Avoiding sector risk - Part 2

In our first part we determined that the cut off date would be 7/8/2008 if we were to use a large loss as a signal of excess risk and eliminated that sector from our universe. This was the period leading into the financial crisis and as most will remember, the bank stocks had substantial losses during this period. So how did our banks stocks do following the cut off date?

Equity

Statistics

	All trades	Long trades	Short trades
Initial capital	50000.00	50000.00	50000.00
Ending capital	55707.23	55707.23	50000.00
Net Profit	5707.23	5707.23	0.00
Net Profit %	11.41%	11.41%	0.00%
Exposure %	5.11%	5.11%	0.00%
Net Risk Adjusted Return %	223.47%	223.47%	N/A
Annual Return %	7.56%	7.56%	0.00%
Risk Adjusted Return %	148.10%	148.10%	N/A
Total transaction costs	148.14	148.14	0.00
All trades	45	45 (100.00 %)	0 (0.00 %)
Avg. Profit/Loss	126.83	126.83	N/A
Avg. Profit/Loss %	2.55%	2.55%	N/A
Avg. Bars Held	5.47	5.47	N/A
Winners	29 (64.44 %)	29 (64.44 %)	0 (0.00 %)
Total Profit	13145.00	13145.00	0.00
Avg. Profit	453.28	453.28	N/A
Avg. Profit %	8.77%	8.77%	N/A
Avg. Bars Held	3.59	3.59	N/A
Max. Consecutive	11	11	0
Largest win	1302.84	1302.84	0.00
# bars in largest win	3	3	0
Losers	16 (35.56 %)	16 (35.56 %)	0 (0.00 %)
Total Loss	-7437.77	-7437.77	0.00
Avg. Loss	-464.86	-464.86	N/A
Avg. Loss %	-8.72%	-8.72%	N/A
Avg. Bars Held	8.88	8.88	N/A
Max. Consecutive	5	5	0
Largest loss	-1994.72	-1994.72	0.00
# bars in largest loss	10	10	0
Max. trade drawdown	-3288.32	-3288.32	0.00
Max. trade % drawdown	-60.91	-60.91	0.00
Max. system drawdown	-9528.14	-9528.14	0.00
Max. system % drawdown	-17.45%	-17.45%	0.00%
Recovery Factor	0.60	0.60	N/A
CAR/MaxDD	0.43	0.43	N/A
RAR/MaxDD	8.49	8.49	N/A
Profit Factor	1.77	1.77	N/A
Payoff Ratio	0.98	0.98	N/A
Standard Error	1466.78	1466.78	0.00
Risk-Reward Ratio	1.82	1.82	N/A
Ulcer Index	3.55	3.55	0.00
Ulcer Performance Index	0.61	0.61	N/A
Sharpe Ratio of trades	1.38	1.38	0.00
K-Ratio	0.04	0.04	N/A

Drawdowns

Conclusion

As we can see, there is a is a large drawdown in early 2009 which is as expected. Although this drawdown is quite large, it is also quite short and steep. This is because the best returns are clustered with the worst returns and we experience out sized gains once the risk has passed. The key thing to note is that the risk adjusted return is 148% which is over triple the risk adjusted return leading up to this period.

As traders we get paid to take risk and during periods of elevated risk there is the potential for out sized returns. Our job is to manage that risk and to get paid appropriately for the risk we take.

Keep in mind this is a very simple test and certainly wont apply to all systems or trading styles. I think it helps illustrate that risk management is as critical to your trading system as the entry/exit criteria.