Nick Radge Interview –

www.bettersystemtrader.com

Nick Radge Interview

Better System Trader – Session 004

Andrew: So Nick Radge, thanks again for joining us today.

Nick: No problems, Andrew, thanks for having me.

Andrew: Firstly, can we start with a little bit about your trading background.

Nick: Sure, I started in the markets at the ripe old age of 18 back in 1985. I didn’t intend to be
involved in the markets; I had no interest at school or anything like that but just one of
those things. I stumbled across it and got a job in it and I’d started to take a big interest
in it and it became my passion. And so, that was 1985. For the first 17 years I mainly traded
commodities, futures and FX and then in 2001 moved along to stocks and today I
predominantly trade just stocks around the world.

Andrew: So those who follow your work know you’re mainly a Momentum and Trend Following
Trader, what does that mean and how did you get into that style of trading?

Nick: I guess I got into that style of trading right from the get go. Some listeners may have
already heard this story before but I was working for a stockbroking company, not on the
dealing side but all just on the administration side. And I took a walk past to the private
client desk one day and there was a guy plotting a 5 and 10 day moving average crossover
on graph paper, remember we’re back in the mid-80s here, and the trends just stood out.
I could intuitively understand right there looking over this guy’s shoulder, how he was
making money. And that was it. That was basically the system, there was no position
sizing, nothing else apart from 5 goes above the 10 you buy it but goes below the 10, you
sell it. That’s where I started trading and understanding what the trends do.

I guess I got more interested after hearing Russell Sands speak and he was one of the
original Turtles. And that just tweaked my interests so much so that I went and bought
Trade Station and this is back in the very early 90s. And then I also got heavily involved
with Curtis Arnold, PPS Trading which essentially is the same thing, although pattern-
based.

So everything that kind of intuitively made sense to me was in one way or another some
kind of trend following, and today I strongly believe that trend following is, well maybe
not the easiest thing to do but from a robust and profitable standpoint, it certainly,

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probably the place where most people should at least start and use constantly over the
longer return.

Andrew: So that meeting average crossover that you mentioned is quite a simple way to determine
momentum or a trend. What are some other examples of systematic ways to determine
a trend?

Nick: Yeah. Good question. Well, in my book, Unholy Grails which was published a few years
ago, we discussed about 8 different ways to look at trend following and built systems
around that from very, very simple things. You’ve got your standard channel breakout
which everybody knows, kind of from the Turtles. So we investigated things like okay,
longer term breakouts like if you make a new highest high in the last 100 days and you
see the trend is up, so you’re jumping on board.

The lowest low in the last 100 days, well clearly the trend is down and you can jump on
board. Other strategies like buying stocks when they hit new all-time highs. Other things,
a very popular strategy that we created was called the 20% flipper and the context is very
simple. When price moves from a low point up 20%, then you buy the stock. At the end
of the day, if you get a stock that is going to be up 200, then 300, and 400, 500 percent,
well it’s got to travel through that 20% barrier first, and you’d just hop on board and if it
reverses by 20%, then you can hop off.

Simple things like that, and you can get some volatility based kind of strategies, for ex
ample using Keltner bands or Bollinger bands. In fact, the trend following strategy that I
continue to use today that I developed back in the 90s and interestingly enough I
developed to trade futures back in the 90s. But today, we only trade equities using the
exact same concept and that is based on Bollinger bands.

Riding a trend is relatively simple, no way is necessarily better than any other way. There
is a few little tricks to be wary of but at the end of the day, hopping on a trend doesn’t
have to be that difficult or complex.

Andrew: Right. So do you use these same methods to stay in a trade or they really just to get in like
a trigger?

Nick: The Bollinger band system as an example that we currently use, the exit mechanism . . .
the Bollinger band as an exit mechanism only comes into play – I don’t know, maybe 10%
of the time. Generally speaking, well, not generally speaking but we do have an adaptive
trailing stop. And the adaptive trailing stop operates on two levels. It operates on a stock
level, that is the individual stock level and it also operates on a broader market level as
well. So I would suggest that 90% of the time, that adaptive trailing stop is actually what

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exits the position and the Bollinger band which is the opposite to the entry mechanism
probably only accounts for 10%.

In Unholy Grails, the strategy that we did test and showed very promising results was an
entry using a Bollinger band and an exit using the opposite Bollinger band, but we use 3
standard deviations for the entry and 1 standard deviation for the exit, just to keep the
trailing stop a little bit tighter. And that showed very, very good results. So it’s something
like that that in its very basic format that everyone can have access to and is certainly a
good platform to start from.

Andrew: So it sounds like the key there is to keep it simple and just try them out and see how they
work.

Nick: I think a lot of people overestimate or don’t even understand that some of these trend
followers that have been in business 30, 40 years use remarkably simple techniques. The
difference is not so much in the technique to being successful. The difference to being
successful is applying the approach over the longer term. I think that is the key difference
between professional traders who can build a 10, 20, 30, 40 year track record and people
who switch up and down systems every second day.

I truly believe that simple works, simple works as well because it is more difficult to break.
It is also very easy to understand what and why the strategy might not be working at any
given time. So let’s use an example right there. A long only equities trend following
strategy, the types of conditions that the strategy is going to not work so well, I’m not
going to say broken, that is incorrect, but not work so well would be in a very choppy side
woods market, or obviously in a down trend.

Now if you have a simplistic system and you go into drawdown and you look that the
market is trading in a sideways band, well you understand why that is occurring; it’s
nothing wrong with the system. That is just a function of trend following in that it will
chop you around a little bit in the sideways market.

However, if you build a very, very complex system with many variables and inputs and
parameters, then there’s . . . first of all, there is a very high chance you have data-mined
or you have curve fitted for a start. Second of all, you don’t quite understand why the
strategy is making money and you probably don’t understand if it is not working, why it
is not working. One of the most important things I try and get across to my clients is you
need to understand why your strategy makes money, and trend following is just such a
simple robust way to do that, i.e. you create a positive expectancy because your winners
outweigh your losers, and that’s the bottom line, that’s what it is all about.

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If you can’t explain why your strategy makes money then when it goes into draw down
you are going to find it very, very difficult to stay with it because you simply don’t know
why it is going into drawdown and why if it’s broken or not.

Andrew: Right. So you said one of the keys for trend following is to apply the approach over a long
period of time. You’ve been trading yourself for quite a few years. How have the strategies
changed over the course of your trading career?

Nick: A strategy we currently use which is the one I built back in the 90s, it is almost exactly the
same; the parameters are the same, everything is the same except we are trading it on
stocks now rather than futures contracts. We’ve probably made two small adjustments
to that strategy since we released it to the public which was back in 2006.

In 2008, when the strategy was switched off during the bear market which was one of its
defensive mechanisms, we used to have a fundamental overlay, if you like. My theory, as
wrong as it was, was that if you have stocks with a high broker consensus, fundamentally
high broker consensus opinion, then fundamentally those stocks are probably quite good
and they would therefore, probably perform better.

We removed that in 2008 because we started to realize that brokers at the end of the
day, their opinion just follows the share price.

A classic example was Iluka. A few years ago when it was trading around $3.50 or $4,
some of the brokers had “sell” recommendations, some of the brokers had “hold,” the
valuation was about $4.20. Now that stock went one way to $18 without the slightest
pullback in any way, shape or form.

Now during that whole one-and-a-half year trend, from $4 to $18, all the brokers slowly
upgraded their valuations after price had already moved. And once the price got to $18,
all the brokers had a valuation of $21-$22 and of course it then just tanked and went
straight down to $12. So what we found is that broker consensus opinion tends to be a
lagging indicator and tends to follow price so we just removed that completely.

The other adjustment we made wasn’t so long ago. What we started to see was we were
being put into trends and this is specifically with high volatility stocks, specifically resource
sector stocks. We found that we were entering the stocks based on expansion of volatility
rather than the start of a new trend. And by removing that expansion of volatility entry
mechanism, we got a drastically better risk adjusted return out of it. Now this was only
possible because of technology. Up until a few years ago we were unable to do that
because the technology wasn’t available specifically being able to strip out certain kinds
of stocks and certain kind of sectors of stocks.

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So basically what we do now is we define stocks very broadly as in industrial stocks or

resource stocks and I guess in some context this goes back to many fundamental opinions
that many fundamental and value investors won’t buy or sell resource stocks because at
the end of the day they don’t understand them, they don’t make money per se and they
just let them go. And that kind of comes through with our trend following strategy. More
so that they tend to be extremely volatile and more driven by sentiment very, very quickly
one way and then the other, rather than steady, sure thing trends like you tend to get
with industrial stocks.

The bottom line is the key strategy remains exactly the same as what it did back in the
90s but we’ve made a couple of small adjustments and look that happens across the
board. One of the greatest examples of that is Dunn Capital. Between about 2003 and
whenever it was 2010, Dunn Capital went into a 60% drawdown. Now that is a significant
drawdown for a trend following strategy managing, hundreds and hundreds of millions of
dollars.

And they had their PhDs all working on this problem and they have just exploded to new
equity highs since hitting that 60 percent drawdown point. And they just made some
slight adjustments basically to the allocations. They basically said they’ve got an algorithm
there, that tends to say, “Well, yep, the market is in a very, very trendy condition, so we
will allocate more risk to that particular trade,” or it’s, “Well, the market is not so much
in a trendy position, we will allocate less risk to that trade.” And obviously they don’t give
away exactly what they’re doing but that sounds like the key element there.

Strategies, if they’re robust, don’t tend to need to be adjusted but we’re always learning
different things. We are always learning about the market, so small adjustments along
the way are pretty usual.

Andrew: That’s an interesting observation that you’ve raised about low volatility stocks generally
being better for trend following.

Nick: Yeah that’s right. We don’t completely remove high volatility stocks. What we tend to find
is . . . and again, it might seem obvious that you put a fundamental overlay but again, how
do you define that? But fundamentally, companies that are making money and doing well
tend to trend a lot better than resource-driven stocks that tend to be more sentiment-
driven.

You’ve seen those penny stocks that go from $.05 to $.65 and then revert back to $.20 in
the space of a week. They are not the kind of stocks that we want to capture because
there is no sustainable trend, not one that we can capture on our timeframe. I guess if
you are using one minute data or ten minute data you might be able to capture something
like that but we certainly can’t using our end of day data. It’s just an observation we made.
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We don’t discount resource stocks completely. We still offer it in our service to our clients
because we certainly do have clients that want to be still involved in those kind of sectors
but personally my own portfolio that I use to manage my super fund, I don’t trade any
resource stocks whatsoever. I still trade a higher beta stocks but they are just not resource
stocks.

Andrew: How do you know when a trend following system does need some tweaking?

Nick: It is a very good question. I am not sure that I have an answer per se but I would suggest
that your own experiences and observations over time will just alert you to seeing an area
where potential improvement can be made without curve fitting or data mining or
whatever else. And that is a very important thing to do.

So in this particular case for example, removing the resource stocks, came from new
technology which allowed us to test it, and an observation. The observation was that
these tend to be more explosive in terms of volatility rather than trendiness and that
observation and then backing it up with a new technology to test it clearly showed that,
well, there is just no real point including these resource stocks in a trend following
portfolio. It is an observation. It is not really a system tweak per se, I guess it is a portfolio
tweak.

But we don’t go down to the nth degree like okay, we are going to drop coal stocks and
we are going to keep uranium stocks and gold stocks. It is not like that. It is either a
resource stock or it is not, and same when you go down the sectors. We trade any kind of
stock regardless of what sector it is using the same technique. It may not be optimal but
optimal tends to fail. So you want something that’s reasonably good all of the time rather
than something spectacularly good just a piece of the time.

Andrew: Alright, thanks Nick. You mentioned bear markets a few times.

Nick: Yeah.

Andrew: Your approach to bear markets seems to be going to cash and waiting for a new bull
market, why is that?

Nick: Very simple reason why buy and hold offers average returns is because you wear all
market conditions. You are fully involved in the great times which is what you want to be
but you are also involved in bad times like the GFC. Now I haven’t met too many people
that complain about the good times. You continuously hear people winch about the bad
times when the market is trending down. And if we think about it, fundamentally to get
optimum results you want to be fully invested when the market is good, that is going up

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and you don’t want to be exposed so much when the market is going down in a sustained
kind of way, like the GFC.

If you think about the error that so many investors made back in 2008, well they stayed
invested all the way through 2008, so they stayed invested during the very, very bad
period of time and then come 2009, they were so shell-shocked and so paranoid about
the world finishing that they couldn’t stay invested when the market rebounded in 2009.

Whereas, we did the exact opposite. We went to cash we were fully in cash by about June
2008. We stayed that way to February or March 2009, and we hopped on board and had
a brilliant year in 2009. Not because we picked it, we had no idea what was going to
happen. We had no idea that it was going to be such a sustained downtrend through the
GFC but the price action led the way. So our philosophy is pretty simple – to maximize
return you don’t want to be involved during the bad times but you want to be involved in
the good times and trend following allows you to do that.

We don’t follow trends on the downside so we are only long only and the reason why we
don’t follow trends on the downside is two-fold. First of all, if you remove the sustained
move in the GFC, you will see historically that long-term trends to the downside really
haven’t been prevalent. So the market has this natural inclination to rise but generally
downside momentum is very, very swift, very fast and tends to bounce back very, very
quickly so it is not perfect for trend following.

The other thing to consider as well, during the GFC short-selling was banned across the
board and what is the point on being reliant on a strategy that you can’t use the absolute
time you need to use it at some stage in the future?

It is all good and well to have a short side strategy but if ASIC or whoever it may be ban
short selling, well, I’m sorry you’re out of the game right there. We only trade on the long
side. And the other reason why we do that is because the kinds of clients we are trying to
attract, middle-aged high net worth individuals who want to control their own money
rather than use a financial plan or a stockbroker. But at the end of the day, they don’t
want to start setting up advanced accounts with CFD providers or short sellers and they
don’t want to have to go through all that rigmarole and complexity, if you like to put that
into play.

By offering a long only trend following strategy in equities using simple processes and
therefore the average man in the street can just use a vanilla eTrade or CommSec or Bell
Direct account and not have all those additional complexities. That is part of what we
offer.

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Andrew: That is some fantastic advice there, Nick, thank you. Just to wrap up this trend following
section, I would just like to cover a couple of common misconceptions or criticisms of
trend following which you also cover in your book Unholy Grails. First one, trends don’t
lasts forever and if a stock becomes too popular, it will reverse, leading to a sharp decline
from which you can lose a lot of money. What do you say to that?

Nick: Well, that is a quote I found, at the end of the day, what the hell does that have to do
with trend following? A fundamental investor or a value investor could be on the exact
same stock, and it has happened before. There was a stock a few years ago that was being
touted by a well known value investor here in Australia, and it went up and up and up and
up and up and up and up and I think when it was about 10 dollars the valuation was
fourteen dollars and everyone was going wild for this stock and on the first dip, everyone
piled in because they got that opportunity to buy it at a discounted price apparently
because it was valued at 14, it has dipped to 8, let’s get on board. Well, it went all the way
down to about $2 and it never, never recovered and a lot of people got burnt.

So that was a value proposition right there, and of course, at the end of the day the
valuation was completely erroneous. But that quote that you’ve mentioned, they have
targeted trend followers and it is just completely incorrect because it doesn’t matter
where you are holding the stock, if that is going to happen to a stock price well, it has got
nothing to do with the people holding it, you know. And the other thing, it is not going to
happen to a trend follower because if the price does reverse, you’ll be getting out. But
there is a lot of those kinds of misconceptions around.

Andrew: Right, and one last one, trend following is time intensive.

Nick: Yeah, it’s just total garbage. It takes me . . . I say to clients, it will take them less than 10
minutes a day and the real time is probably 3 minutes or 4 minutes a day. In this day and
age with computing power that we have, and off the shelf software packages, I put my
account balance into my software, I push the button, it generates the buy and sell signals
as well as the position sizing, I can even connect that software to my broker so it places
the order but I just manually do that. And I’m done.

Don’t get me wrong. That takes less than 5 minutes a day. It has taken 25 years to get to
that point but it takes less than 5 minutes a day, it is not time intensive. It is absolutely
garbage it’ time intensive. Time intensive is reading annual reports, visiting company
headquarters, speaking to CFOs, CEOs and staff, and that kind of stuff. That is time
intensive. That is what fundamental and value investors do, that is not what we do, we
are quant based. We just push the button and it generates the buy and sell signals and
we move on.

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Andrew: Excellent. Thanks Nick. I’d like to move on to the research and validation process. How do
you validate systems and ideas?

Nick: Well the main software that we use these days is AmiBroker. I started using Trade Station
back in the early 90s. The problem with Trade Station was you could really only test single
market systems, you really couldn’t do any portfolio testing. AmiBroker allows you to do
all the portfolio testing and significantly more advanced kind of stuff as well. In more
recent times, databases have become more advanced so we can do historical testing on
historical constituent lists. Say for example you’ve got a strategy that you just want to
trade the S&P 500 stocks, that’s your universe.

What we are able to do now is go back to 1980 and understand what the S&P 500 list was
back then because back then it was different to what it is today. Classic example here in
Australia for example you think about stocks like Onetel, HIH, all these stocks that don’t
exist anymore. They actually used to be in the ASX 100. They were big-end stocks. So we
have to include those in our tests to remove survivorship bias and the technology and
databases available now enable us to do that very, very easily. So yes, AmiBroker and we
use the Premium Norgate Data as our data provider.

Andrew: Oh, okay. So how do you measure the performance of the strategy when you are testing
it?

Nick: Well you’ve got to look at a lot of different things, you just can’t look at the return. One
of our key concepts is what we found especially delivering strategies to the public is that
most people can handle a drawdown up to about 20%, but once you get past 20%, it
becomes more and more difficult. So we are looking for strategies that offer reasonably
good returns, in excess of 15% and with reasonably controlled drawdowns, i.e. below
20%. That’s what we’re looking at.

We also have to look at the other things as well, how often the drawdowns, how smooth
the equity curve is. We are realists. We understand that with trend following models,
there is going to be periods of time of equity decline and flatness, that’s a part and parcel
of the environment we choose to invest in. Also winning percentage of trades, we tend
to want a strategy that has a winning percentage of trades no less than 45%. Generally
speaking, once you start going below 45%, the profit factor drops or the comfort of the
strategy drops and it becomes more difficult for the people to use them.

Even the profit factor, a very low profit factor, or example, the Turtles have very low profit
factors even though they are very, very profitable, but psychologically they’re a lot more
stronger than the average person in the street. So it is trying to find a balance if you like
of return, risks and the level of comfort to trade.

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Now it’s important that people find a strategy that they are comfortable with, and if
they’re comfortable, then they will be able to apply it over the longer term in which will
probably determine their success but if they are uncomfortable every time they get a buy
and sell signal, they uhm and they ah and they balk and they wonder and they stay awake
at night concerned about it, then chances are they are not going to be applying it for the
longer term, and chances are they won’t be successful with that strategy.

Andrew: So how do people become comfortable with a strategy? I mean, it is easy to look at the
strategy results on a piece of paper but applying it can be a different kettle of fish.

Nick: Absolutely, and that is what I said earlier on, the difference between very successful
traders and everybody else tends to be the ability to apply the strategy over the longer
term. And you’re absolutely right; you can’t just look at it on paper. I did a talk, it’s
available on the website, back in 2009, and I think I even made a mention of it in the book
Unholy Grails but The Lake Wobegon effect, it basically means that people overestimate
their own capabilities. So you might have a strategy that shows a 20% drawdown, this
person will go, “Ah, yeah, no problems. I can handle a 20% drawdown.” Well, I’ll give you
the tip, you can’t. It is generally whatever drawdown you think you can handle on paper
is probably about half than the real world. So, it is a very, very different game when you’ve
got money on the line, so reading a piece of paper is not going to help you in any way,
shape or form.

The key to being comfortable with a strategy is first and foremost understand why that
strategy makes money. Understand where that strategy will get into a little bit of strife
and why it will go into drawdown, and once you accept that’s part and parcel of the
journey, then you are at a better level to be able to trade it, and then from that point in
time, it is just a matter of experiencing it. And look, it is not a race. If you’re unsure but
you need to experience it, then you go in it a little bit softer.

One thing we see is so many traders come into this game and they just go hard and fast
and as soon as they hit a hurdle, which are inevitable, they freak themselves out and they
can’t go on with it and back to the beginner’s cycle they go. So slow and steady wins the
race. If you’ve got a hundred thousand dollar account, you’ve got a new strategy which
you understand how and why it works then perhaps the best way to start is with $50,000,
go slowly for a year or so and then up the ante and then you’ll be fine.

So many people takes such a short term view of it all. You know all these guys, Abraham,
EMC and David Drews, all these guys that have been there for 40 years, you just got to
think, every day they step up to the plate, every day, every week, every month, every year
for forty years, they’re placing and managing their trades. The average man on the street
who comes into the trading world, struggles to do it for 3 weeks. That is the difference
right there. So slowly but surely, but more importantly understand why a strategy is
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making money and that way you’ll be in a better position to know the market conditions
that need to exist where the strategy will go into draw down.

Andrew: If I can just take a step back into back testing. There are a number of challenges and issues
with back testing that need to be addressed for reliable results. You mentioned
survivorship bias already; perhaps you can talk about that a little bit more.

Nick: Yeah. That is a very, very important aspect that needs to be understood and needs to be
overcome. So survivorship bias basically means you are basing results on something that
may not have existed back then. So for example, let’s assume that again, you want to
trade the All Ordinaries here in Australia which is the top 500 stocks.

Well, the All Ordinaries today is very different to what the All Ordinaries was made up of
back in the late 90s. Back then you had HIH, that’s gone bankrupt. So you have got to
include stocks like HIH in your testing to see how your strategy would have done. Now
different strategies are going to operate in different ways. For example, most stocks that
delist in Australia tend to trend down for a sustained period of time. We showed this in
Unholy Grails, stock after stock, they all trend down and even HIH, even though it went
bankrupt it was in a downtrend for a good year-and-a-half. A trend following strategy
won’t tend to be involved with those kind of stocks anyway, but you have to put them in
there to understand what impact they would have had on the back test. That is a very
simple version of it.

Other versions of survivorship bias as an example, back in the 90s many of the Tech stocks
in the U.S. split almost every year. I think Microsoft split almost every year for year after
year. So if you build a system that has some kind of a price limiter on it. Say your systems
says well I only want to trade stocks below $50 and if you don’t take those stock splits
into account, well you’ll actually get Microsoft in your back test when in the real world
that would not have been possible so little things like that make a difference.

How about things like volume? For example, we do a lot of testing using CPI-adjusted
volume. If you have a strategy that you build today, that you require a minimum turnover
of $1 million, the market today is substantially larger than what it was back in 1990. So
back in 1990 you might not have been looking or trading stocks, or there may not have
been any stocks whatsoever with that kind of turnover back then.

So we will go back and set a base date and then we will adjust the volume via the CPI
every year up to the current year as an example. You can get quite advanced with a lot of
this kind of stuff. Is it necessary? Well, again if the system is relatively robust, less testing
is actually needed, but it is always good to have a look at those kinds of things.

Andrew: Right. So another challenge you mentioned previously as optimization or curve-fitting

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Nick: Yeah.

Andrew: Can you talk about that a little bit more?

Nick: Sure. It is probably one of the biggest problems across the board. Curve-fitting or data-
mining is basically taking optimal inputs from the past and expecting them to continue to
work into the future.

For example, let’s use something like a moving average crossover. Or let’s use something
simple like the Turtle’s breakout. Now the Turtle’s, they had the 20-day breakout. Trading
that kind of strategy these days doesn’t work particularly well, so you might go back and
optimize, what’s the best breakout and you might find that rather 20 days it’s actually 100
days. Now the problem with that is you’ve made that decision after you’ve realized the
20 days doesn’t work. So, you’re always chasing your tail when you optimize. It is this
thing where people want the perfect strategy, they want the all weather strategy, they
want the strategy that is going to work in all market environments all of the time.

First of all, that doesn’t exist. The markets are always changing. Second of all, it doesn’t
have to exist. You’re going to have to look at some of those guys for 30, 40-year track
records. They are producing 15, 16, 17, 18, 19, 20% return over a 40-year period. Now the
compounding available there is huge. You’ll get very, very wealthy. I mean, look at Warren
Buffett, he’s got a compounded return of 19% over the long-term, and that’s what we’re
talking about. But for some unknown reason, people think that professional traders a.
make substantially more money and maybe some do, but it’s not necessary.

And second of all, I think professional traders must get around 80, 90% of the time and
that’s the way we’re brought up and that’s the way most people think but again, that’s a
long way from the truth. So I think it’s important that when people have these
misconceptions, they tend to optimize and data mine strategies simply thinking that,
“Okay, well this will got a 75% win rate. It is a much more profitable strategy than this one
that has a 45% win rate.” And that is actually incorrect. It is very easily proven that high
win rate systems unless they have a high frequency don’t generate enough profit, or don’t
generate more profit than something simple like a trend following strategy that has a
higher dollar win per trade.

I think it is a natural thing for people to want to optimize a strategy to get that win rate
very, very high, it sells books, obviously. I think of something like Larry Williams’ Long-
Term Secrets To Short-Term Trading. You’ve got a myriad of patterns in there with win
rates, some as high as 95%. But they are all data mined, they will never work in the future
and unfortunately, people have; I know one guy that blew his account up in one night
because these data mined patterns basically have no statistical significance whatsoever,
and they will not work into the future.
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So as I said earlier on, it is more important to have a strategy that works reasonably well
all of the time, rather than a strategy that works absolutely, incredibly well but just part
of the time.

Andrew: Are there any warning signs that you may be over optimizing a strategy?

Nick: Yeah, oh absolutely. There is a few warning signs.

I think the easiest warning sign is the single market system. A lot of vendors will sell a
strategy that trade soya beans, or trades BHP, or trades the S&P 500. Now, usually a single
market system has some kind of data mining curve fit optimization element. That’s the
first thing, so be very wary of single market systems.

If you’ve got a pattern that operates in a single market, if the pattern has any validity
whatsoever, it should work across a variety of different markets. So the first thing I do
when I see a single market system that works particularly well is I’ll go and trade it on a
bigger universe of stocks, say the S&P 500. If it doesn’t work, then the pattern is curve-fit
and it is going to fail. That’s the first thing.

The second thing is the number of inputs into a system. Generally speaking, the more and
more you filter a pattern or a setup or whatever it may be, the more you’re curve-fitting
to pass data and generally speaking, the results will be too good to be true in that
instance. So that is where you get these systems that are generating up to a 40%
annualized return with a 4% drawdown. I mean, they just don’t exist. And that would
because, what happens is people continue to remove the bad parts of a system, the bad
trades and that is done by filtering. But unfortunately what happens in the future, bad
trades will come from somewhere else which you haven’t taken into account.

So what else is there? Single market systems... and yeah, as I said, I think the most
important thing is that any kind of setup or pattern that has any validity whatsoever
should be showing to be working very, very well across a number of markets at any given
time, and that’s just a simple test. I wrote about a set up that trades just one gold ETFs.
Now that same set up failed dismally as soon as you traded it on S&P 500 stocks.

Another warning sign would be if you have a very specific universe. Let’s say, okay this
system has to be traded on this 5 ETFs. Now there is hundreds and thousands of ETFs.
One would assume that the strategy is going to work on the very vast majority of those
ETFs rather than just 5. Unless there is some specific reason why those 5 were chosen,
then there is a very high chance that that has been a curve-fit.

You can’t come to me and say, “Well, the system works best on these 5 ETFs, so we are
just going to try them.” That’s not good enough. That may be the case but unless the

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system still works well in all the other stocks, then you wouldn’t go and try those 5 ETFs
with it.

Andrew: Another common approach to strategy testing is to split historical data into in sample
and out of sample.

Nick: Yep.

Andrew: Can you explain that a little bit more please.

Nick: Yeah, basically again this tends to come back towards those that move towards
optimization. Now optimization is all good and well and fine when it’s done correctly, but
usually people do it incorrectly.

So the way I was always taught about in sample and out sample data is you divide your
data into 3 parts. Let’s go back to 2000, alright? We’ve got 15 years, we divide it into 3’s,
so we take 2000 to 2005, we take 2005 to 2010, 2010 until today, so you basically got 3
sets of data. And then what you do is you go to that middle set of data, 2005 to 2010 and
theoretically, you would build your system in and around that 5-year period of time only.
So you would do your optimization tests and do whatever you wanted and come out with
a strategy that looked good, and then what you would do is you would take those exact
rules from that 5-year period and apply it to the first 5-year period and the last 5-year
period, and that is your out of sample data.

If those two out of sample periods are similar to that middle sample, then you’re on to
something. But usually, they will be way out. Now the problem I had with all of that is first
of all, the optimization. I just simply don’t really agree with optimization whatsoever, but
as I said, if it’s done correctly, then that’s probably okay.

The other issue especially for equity-based trend following strategies which is what we’ve
been talking about. Well, it’s very different periods of time, okay. If you take that 2005
period of time through to 2010, you’ve got the GFC in there, and that was a very, very
nasty period of time. And again, in my view, you’ve got to look at the whole picture of
trend following and understand that well, that was a freak event in 2008, it could happen
again but it is going to impact a trend following strategy in a certain way. So if you test
your strategy in a really, really good period of time, say for example, 2004 to 2007 as an
example, you’re probably saying, “I’ve got the Holy grail.” And really, you’ve got to look
at it in a more bigger picture perspective, understanding that the GFCs are going to
happen and a trend following strategy that is long only is going to be impacted in a certain
way.

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I saw recently, a Quant blog in the U.S. criticized a mean reversion system that was long
only because it had flat periods in it. So what? It’s a long only mean reversion strategy
that switches itself off during bear markets. I can’t see that that’s really a problem with
the strategy. It is a defensive mechanism. It is just one of those things. Warren Buffett
doesn’t have winning years every year. He doesn’t need to.

If you can understand, okay this equity curve is a little bit flat here because of this reason,
then that’s fine. That’s the most important thing. So, in sample, out of sample, most
people talk about two periods of time. So your in sample period would be say, 2000 to
2010 and then your out of sample would be 2010 to 2015, but I have always been taught
3 periods of time. You take the middle time, do your testing on that, then apply those
parameters to the first set and then the last set, and if they equal up, then you’ve got
something.

Andrew: Okay, alright, thanks. If I can just ask one more back testing question before we move on?

Nick: Sure.

Andrew: What part of the process do you include position sizing or money management.

Nick: Again it depends on the kind of system, but the very vast majority of systems we design
are designed to be simple to use, okay. That’s where we are coming from. We, with our
trend following models, we tend to use fixed percentage allocations and fixed portfolio
levels. So we will divide an account into 20 equal parts and allocate 5% of capital to each
one. We are not necessarily doing any advance kind of position sizing or anything like that.
We are not doing fixed fractional position sizing that has inherent limitations when it
comes to stock trading. And we just, again, our target market is people that want simple,
easy to understand, easy to manage and easy to implement. So that is the way we go
about it.

Andrew: Excellent, thanks a lot, Nick. I’d just like to wrap up with some closing questions.

Nick: Sure

Andrew: First one is, what’s the biggest lesson you’ve learned through trading?

Nick: Patience. You’ve got to be patient. You just need as a relatively simple system and apply
it over the longer term and that requires patience. And when I talk about patience, I’m
talking about years, not 20 trades, not 30 trades, not two months, not 6 months. It’s got
to be years. I once had someone ring me up and say, “If a strategy doesn’t make money
in any 3-month period, it’s useless.” Well, sorry, but that’s just total hogwash in my view.
And someone like that is going to be spending the next 20 years of their life searching for

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something that doesn’t exist. So, patience, patience, patience is what it’s all about in my
view.

Andrew: What is the best trading advice you’ve received?

Nick: “Next 1000 trades.” That’s my little mantra that I like to use. I used to have some mates
that run a hedge fund and on their computer they had a little sign, next thousand trades,
you walk in the bathroom, on the mirror, next thousand trades, you walk in to the
cupboard on the inside of the cupboard door, next thousand trades, and basically, that
mantra is that, it’s two-fold.

First of all, it’s about that patience. One trade is not going to make you or break you. Too
often we get lured into this situation where you hear someone has won the jackpot by
going to some trade of 2c that went to 6 bucks. Well, sure, but people also win the lottery.
The probability of that happening to you is very small so don’t rely on it.

In other words, build a system that slowly but surely is going to be able to repeat itself
into the future and it may take a thousand trades to get there, whatever. Not a single
trade is going to make you and not a single trade is going to break you, and a thousand
trades is another trade around the corner.

Andrew: That’s excellent advice, thanks Nick. Can you share one of your personal habits that you
strongly believe contributes to your own success?

Nick: I guess the passion for research. I’m not sure if that’s a habit, though. I don’t know how
you create a passion for something that’s inside you. And I am constantly researching. We
are always looking for not only how we can improve what we currently do, but other
things as well.

Our Dividend Momentum strategy which has been incredibly popular and incredibly
profitable over the last 18 months since we introduced it. That was just an idea I had, I
learned from someone else back in 2005. I researched it, it looked good, I put it aside for
about 6 years for no other reason than well, I’ve got the strategies I need now. I don’t
need any more personally, but we reviewed it again after the GFC and sure enough it held
up extremely well and you’ve just got to keep asking the questions, how, what, how can
we do this better? How is, how can, or make this entry better or whatever. I’m not saying
about curve-fitting. It is more broader ideas, just like that dividend momentum strategy;
incredibly simple concept. Anyone can do it but I think the fact that I was passionate
enough to investigate it and test it and look into it further and build rules around the
momentum,; that makes it different.

Andrew: What is your favourite trading book?

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Nick: Well, Unholy Grails, surely. I guess probably one of my favourite trading books is the
Michael Covel book, Turtle Trader, simply because it gives you the background history on
how these Turtles and these top traders have gone through their journey and I continue
to say that’s very, very important. And even today, I’m always looking at the performance
data of all these top traders. There is a few websites that you can get the performance
data.

And I’m looking at the journeys that they have travelled over the last 20, 30, 40 years, and
the whole idea of understanding these journeys is that if it happens for these guys, it’s
going to happen for me. So the more I can understand what they’ve been through, how
they’ve kept their head down and keep pushing forward, it gives me faith that well, what
I’m doing is right, all I’ve got to do is keep on doing it.

So whenever I go into a period of drawdown or a little period of uncertainty or personal

doubt which still happens, I always refer back to that particular book and also the data
provided by many of those managers and reinforce it, that what I’m doing is okay, it will
be okay, I’ve just got to get through that next thousand trades kind of thing.

Andrew: Okay, thanks. What’s the best way for listeners to get in touch with you?

Nick: You can get in contact with us via our website, www.thechartist.com.au. You can drop me
an email directly, nick@thechartist.com.au. Lots of articles on our website, we give away
a free eBook, we do a weekly newsletter that is very, very popular; we talk about
strategies and psychology and all sorts of different things. So yes,
www.thechartist.com.au

Andrew: Well thanks so much for sharing your knowledge and experience with us today, Nick. Is
there anything else you’d like to mention before we wrap up?

Nick: No. Next 1000 trades, everyone can do it, you’ve just got apply yourself over the longer
term.

Andrew: Fantastic. So I highly recommend everyone here out to Nick’s website,

www.thechartist.com.au to check out more of his work. And as we’ve mentioned he also
has a couple of fantastic books loaded with profitable strategies for you to test out for
yourself. Nick Radge, thanks a lot for your time today.

Nick: No problems. Thanks, Andrew.

***End***

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