Nelson Freeburg On Developing The Perfect

Trading System
August 1, 2005 by Larry Connors

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.
Nelson Freeburg On Developing The Perfect
Trading System, Part II
February 8, 2003 by Larry Connors

Last week we covered the first part of our interview with Nelson Freeburg. Click here for Part I of this
interview. Here is Part 2:

Freeburg: Here’s an example of how I implement this is my own personal investing: I’ve got three
children and I started a trust for my youngest about five or six years ago. I just calculated what the total
annual return was for it and it was 11%, which is about 50 basis points above what the S&P produced
during the same period. So I wasn’t swinging for the fences, but the drawdown was negligible. And that’s
the key thing you’ve got to do. When you’re managing a child’s portfolio, if you take a 50% hit, it might
take 12 years to recover from it.

Connors: The five-year performance may be in line with the S&P, but if you take a look at what you’ve
done over the past couple of years, you could have just as soon started this money three years ago and
the S&P performance would be in the negative right now. You’d greatly outperform it over a three-year
period.

Freeburg: Yeah, probably, especially on a risk-adjusted basis. That’s the operational perspective I bring
to the task of strategy development.

Connors: So really in a sense then, management of risk is the Holy Grail for you. It’s making sure that
you’re minimizing risk at all times.

Freeburg: Yeah, I just did a study. We used one of Mark Boucher’s timing models to trade the S&P going
all the way back to 1928. I don’t care what kind of strategy you’ve developed, you’re going to have some
rough sailing during the period from 1929 to 1932. That was the most volatile and the most risky period
for the stock market in history. My point is, if you were a buy-and-hold investor, you would have suffered
an 84% drawdown between 1929 and the market bottom in 1932.

But using Mark’s method — or actually a blend of two of Mark’s models, a bond model and a stock model
— the drawdown was reduced to 20%. Now that’s a pretty steep drawdown, but this was a once-a-
century event, the Great Depression. If you have a 20% drawdown, you need a 25% gain to recover. If
you have an 84% drawdown, you need a 525% gain to recover. This kind of extended historical testing
through every conceivable range of price behavior to me reinforces confidence in a timing model.

Connors: When we can, we try to look at strategies to see if they work in other decades. We ask “Did this
work in the ’30s? Did this work in the ’50s? Did this work in the ’70s?” You really get a feel if you have a
robust system. Do you recommend people doing this? If they have a methodology they’re trading, to try
go get data that goes back decades to see if it holds up during those times?

Freeburg: It’s controversial. The knock on that approach is that the character of the markets may change,
and the nature of price behavior may evolve over time and therefore if you’re extrapolating from trends
that are no longer present, your performance will suffer in real-world application, and that’s a good
theoretical point. A contrasting, or countervailing point is if you don’t test your model through very very
difficult, very very challenging times of economic turbulence, you could be exposed coming in blind to a
horrible collapse in the market that you were just unprepared for.
That’s exactly what’s happened to so many money managers who were children in the ’70s and then
reached their professional standing in the ’90s. All they remember is from 1982 on. And they just fell over
a cliff with this bear market which, of course, is the second-worst of the last 110 years. And so many
people were just unprepared for the catastrophic collapse of the stock market. I’ll give you an example:
I’m on the board of the only growth fund of thousands in the entire country that showed a profit in
calendar year 2002; it’s the Hussman’s Strategic Growth Fund. My point is that all the other money
managers — including people with a lot more experience, and John is still a young man — none of them
could make a profit in all of calendar year 2002. It’s that kind of historical testing that prepares you for a
wide range of contingencies.

Connors: How do you go about putting together a portfolio to minimize volatility?

Freeburg: Well there are two ways. You can diversify across markets and choose the proverbial non-
correlated asset mix, so that you’re not trading all within one family of markets. And second you can
actually trade a portfolio of diverse markets with a mix of different trading strategies; you can have several
longer-term trend-following systems, you can have shorter-term trend-following systems and you can
throw in a sprinkling of countertrend systems. This has been the approach of a number of successful
portfolio managers and I think it might be a prudent alternative.

Connors: So they’re trading both breakout and countertrends at the same time?

Freeburg: They’re doing that, and they have different rule-based algorithms in either case and
furthermore to reinforce the principle of diversification they apply these strategies to a wide range of
markets.

Connors: You didn’t answer this question completely the first time. Is money management the Holy Grail
to you?

Freeburg: I have done a lot of testing of systematic money management algorithms, fixed fractional…all
of them, and I do think it is critical to smoothly running a portfolio but I don’t endorse the view advocated
by some, that money management is more important than trade entry and exit. There are people who say
that where you get in and out of a position, whether it’s in stocks and futures, is less important than than
money management rules you embrace, in other words, bet size. I don’t really believe that although I
certainly agree that position management has a decisive impact on equity curve.

Connors: So the best money managers that you’ve seen out there and the best traders out there have
superior entry and exit strategies as opposed to pure money management strategies, is that what you’re
saying?

Freeburg: Yes, I am saying that. But you need both. You can’t take a flawed entry and exit logic and
make the system work by better money management.

Connors: There’s a fairly well known individual out there who basically says you can flip a coin and make
money of you have proper money management. You’ll completely disagree with that?

Freeburg: If there were no transaction costs…maybe. Unlikely, but maybe. But with slippage and
commissions, real world constraints and that kind of thing, any money money management algorithm is
likely to exacerbate the losses.

Connors: So to you, entry and exit is critical.

Freeburg: I think it’s critical. Money management also critical, but it is not the Holy Grail.
Connors: And then keeping volatility within that portfolio to a minimum is also critical, but that comes
from position size, correct?

Freeburg: That’s a value choice. There are other people that are less risk averse than I am. To some
degree, you and I are alike. Our personalities call for containing risk. Other people maybe don’t care as
much. I don’t ever bet at Las Vegas, for instance.

Connors: You wimp.

Freeburg: Ha. Can’t stand it. The most boring activity in the world. I prefer the stock market.

Connors: Some people trading their own money are more aggressive or less aggressive than if they
trade other people’s money. I know for my own money, I’m a heck of a lot more aggressive. We
sometimes joke about some of the swings that we take, if we were managing public money there would
be no way we’d be taking these type of swings, we would lessen the position size. It really becomes a
personality choice. It becomes what the marketplace wants. I don’t think today you can have a money
management company that draws down 50%, 60%, 70%.

Freeburg: It’s amazing, I follow all sorts of performance statistics, both for people in the cash stock
market and obviously the CTA listing on the Internet, but many of these market timers can’t even beat the
S&P over a five-year period even after suffering the losses of the past two years. I don’t know how they
stay in business with drawdowns that have ballooned to exactly those proportions. It’s amazing, in the
real world, there are practitioners out there with that kind of track record. I’m with you. I would certainly be
more prudent in maintaining custody over other people’s assets than with my own account, although as I
get older I’m a lot more conservative than I was when I started out trading in the early ’80s.

Connors: What are the top mistakes people make when they go to construct a system?

Freeburg: The first one is unrepresentative testing, where they look at only a selected period of time, or
price behavior.

Connors: What does that mean, a selected period of time? What is your definition?

Freeburg: The best example would be somebody in 1985, let’s say, let’s go back 17 years, and they’re
just introducing computerized software for testing and so he takes all of the available S&P futures data
which goes back 2 1/2 years, let’s say. And basically the S&P went straight up from the time it got started
in the spring of 1982 to the time this guy’s developing his system. Let’s make it even better: Let’s say he
starts testing in August 1987 and essentially, with the exception of some turbulence in 1984, the stock
market went straight up from 1982 to 1987. If he extrapolates from that limited sample of data, he’s going
to get killed six weeks later when the market crashes in October of 1987. So that would be one hazard in
terms of developing trading strategies. Somewhat similar is letting the computer optimize 1000 different
parameters and develop a rule set that perfectly reflects performance in the past with very little capacity
to perform well in the future.

Connors: It reminds me when we had a guy working for me in 1994. He used to come up to my house
and write code all day. And then he would have the computers run all night looking for the perfect
optimization over thousands of different variables. I think my wife and I are still paying off the electric bill
he generated from doing this.

Freeburg: Yeah, it’s a common problem that I see all the time. Guys will take the optimized version of
these tests and then attempt to trade them. They rarely succeed. The markets are far more complicated
and it’s impossible to think you will put a whole number of variables into a computer and the Holy Grail
system will pop out.
Connors: Thanks very much, Nelson. This has been great.

Freeburg: My pleasure Larry, thank you.