Why Would I Trade A Losing System?
Adding A New Trading System To My Trading Portfolio
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Introduction:
Do you want to be successful trading systematically? Nice, me too! To do that, we need some profitable trading systems combined to create a portfolio. Then trade that portfolio of trading systems and, ideally, make some profits. This is what I’ve done over the past few years. I’ve created a profitable trading system, evaluated the trading system, decided I wanted to trade it, and then added it to my trading system portfolio. I currently have over 25 profitable trading systems live. However, the next trading system I am going to add to my portfolio is a bad system—a terrible system, a system so bad it LOSES money over the long term Most people I’ve told about my plan to trade a losing system have a similar response: Why would you do that?! That goes against everything—do you even want to make money? Why would you trade a losing system? This is what we are going to explore today: my controversial decision to trade a system that has lost money over time.
The Losing System:
First, let me introduce the system. At a very high level, the system is simple: if the VIX index is trending up, buy the VXX ETF. If the VIX is trending down or flat, do not hold the VXX ETF. For anyone unaware, the VIX is the volatility index. You cannot directly trade the VIX, but you can trade an ETF with the ticker VXX to gain volatility exposure. Essentially, when market volatility increases, the VIX and VXX increase; when market volatility decreases, the VIX and VXX decrease. Nothing too complicated. This trading system concept is called a long volatility trading system.
When volatility in the markets increases, it typically coincides with market panics and sell-offs. These are the periods when my portfolio equity curve drops, and I lose money. Hence, having a system that profits during high volatility events sounds pretty appealing. Here is the equity curve of the long volatility system I am looking to add to my portfolio (in green).
Long Volatility Trading System Equity Curve:
Long Volatility Trading System Equity Curve Compared to SPY:
You’ll notice two things when looking at the equity curve. The first is that the long volatility system tends to have huge profit spikes followed by a slow bleeding of money. The second is that these profitability spikes occur when the S&P 500 experiences huge sell-offs. That second point is what’s interesting. This system makes money when the rest of the market is tanking. Now that’s interesting and worthy of exploring…
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Why Would I Trade A Losing System?:
Let me clarify a couple of things. I would not trade a losing system on its own. Trading one system that loses money is crazy. I would also not trade just any random losing system. The system has to achieve its intended purpose. The purpose of this long volatility system is to make money when the rest of my portfolio does not. It’s basically an insurance policy: you pay small fees every month and slowly lose money for 95% of the time. But for that other 5% of the time, you’re pretty glad you have that insurance policy. This system works the same way—it loses money when times are good (paying the cost of insurance), but when markets turn sour, the system’s equity jumps up quickly and makes some gains in the short term (the insurance payments kick in).
What this does is smoothen my equity curve. When the markets crash, rather than my entire portfolio crashing as well, this long volatility system makes money during these scenarios, smoothing out my equity curve. During good market periods, I give up a small portion of returns to have this insurance policy in place.
Essentially, I look at it this way: I plan to trade for the rest of my life, so I want my experience to be as low-stress and easygoing as possible. I don’t want to be freaking out when markets crash, I don’t want to experience huge drawdowns, and I don’t want the stress of not knowing what the markets are going to do next; I want to be positioned for the best possible outcome no matter the market environment. The less stress I have, the more hair I keep! So, to make my time trading systematically as enjoyable as possible, I am going to pay a small amount for insurance to ensure I’m covered during adverse events. While everyone else is scrambling and having a bad time, I’ll be in a zen zone because my portfolio is experiencing significantly less volatility than it would otherwise without this long volatility system.
As I mentioned, you would never trade this system on its own—that’s insane. You need to have a portfolio mindset. You do not experience the equity curves of each individual system on their own; you experience the collective sum of all the systems working together. Your PnL shown on your broker application is the result of every system working together. If you trade two systems and system 1 made money while system 2 lost money today, you don’t feel the result of each system individually. You see the combined result of both systems. If system 1 made more money than system 2 lost, you made money that day, and that’s what you experience, and vice versa. So, if the markets are roaring upwards and I’m making good money with my long-side trend systems, paying a few hundred bucks here and there to this long volatility system is no big deal—it’s serving as my insurance policy, and my account is still growing. Once the bull market ends, the long volatility system will start to make money while the rest of my systems start to lose money. What I’ll experience at the portfolio level is a flatter performance rather than a massive drawdown. The portfolio level is what matters. The portfolio level is what you experience day to day, so one individual system alone doesn’t matter—if that system adds value to your entire portfolio, that’s all that matters; and this long volatility system adds value on a risk-adjusted basis to my portfolio.
I received a lot of flak on X for posting about this concept, and that’s completely fine—I knew that would happen. I’m telling people I’m considering trading a losing system; most would think that’s crazy. But they fail to realize the impact it has on my overall portfolio because, on a risk-adjusted basis, my portfolio is better off with this system. My trading goals are not simply outright returns; I care about risk-adjusted returns. My goal is to achieve better than market average returns (about 2x those returns) with less drawdown. This system helps me get there.
The Losing System Applied To My Portfolio:
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