. There is no difference in what markets producethe profits. This is a numbers game and it needs to be played accordingly.If I made a profit of $500 today, can you tell me which marketthat $500 was generated from? Neither can the account equity. It iscompletely independent of what markets and/or strategies are beingtraded. As a result, everything can be treated equally when applyingmoney management.However, the following illustration is for those who are still notconvinced that you can trade the same number of contracts as theS&P market. We have in our portfolio a system that trades the cornmarket on a long-term basis. We also have an end-of-day S&P systemthat exits on the close if a position is entered during the day. Thecorn system has a drawdown of $5,000, while the S&P system has adrawdown of $15,000. The combined performance would yield adrawdown between the two markets of $12,000.According to common weighting practices, the portfolio wouldtrade 3 corn contracts for every S&P contract since the S&P’s potentialdrawdown is three times the size of the corn, thereby “equalizing”the markets. Before applying this type of logic to trading, thequestion must first be answered: What benefits will come fromequalizing the markets? Traders apply this system because it simply“sounds” logical. But what benefits come from equalizing the markets?The only possible benefit is from increasing the profits due toincreasing the number of contracts. However, if that were the truegoal in making this decision, why equalize? Why not just trade anotherS&P contract? The logical answer is that if you trade anotherS&P contract, you will have the potential for $30,000 in drawdownfrom just the S&P. This is correct. But let’s take a look at what happenswhen you trade one S&P with three corn contracts.As stated earlier, the drawdown with the S&P and corn methodschronologically combined came to only $12,000. The reason thisdrawdown is $12,000 and not $20,000 is because the largest drawdowndid not occur at the same exact time. However, by adding an additionalcorn contract, the drawdown from the corn contract mustoccur at the exact same time as the original corn contract. Therefore,by trading three corn contracts, the drawdown potential from thosethree contracts is now $15,000, not $5,000. Therefore, the benefit ofthe noncorrelating drawdowns is severely diminished.The results in the box are from a system in the S&P that buys orsells on the open and exits at the end of day. The only other exit ruleis a protective stop that is placed to keep losses reasonable.S & PTotal net profit = $59,212.50118/203 winning trades58% correctWin/loss ratio = 1.45Average trade = $291Largest drawdown = $9,100The next set of results come from a longer term trend followingsystems traded in the corn market.136138 MARKET WEIGHTINGC o r nTotal net profit = $21,92528152 winning trades53% profitableWin/loss ratio = 2.72Average trade = $421Largest drawdown = $2,662.50The combined results of trading these two systems across the twodifferent markets are shown in the next box.Combined S&P and CornTotal net profit = $81,137.501461255 winning trades57% profitableWin/loss ratio = 1.64Average trade = $318Largest drawdown = $8,925JThe net profit is simply the two individual market net profitsadded together. The number of winning trades and losing trades remainthe same as well as the average trade and win/loss ratio. However,the largest drawdown is pegged at $8,925, which is lower thanthe S&P but somewhat higher than corn. The ratio of the S&P singlemarket drawdown to the corn single market drawdown was approximately3.4, meaning the S&P drawdown was 3.4 times the size of thecorn drawdown. Therefore, to equalize the markets, three corn willbe traded for every one contract in the S&P. The results (complimentsof the Performance I software) are shown in the box at the topof page 139.By adding two additional corn contracts, the drawdown increasedby at least a full contract. Therefore, we lost the benefit of noncorrelatingdrawdowns of one of those contracts. The reason we did notlose the benefit of both additional contracts is that the main drawdownoccurred during the S&P’s largest drawdown, not the corns.There is a 50150 shot of the largest drawdown occurring during eitherMARKET WEIGHTINGAdding Two Corn ContractsTotal net profit = $124,987146/255 winning trades57% profitableWin/loss ratio = 1.8Average trade = $490Largest drawdown = $11,3251139market’s individual largest drawdown. If we had added three contractsto the S&P instead of corn, the results would look as shown inthe box that follows.Adding Three S&P ContractsTotal net profit = $199,5621461255 winning trades57% profitableWin/loss ratio = 1.56Average trade = $782Largest drawdown = $24,375The largest drawdown represents 2.74 times the combined cornand S&P drawdown. We increased the drawdown by 2.74 of the additionaltwo contracts. By trading the S&P alone, the drawdown wouldhave been $27,300. There was a 50/50 chance that this is exactly howadding the corn contracts would have resulted.According to drawdown and the fact that money management ismore efficient with lower drawdowns, the logical thing to do is totrade one corn contract with one S&P contract. If the goal of weightingthe markets is to increase potential profits, it would be better toincrease those profits by adding a different market rather thanadding an additional contract to an existing market. By doing so, youwill increase the net profit of the portfolio as well as your chancesthat the drawdowns will be noncorrelating. The results in the box atthe top of page 140 are from the same system that was applied to thecorn being applied to the bonds.140 MARKET WEIGHTINGBonds iTotal net profit = $67,78132173 winning trades43% profitableWin/loss ratio = 3.18Average trade = $928Largest drawdown = $6,093The next box shows results from combining the single contractperformances of each corn, bonds, and S&P.Corn, Bonds, and S&P CombinedTotal net profit = $148,9181781328 winning trades54% profitableWin/loss ratio = 1.95Average trade = $454Largest drawdown = $9,168Specifically, this combination should be compared with the combinationof trading three corn contracts and one S&P. Notice that thenet profit was $24,000 greater while the drawdown was more than$2,000 smaller. This may not seem like a huge amount, but in anarena that has a very small margin of error, it can be quite a bit.Further, the money management results will magnify the differences.By applying the Fixed Ratio method with the delta = to 72 thesize of the largest drawdown, the following results occurred, firstfrom the additional corn contracts added to the portfolio and thenwith the single corn, bond, and S&P contracts (see box on p. 141).The difference in net profit was over $775,000 within an eightyeartesting period. That is like missing out on a salary of about$100,000 a year simply because of an alternative to market weighting.Further, after the drawdown, the three market combinationMARKET WEIGHTINGThree Corn, One S&P with Money ManagementTotal net profit = $1,113,7001461255 winning trades57% profitableLargest drawdown = $128,175(11.5% profits)Maximum number of contracts held = 20One Corn, One Bond, & One S&P with MoneyManagementTotal net profit = $1,890,1751781328 winning trades54% profitableLargest drawdown = $266,000(14% of profits)Maximum number of contracts = 30141would be at $1,624,175 while the three corn, one S&P portfolio wouldbe at $985,000. This is a 60 percent increase in net profits after thedrawdown!Some traders may find this chapter is extremely hard to swallow.The logic doesn’t seem to flow with the math and vice versa. However,if you will take a look at the logic from a numbers standpoint,not the market or the historical volatility of the markets, you will seethat it makes perfect logical sense. Nonetheless, if you still havetrouble, I think the next chapter is for you.