Nelson Freeburg On Developing The Perfect Trading System
Editor’s note: This is a reprint of a popular interview of Nelson Freeburg conducted by Larry Connors during the past couple of years. We thought you’d enjoy it this afternoon.
In 1996, I came up with the first CVR signals (Connors VIX Reversals) which now make up the backbone of my market timing methodology. At the time, I used to hand-do my research and testing to assure the accuracy of the results. The original CVR results were so strong vs. anything I had done up until that time that I re-did them from scratch in order to confirm my original findings. When these findings were then confirmed, I decided to send them to be picked apart by the person I consider to be among the best and most meticulous systems researchers in the country. That person is Nelson Freeburg. If you are into trading systems development, I’m sure you’ll enjoy this Big Saturday Interview. If you run a fund or are thinking of running a fund, there are some gems here for you, too. And, if you trade for yourself, you will certainly learn some things from Nelson here that will improve your trading. This interview will be published in two parts. I hope you enjoy and profit from it.
Connors: Welcome Nelson…
Freeburg: Hi Larry. Thanks for inviting me.
Connors: Let’s start from the beginning. How did you get into the markets?
Freeburg: I was in graduate school at Columbia University in New York in the late ’70s and as you know this was a time of surging inflation. Commodities like copper and oil were just exploding and gold was making a spectacular climb. My cousin was a full-time private commodity trader, and he got me interested in it and I shifted my focus from political science/international relations/strategic arms control into trading in 1980-1981. I’ve been hooked on it ever since. I never did get my doctorate in world politics — instead I’ve been pursuing this vision of research in trading for the last two decades and it’s been very satisfying.
Connors: Let’s make believe this is day one, and I came to you and said “I want to build a system to make a living off of.” Where would I start? What would be the first thing that you would tell me?
Freeburg: I guess the first thing I would do would be save you a lot of trouble by telling you which of the thousands of books and texts that have been published on trading actually have merit. There are really only a handful that are worth reading. Probably foremost among them — and this is not meant to be self-serving — but I think Street Smarts is probably one of the best trading books ever published. I do believe that. Get somebody like you or me who’s got some experience culling through literature — most of which doesn’t have any merit — and get the 10-15 best books that have ever been written on trading. I tend toward the systematic side of the picture, so I tend toward work by people like Perry Kaufman and Chuck Lebeau, Martin Pring, John Murphy, that kind of thing. I tend toward the systematic rather than the psychological side. I would take a handful of books — begin with that — and then develop an interest in a particular sector of the market and go about creating a strategy in that sector.
Connors: Does that mean common themes? You’re looking at these books and saying, “OK, Street Smarts covers situation with low volatility, Toby Crabel’s book covers information on low volatility.” Are you looking for themes where many people are saying the same thing at same time, to give you confirmation that there is something there?
Freeburg: I guess the key point for me is the claim of an empirical one rather than a psychological one, and by that I mean that a price pattern can be specified and therefore tested, and that’s the key to Toby’s book, Street Smarts, certainly Perry Kaufman’s work, but even people like John Murphy and Martin Pring, who don’t explicitly develop rule-based trading strategies, they do furnish patterns that can be back-tested.
Connors: That’s step one. What’s step two after you’ve done that?
Freeburg: It probably would help to find a market that you’re particularly interested in — most of us like trading the S&P, bonds are good, a few of us trade soybeans — so I would develop a specialized focus in a particular market and become very familiar with it.
Connors: Does that mean that you’ve never seen a system that works in every market? Let’s say, for argument’s sake, someone’s interest is in the cotton market, and the system doesn’t work in cotton. Does that lead to throwing out the system where in fact the system would work in other markets? How do you go about taking care of a situation like that?
Freeburg: A contrasting approach to the one I just recommended is also fully viable and that is to develop a universal system and apply it across a whole spectrum of diverse commodities or stocks This is the Aberration route, let’s say, to use that popular trading system. It’s a perfectly reasonable approach to the markets and might be the optimal approach if you’re managing money either as a stock portfolio manager or as a CTA. Take one system and trade it over a diversified range of markets. There’s nothing wrong with that and what you’ll find is that some markets — usually these are going to be trend following systems — some markets respond very well to such trend based, trend sensitive rule-based systems — markets like the euro/dollar and the currencies, generally, and then every so often other markets will sometime perform well and then sometimes not so well, and the mix of markets that perform well at any given time may shift, but the portfolio as a whole, provided it’s sufficiently diversified, can generate statistically acceptable returns.
Connors: In your opinion, what is the better route to go, focus on one market or focus on one strategy and cross markets?
Freeburg: It’s pretty straightforward. For somebody like myself or an individual active trader, it’s probably best to develop specialized expertise in one market or one family of markets. By a family of markets I mean let’s say the currencies, the metals, or interest rate futures….
Connors: Or the S&Ps.
Freeburg: Yeah, or index futures. A lot of people are switching from the S&Ps to the Mid-cap S&P. I’ve never done it myself but a lot of people say it trends better than the S&P.
Connors: So if I was to trade the Midcaps, then, you would tell me to come up with multiple strategies to take advantage of the Midcaps. Is that correct?
Freeburg: Before I get to that, If you don’t mind, let me…you asked when would you use a composite approach where you trade a single system across a diversified range of markets vs, focusing on individual markets. I say if you’re an individual active trader, focus on a narrow range of markets, or a narrow family of markets. If you’re going to be a money manager, out in public, with custody over other people’s assets, then it would probably be best to trade a multi-market system over a diversified portfolio.
Connors: Let’s talk about time frames. If you’re going to go the money management route, obviously you’re not going to be trading on one-minute bars. You’re just not going to have the liquidity there to be able to make the money. Versus if you’re looking to make a living for yourself and you’re trading small size — to go in and out — you could go the one-minute route. So from a time frame basis, it’s going to depend on what your trading goals are. Correct?
Freeburg: Absolutely. If you’re managing a billion dollars in a commodity pool, your time frame conceivably could not only be days, but weeks and even months, and there are John Henry types who trade on these extended time frames. You mentioned our old friend Toby Crabel. The last time I saw him was in Linda Raschke’s kitchen five or six years ago — he was managing about $5 million — now he’s up over a billion dollars! As I understand it, and I haven’t talked to him in a while — a lot of his strategies are still remarkably short term in nature and I don’t know whether they’re measured in intraday intervals or not, but they’re still fairly short term. I just mention that as an aside because you and I both have known Toby for a good long while and it’s kind of interesting to see how he’s developed a very unique money management operation where he still employs these shorter term time frames even though he’s managing huge sums of capital.
Connors: Even though I don’t know exactly how Toby is trading…I’m familiar with his research. I suspect he’s doing little intraday trading and probably more two-, three- and four-day trading with that type of size. Is that a safe assumption?
Freeburg: I think that probably is.
Connors: From what you’ve seen of the methodologies that work out there and the methodologies that you’ve put together, are trend-following systems better than short term, let’s say swing trading systems or reversion-to-the-mean systems? Have you been able to quantify this?
Freeburg: Almost all of the published systems that have been historically successful are trend-following systems and the fact is, whether it’s a channel breakout system, or a standard deviation-based system like Aberration, or even a moving average type system, these trend-following systems do work over the long run. You will achieve fairly consistent profits over a long period of time, at the cost of what always seems to be an irreducibly high amount of drawdown. Most seem to entail huge drawdowns on the order of up to 70%. I haven’t even tested that many counter trend systems — there just aren’t that many in the public domain — and the ones that I have, typically for a market like the S&P as opposed to a trending market like the Japanese yen — the ones that I have tested have proved to be very profitable in finite segments of time, but not over the totality of the data.
Connors: Are you talking about breakouts in the S&P?
Freeburg: No I’m talking about counter trend systems in the S&P which have been remarkably profitable, but only for limited periods of time, and not over the entire range of data going back to the inception of S&P futures in April 1982.
Connors: What’s the common theme of the periods of time that are profitable? Was there any one thing you can identify?
Freeburg: What I find is that people focus on some parameter — let’s say they sell the S&P when stochastic is overbought and they buy it when it’s oversold — what happens is that there’s a kind of parameter shift, which means that a buy signal that worked in 1984 no longer works effectively in 1994. So my point is that there are not that many counter trend systems that are out there in the literature, and those that are tend to be spectacularly successful for finite periods of time but also unsuccessful outside that limited area of application.
Connors: But can’t the same thing be said for some of the trend-following systems? Take a look at some of the breakout methods out there in the equity markets. They tend to produce spectacular results when the markets are strongly trending and the rest of the time they get chewed up.
Freeburg: It’s absolutely true and that’s why these longer term breakout, channel breakout, moving average, percent swing and other trend-following systems that will produce a decent compound annual return on the order of 12%-16% — that’s over a period of decades — but in order to gain that decent return you have to sustain drawdowns of a minimum of 25% all the way up to 60%-70% , and there could be not months, but years of so-called “flat time” that is, between disparate equity peaks.
Connors: Among the money managers who are able to keep it to 25%, is there a common theme in how they went about doing it?
Freeburg: The real truth is that if you tested a system over a period 30 or 40 years — a system that produced a 15% return — whether it was in stocks or in the futures markets — my guess is that the same system would entail drawdowns well over 50%, realistically. There are not that many people that have produced 15% annual returns over a period of decade after decade after decade that have also been able to keep drawdowns contained to the 20%-25% level.,
Connors: How do you account for the traders who do triple-digit returns year after year in the equity market? They haven’t done it for decades, but they’ve done it for, let’s say 5, 10, 15 years? I know you’re not into the psychology side, but is that where the intuitive sense comes in? Intuition is nothing but experience, and these people are able to know when to get out of a trade?
Freeburg: I guess my point, and I can maybe benefit from your insight on this — you probably know some people who have done this — you have personal experience, maybe with Steve Cohen, maybe with others — but most of the money managers I’m in touch with — the Paul Tudor Jones, the Toby Crabels of the world — and some of the people I’ve read about, Peter Lynch and John Neff and people like that — they really don’t strive to make 20%, 30%, 50% let alone 100% returns year after year.. They’re content with mid-range returns of 10% to 16%, let’s say, and then try to keep drawdowns at the 10%-12% level.
Connors: And how do they keep the drawdowns to that level? Is it the position size?
Freeburg: I definitely think it’s reducing leverage and some kind of money management, obviously. You need to put a stop in there in case a position gets out of control. If you can make 12% a year with 6% drawdown, then somebody could use nominal funding and ramp that up to 30% return, with a still acceptable drawdown.
Connors: Nominal funding means leverage?
Freeburg: Yes, where your individual account as opposed to the entire portfolio, is leveraged.
Connors: So if I give you $100,000 if it’s 2:1, you’re saying you’re really trading $200,000 for me?
Freeburg: That’s exactly right; it’s like margin almost.
Connors: Then the key here from what you’re saying, is to look for these consistent returns month after month and then if you’re so inclined, leverage those returns, if you can do it. Is that what makes a great system?
Freeburg: That’s exactly right Larry, and when I start managing money, what I’m going to do is not shoot for home runs. In fact, you told me this years ago, and I can’t remember if it was managing your own money or whether it was when you were managing public money, but you told me basically the same thing — that you were shooting for 14%-15% annual returns. This is when the stock market was going up, you know, 30% a year. You weren’t interested in that. You wanted to keep risk to a minimum, and you were satisfied — I specifically remember you told me you were satisfied with a 15% annual return just as long as these returns were consistent.
Connors: Yes, it was during the three-year period when we had our hedge fund open. The returns were extremely consistent. And, we were grossly under-leveraged. We were 40% cash almost at all times. It’s a difficult approach when the market’s going up 30%, 40%, 50%, but it works very well in environments where the market moves sideways or down. Mark Boucher is a good example. When the markets go crazy, Mark still does his 1%- 2% a month, and he looks like a goat, and then when the market caves in, he looks like a hero. And it’s this consistency that’s allowed him to succeed in this business for over a decade. And I suspect it’s the same for Toby Crabel. I’ve seen Toby’s monthly numbers; they’re just incredibly consistent. Eight tenths of a percent, six tenths of a percent. One percent is a home run month for him. But he does it nearly every single month.
Freeburg: And furthermore, his drawdowns are under 5%. I am completely in accord with that perspective. That’s the ideal. When I start managing money, that’s going to be the hallmark of my money management perspective. Another thing, you look at famous investors like Peter Lynch and some of these stock guys — John Neffs and others. Buffett made 30 some odd percent a year with reasonably limited drawdowns, but he’s an exception. Most of the famous ones made 14%-15% a year.
That’s the end of Part I. Part II will be published next Saturday. If you would like a FREE issue of Nelson’s publication, Formula Research, call (800) 720-1080, or for international callers, (901) 756-8607, or e-mail sigma20@midsouth.rr.com and tell them you’re a TradingMarkets.com member.