Issue July 2011

futures
editorial
Eduard Pomeranz, CEO (ep@ftc.at)

Very few quants today will know the names of Richard Donchian and his trading firm Futures Inc. Even when I started to work on systematic futures trading at the beginning of the 90s, the two names were legends from the dawn of history, and had been overshadowed by the brilliant Market Wizards who Jack Schwager had just portrayed in his book of the same name, which had just appeared. In those days, every young trader wanted to be like Ed Seykota, whose computer-managed futures system was reported to have made a fantastic 250,000 per cent return in 16 years. Ed Seykota himself had known Donchian, and anyone reading Jack Schwagers interview with him for Market Wizards closely will find two mentions of the name of the founder of the very first managed futures fund, without whom Seykota and many others would perhaps never have become star traders.

Or, as Seykota once said in another article*: I became a computer applicant of Dicks Ideas. () He inspired a great many people and spawned a whole generation of traders, providing courage and a road map. In view of all this, it is only fair to devote this entire issue to Richard Dick Donchian, and I am particularly happy that we can offer you some real treats in this. These include particularly the formulation of the legendary 5/20 system by Brentin C. Elam, which has never before been published. I hope you find our issue exciting, and wish you a relaxing vacation season.

Eduard Pomeranz

* in Futures Industry, magazine of the US-branch of trade Futures Industry Association

Media owner, publisher & editor: FTC Capital GmbH | Praterstr. 31/11 | 1020 Vienna | Austria | Tel.: +43(1) 585 61 69-0 www.ftc.at | office@ftc.at

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Systematic trading strategies Part 3: The Donchian puzzle

Wolfgang Schimmel, FTC Capital (Translation: Andrew Smith) Richard Davoud Donchian is one of the giants in the history of quantitative finance. In the literature you find him mentioned as the father of trend following, the inventor of managed futures, and the man who gave the name to the Donchian channel technical indicator. Even so, the facts known about the life and work of the twentieth centurys most influential futures trader can be summarised on one page. The result is a jigsaw puzzle, with a lot of gaps. Richard Davoud Donchian was born in Hartford, Connecticut, in September 1905. His parents were Armenian immigrants trading in Oriental carpets. In 1928 Donchian graduated with a bachelors degree in economics from Yale, and first joined his parents firm, where he started speculating in equities, inspired by the stock market bestseller, Reminiscences of a Stock Operator. In the stock market crash of 1929 he lost most of his investments, which was probably the starting point for his studies in securities analysis. At first, Donchian pursued this as a second occupation alongside his duties in the family company. In 1933 he joined the Wall Street brokers Hemphill, Noyes & Co. as an analyst (one of the many investment firms which in various ways later became part of the

Richard Davoud Donchian (1905-1993)

Shearson-Lehman empire). This period produced a document which is virtually unknown today: in Twenty Trading Guides, produced in 1934 for equities trading and modified in 1978 by the Commodities magazine for commodities, Donchian brings together general rules for action (e.g. LIMIT LOSSES, ride profits) and technical rules for good entry and exit points, which are still strongly influenced by the vocabulary of the Dow theory.

From Wall Street to LaSalle

After the USA entered the Second World War, Donchian first served in the landings in Sicily and then as a statistical officer in the US Air Force. Perhaps he had already begun to take an interest in the commodities market, perhaps not. It is, however, a fact that Donchians attention after the end of the war shifted from Wall Street to LaSalle Street in Chicago, the home of what was then the worlds biggest commodities future market. In the mid-40s the Chicago Board of Trade (CBOT) building was the highest and most impressive in the city on Lake Michigan. The huge trading floor, six stories high, housed the legendary

Foto: The Richard Davoud Donchian Foundation

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pits, structures with the atmosphere of an amphitheatre in each of which a specific commodity was traded. However dignified the CBOTs faade was, the action in the interior was very down to earth. The open outcry procedure that pit traders used to do business appeared to outsiders to be pure chaos, even in quiet trading. In hectic phases, the pits looked like a bar brawl which had got completely out of control. The cowboy manners on LaSalle Street were a glaring contrast to the gentlemans business on New Yorks Wall Street, and being involved in futures markets was hardly seen as prestigious. Trading in corn, wheat, soy or copper was hardly a logical step for a graduate economist and Wall Street analyst like Richard Donchian. Like so much else, we do not know why he decided to get involved with CBOT and the other, smaller futures markets. Perhaps it was partly the fact that commodities prices after 1946 clearly delivered more of the fuel which most systematic trading approaches require: volatility. Again, perhaps it was Donchians favourite subject, which runs as a key theme through the few publications we have: diversification. The commodities markets, then still much more strongly driven by various fundamental factors, offered more of this than the equities in the two Dow Jones indices. Strong support for this theory is provided by a Donchian quote from an article by the journalist and textbook author Darrell Jobman: When I first got into commodities, no one was interested in a diversified approach. There were cocoa men, cotton men, grain men they were worlds apart. I was almost the first one who decided to look at all commodities together. Nobody before had looked at the whole picture and had taken a diversified position with the idea of cutting losses short and going with a trend.1

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After 1960 Donchian headed the research department for commodities at Hayden Stone, another New York brokerage that also subsequently became part of the ShearsonLehman Group. In this position he wrote a newsletter which appeared weekly until 1979 under the title Trend Timing Comments. Futures Inc. or at least the legendary 5/20 trading system continued to be managed from the 1970s to 1989 by Donchians personal assistant, Barbara Dixon. In June 1983 Managed Account Report, the leading publication of the day for managed futures, gave the first Most Valuable Performer Award for extraordinary services in the field of Commodity Money Management to Richard Donchian. He died on 24 April 1993, leaving the charitable Richard Davoud Donchian Foundation, which supports projects in the fields of education and health. And this is all the information available on the innovator of the managed futures industry from publicly accessible sources. This biography leaves many interesting questions unanswered. For example, how exactly did Donchians trading system work? How was Futures Inc. organized? What happened to the estimated 4,000 pages of newsletter Donchian wrote, after the demise of Shearson-Lehman? And what historical treasures might be hidden in these? Donchian was a man of the predigital age. As a result, anyone looking for answers to these questions has to dig deep. Contemporary witnesses are hard to find or unwilling to provide information. His personal assistant, Barbara Dixon, mentioned by name in the small biography on the Donchian Foundation website, today manages Spackenkill Trading in New York, a small CTA with an impressive track record. She could presumably supply many of the missing pieces of the puzzle, but did not reply to our enquiries for whatever reason. By contrast, Brentin C. Elam, a colleague of Donchian from 1970 to 1975, and today Vice President of Northcoast Asset Management who we discovered in the course of our research, proved positively informative. We owe key findings to him. More pieces came from Trish Foshe, Vice President of the Institute for Financial Markets, who plundered her archives for this article. And a couple of pieces came from research into the literature. Here is a summary of our findings to date:

The mother of all futures funds

Whatever the facts were, in 1948 (or 1949, according to some sources) Donchian founded the company Futures Inc. and opened it to investors. This is how the first vehicle for joint investment in commodities came into being the mother of all subsequent futures funds.
1

Darrell Jobman, Richard Donchian: Pioneer of Trend-Trading, Commodities (September, 1980), p. 42.

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Title page of Donchians Trend Timing Comments. This series of newsletters appeared weekly from 1960-1979, averaging four pages an issue.

Fundamentalist and system architect

First, we must abandon the oversimplified picture of the father of trend-following, as the technical literature likes to call Donchian. Richard, or Dick Donchian as his friends called him, was neither an early quant in its pure form, nor did he discover trend following. Instead, he must have been a brilliant analyst, a conscientious collector of data, and one of the few who understood how to combine profound fundamental knowledge of the market and technical analysis although not always without conflict, as Brent Elam comments: Mr. Donchian came to the financial markets as a fundamentalist. He often supported himself during the 1930s and 40s by creating and selling independent research reports on individual stocks to the various stock brokerage firms. His interest in systematically managed portfolios emerged in the late 1950s. He was torn between his market judgement and his trading models. It became a constant struggle. While he believed in models he had a very difficult time following them.

nal. The 10-page article High Finance in Copper in the November 1960 issue of the Financial Analysts Journal looks in detail at the fundamental data of the copper market: the history and current production statistics of the mines, prices on the US market since 1893 and price and volume statistics on copper futures and their correlation with production (negative) and copper shares (positive). In the second part of the article, Donchian looks at three ideas for trading profitably in copper. The first idea is strictly fundamental, but at the same time systematic: In practice it seems to work out rather well to buy copper when stocks on hand show a decline of at least 40,000 tons from a previous high point, and to sell copper whenever they show a 40,000 ton increase. The second idea suggests that people speculating in copper shares should use copper futures instead, as the correlation between the two is surprisingly high and the margin on futures is significantly lower than on shares. This means that people could make greater profits in futures with a lower risk:

Profits in copper
The picture becomes clearer if we look at what was probably Donchians only contribution to an academic jour-

A position of as little as 2 contracts (margin $2,000) would have made a greater profit than the $12,500 position in copper stocks. [Note: from the S&P Copper Stock Group Average between September 1953 and 1955.]

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Facsimile of High Finance in Copper. Results of backtesting the 10-day out-break system using copper contracts between December 1959 and December 1960.

The third idea involves a technical systematic model, which subsequently became famous under the name Channel Outbreak and is named after the Donchian Channel trend-following indicator: One rather simple, easy to follow, automatic trend-following method which tends to produce good results is submitted as follows: a) Whenever the price [note: of copper futures] exceeds the highs of the two preceding calendar weeks ranges, buy (and cover shorts if you have previously sold). b) Whenever the price falls below the low of the two preceding calendar weeks ranges sell, and sell short. c) One exception to (a) and (b) above is advisable; namely, if the extreme high or low of the two preceding weeks comes on Friday or the last trading day of the two weeks if the market is closed on Friday and the first trading day of the third week is about to give a buy or sell signal by exceeding the Friday extreme, do not take action unless the Friday extreme is exceeded by 20 points or more. Rules (a) and (b) could be put more briefly: Buy an out-

break above the highest high and sell an outbreak below the lowest low in the last ten trading days. According to Donchian, the method, although crude and heavily simplified, had the unique advantage that it works, and he provides the calculation for the reader (see facsimile).

Archetypal trend follower: the Four Week Rules

Later, Donchian generalised this model in a longer 20-day version for all futures markets, and Donchians Four Week Rules (sometimes cited as Weekly Rules) entered the trading literature. The model deals with price outbreaks above and below the four-week highs or lows. The system itself and numerous modifications of it are still found in standard works today, like John J. Murphys Technical Analysis. In a more modern version, it was used by the legendary 1980s Turtle Traders, among others. The original model is a trend follower by nature, and has the major advantage that it is very simple to implement. A time series of prices is all that is needed, not even a chart is necessary. The model automatically limits losses and

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-

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Donchians Four Week Rules, taking corn as an example (December 10, continuous chart). The system produces nine trades in the sideways market to July, with moderate
+ +

losses. The last long position is then followed by an extended

+ + +

profitable trend, which only breaks in November. The profit on this trade exceeds the previous losses. The balance is typical of trend follower systems of this construction.

rides out existing trends. However, it has neither stops nor risk management. It is invested at all times, and particularly in volatile range-bound markets it gets whip-sawed. Nevertheless, even such simple trend-following systems can be profitable over long periods. Loss-making trades are in the majority, but their cumulated losses are often smaller than the profits from a small number of highly profitable trades. However, if the markets go for a long period without sustained trends, Donchians outbreak system can also lose a lot of money without additional rules. This danger can be reduced by e.g. stop-loss techniques for example by using a period half as long (10 days) for the exit signal. Another technique as an improvement would be position sizes based on current volatility.

recommendations such as ...Sell Short Dec CBOT Corn at the opening, Liquidate Long Feb CME Hogs at opening.... This was the practice until at least 1977. There is a detailed description of the model by Donchian himself in the December 1974 issue of the industry magazine Futures3. This also shows when Donchian started using it in 1961: A unique advantage of the method of 5 and 20 day moving averages is that it has a record going back 13 years There may be several reasons why this system did not pass into the standard literature, unlike the Four Weeks Rules. One might be the high degree of complexity of the rules nested in the system. Another is that Donchians description of the rules in the Futures article was insufficient to apply them confidently. As Brent Elam puts it: While Mr. Donchian made a loosely written description of his model widely available it was not sufficient for trading. When I attempted to reduce his description to a decision tree Mr. Donchian had to clarify a number of ambiguities in the rules which made a most significant difference in application. The result of this formulation as a preliminary stage in programming the Donchian 5/20 system was never published, as far as Brent Elam knows. To close this historical gap, he authorized us to publish his decision tree from August 1971 (see pages 6-7).

The legendary 5/20 system

Donchian himself already used his 5/20 moving average system in 1970, which was the year the Four Week Rules were first published in a book entitled Traders Notebook2, now out of print. The 5/20-signals were regularly discussed in his Trend Timing Comments and, according to Brent Elam, wired to all Hayden-Stone branch offices each morning before the futures openings. The wire contained specific
2 3

compare: John Murphy, Technical Analysis of the Financial Markets, NYIF 1999, p. 215. Richard D. Donchian, Donchians 5- and 20-day moving averages, Futures (December, 1974)

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UNIT (see note 2)
Unit = IF ClosingPrice > 2.00 AND ClosingPrice <= 4.00 THEN 0.01 ELSE 0 Unit = IF ClosingPrice > 4.00 AND ClosingPrice <= 15.00 THEN 0.03 ELSE Unit Unit = IF ClosingPrice > 15.00 AND ClosingPrice <= 40.00 THEN 0.05 ELSE Unit Unit = IF ClosingPrice > 40.00 AND ClosingPrice <= 120.00 THEN 0.10 ELSE Unit Unit = IF ClosingPrice > 120.00 AND ClosingPrice <= 400.00 THEN 0.20 ELSE Unit Unit = IF ClosingPrice > 400.00 OR ClosingPrice < 2.00 THEN 0.002*ClosingPrice ELSE Unit

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Richard D. Donchians 5/20 System: Decision Tree by Brentin C. Elam

2. Has todays close crossed the 5 day moving average in the direction opposite the current position and exceeded, by 1 full unit, the greater of 1) any previous penetration (3) of the 5 dma (in the same direction) within the last 25 (4) trading days, or 2) the prior same side penetration? 3. Have any of the last 15 closes penetrated the 20 dma in the direction of the current position by 1 full unit more than any 20 dma penetration (either direction) of the last 60 days, including today? In other words: Out = IF 1 OR ( 2 NOT 3) i.e., liquidate position if Out

[Rule A]
If todays close crossed the 20 day moving average (dma) and penetrated (note 3), by 1 full unit or more, the maximum of the previous 20 dma crossing in the same direction, no matter how long ago, then take new position in direction of the crossing.

[ Rule E ]
Re enter the last basic position from an out if the closing price penetrates the 5 dma in the direction of the last basic signal (signals A, B, or C) by 1 full unit more than any penetration in the same direction within the last 25 trading days.

[ Rule B ]
If todays close exceeded, by 1 full unit, the previous 25 closes, take a position in direction of the crossing.

[ THE TIMING of SIGNAL TAKING ]

1 - Signals on the close of the day prior to the last trading day of the week ( usually Thursday), are executed on the close of the last trading day of the week (usually Friday). Ie, if Friday is a holiday, then signals on Wednesdays close are executed on Thursdays close. 2 - Signals on Fridays close are executed on Mondays opening.. 3 - For signals occurring on the trading day prior to a holiday (either midweek or long weekend): if a sell signal execute the sell on the opening of the 1st trading day following the holiday, if a buy signal execute the buy on the opening of the 2nd trading day following the holiday. 4 - All other signals are for opening of 2nd trading day following the signal day.

[ Rule C ]
If the 1st day of the 20 dma crossing which lead to the currently held signal occurred within the last 20 (note 4) trading days, and if todays close exceeded the previous 15 closes by 1 full unit in the direction opposite of the current position, then take position in the direction of the crossing.

[ Rule D ]
1. Has todays close penetrated the 5 dma in the direction opposite the current position by 1 full unit more than any 5 dma penetration (in either direction) of the last 25 trading days?

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[ NOTES ]
(1) Closing prices- Use lower middle price of the closing range except: a) if 2 point range in BO, SU, & PM, use lower value. b) if upper middle in grains is an even 1/4, use it. (Note from BCE: this applied during those years when Mr. Donchian kept the books manually. From 1991 forward, the actual execution prices are used. ) (2) Unit For Price Ranges 0.00 to 4.00, a price unit is 0.01 For Price Ranges 4.00 to 15.00, a price unit is 0.03 For Price Ranges 15.00 to 40.00, a price unit is 0.05 For Price Ranges 40.00 to 100.0, a price unit is 0.10 For Price Ranges 100.0 to 400.0, a price unit is 0.20 [Note from BCE: The above penetration units are as defined by Mr. Donchian. As nothing had traded over 400 or under 2.5 at the time he defined the system to me , I have been forced to extrapolate his penetration rules to to cover such things as cocoa (now trading at 1250 $/ Ton), and Jap Yen ( trading at 0.007457 where a price change of 0.000001 = $12.50). As his penetration standards seem to range from 0.05 to 0.5 percent I have adopted a standard of 0.2 percent (2 tenths of 1 percent) for prices over 400 or under 2.0. This results in 2.25 points for the Jap yen and 2.4 points for cocoa at todays prices. In addition, I shortened his 0.00 to 4.0 range to apply to 2.00 to 4.00 only. Futhermore, I have changed the 40 to 100 range and the 100 to 400 range to be 40 to 120 and 120 to 400. This keeps the interest rate futures in the lower bracket. This is desirable because rate futures have a substantially smaller range of trade than do the more traditional com-

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modities. For a bond future to vary from 4 to 66 (as has sugar) would require that long term rates range from 1% to 1000% per year. Were this to happen, the rules for penetration would become moot. (3) Penetrations: To count as a point to be exceeded, a previous penetration must be at least 3 full units for 1 day, or 1 full unit for 1 of a 2 or more consecutive day crossing. (4) Counting days: + + - (1) - (2) - (3) etc etc etc etc + (18) + (19) + (20) = if this is today, it must fall within the allocated number of days. = day of currently held signal = 1st day of crossing

Except where noted otherwise, the 5 & 20 Day Moving Average system as described here is as it was defined to me by Mr. Richard D. Donchian on Aug 9, 1971. The programming is mine. Brentin C. Elam 12/4/1990

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800 750

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E B C D Long signals from rule A using the example of wheat, 2009: A: First crossover maximum B: No signal, as significance

700

650

level under A not reached. Second crossover maximum C: Significance level under B

600

exceeded: long signal D: Third crossover maximum E: Significance level under D

550

exceeded: long signal

.0 9 02 .20 .1 09 0 04 .20 .1 09 0 06 .20 .1 09 0 08 .20 .1 09 0 10 .20 .1 09 0 12 .20 .1 09 0 14 .20 .1 09 0 16 .20 .1 09 0 18 .20 .1 09 0 20 .20 .1 09 0 22 .20 .1 09 0 24 .20 .1 09 0 26 .20 .1 09 0 28 .20 .1 09 0 30 .20 .1 09 0 01 .20 .1 09 1 03 .20 .1 09 1 05 .20 .1 09 1 07 .20 .1 09 1 09 .20 .1 09 1 11 .20 .1 09 1. 13 20 .1 09 1 15 .20 .1 09 1 17 .20 .1 09 1 19 .20 .1 09 1 21 .20 .1 09 1 23 .20 .1 09 1 25 .20 .1 09 1 27 .20 .1 09 1. 29 20 .1 09 1 01 .20 .1 09 2. 20 09

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Basic characteristic: trend follower

The characteristic of the system is also clearly a trendfollower. Stripping the model of its subtleties and restrictions yields a classic system, which uses simple moving averages (SMAs) with two periods and Donchian Channels, and generates signals solely on the basis of closing prices (CP): 1. Entry in the direction of the crossover if CP crosses the 20 day SMA or in the direction of a 25 day outbreak. 2. Exit if CP crosses the 5 day SMA in the opposite direction to the existing position. 3. Re enter the last basic position from an out if CP crosses the 5 day SMA in the direction of the last basic signal. It is conceivable that Donchian originally started with this simple version, and discovered that he was getting a large number of false signals. Possibly the final version emerged in steps as he introduced additional rules one by one to improve the accuracy. At the end of the process, Donchian used a buffer (UNIT), four alternative entry variants (rules A, B, C, E) and a fairly tricky rule for exits (rule E).

What was a simple system at its core becomes very complex as a result of the various additional rules 21st century system developers might add and pretty tedious. But Donchian was not thinking in terms of modern programming languages, but in terms of a committed chart analyst. His tools were paper and pencil. His trading platform consisted of a cashbook in which he entered commodity prices daily and calculated the values for the SMAs and charts (which he drew himself). Seen in this light, the tedious instructions appear thoroughly sensible. All you need to check them is a good eye, a steady hand and a ruler. You can see this very clearly taking rule A as an example, which requires the following checks: When the closing price crosses the 20 day SMA, take a position in the direction of the crossing but only if: the closing price is at least 1 UNIT further outside the 20 day SMA than the MAXIMUM previous crossing in the same direction, however far back this previous crossing might have occured. All that can be quickly and easily checked on the chart. However, to package the rules in a program, a whole series

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Facsimile of Futures December 1974: Donchians ex post calculation for his 5/20 system form January 1961 to June 1974, assuming one contract was traded in each trade. Overall, the system would have earned more than a quarter of a million dollars on this basis. Sadly, Donchian did not show the number of trades, which could have been used to calculate other important statistics.

of tasks must be performed. In particular, identifying the MAXIMUM comparative figure at an unspecified distance in the past is not entirely trivial. If the goal is to translate the whole set of rules into a computerized trading program, things become quite tricky. Brent Elam, who did this in 1990 in the environment BASIC/Realizer used over 70 variables and a considerable number of data vectors (arrays). Even if Donchians 5/20 system looks a little clumsy today, it was ultramodern in the time when it was invented. The various significance tests hidden in the individual rules significantly reduce the false signals that appear particularly in times of high and trend-free volatility. With this, Donchian achieved an effect similar to using an additional volatility filter, such as the Average True Range although this was not invented until the end of the 1970s.

The trading rules can very likely be revised and improved.3 Instead, it was the idea to apply the system to a broadly diversified portfolio. As Donchian noted in the same article, Diversification reduces the risk of loss. Markowitz won the Nobel Prize in 1990 for proving this idea. Brent Elams Decision tree means that Donchians 5/20 system for trading signals can now be completely and unambiguously followed. Implementation for a current trading platform and backtesting a futures portfolio for the period after 1974 would be an attractive task, which we may perhaps take up in a future issue.

What happened to Futures Inc. and the Comments?

Working through the several thousand pages of Trend Timing Comments would be another fascinating project they may be as valuable for the history of technical analysis as Charles Dows Wall Street Journal columns. In any case, we have succeeded in locating what may be the last copies: they are stored, bound and in hard copy, in the archives of the Institute for Financial Markets (IFM) in Washington.

Diversification as a basic consideration

Donchians most important idea and it is necessary to repeat this again was not the trading system itself, where Donchian himself modestly commented in 1974:

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Our researches also shed some light on the late days of Donchians firm Futures Inc. Brent Elam reported that Donchian tried in the early 1970s to buy back all the shares at prices between $ 0.75-1.20, with the goal of liquidating the company. In any case, there are no records of Futures Inc. in the files of the CFTC regulatory agency. This suggests that Donchian succeeded in his project, as after 1979 Commodity Trading Advisory and Commodity Pool Operators also had to register with CFTC. Futures Inc. would in any case have come under one of the two cat-

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egories. A further reaching enquiry under the Freedom of Information Act covering a number of agencies was submitted in May, but no results have emerged as yet. This means the most likely version is still that Futures Inc. was closed down at some time between 1972 and 1979, and the 5/20 system only continued to trade privately for Donchian. The track record of the system in the period 1974-1989 remains a missing piece of the puzzle.

FTC Futures is a publication of FTC Capital GmbH. The content and structure of the present document are copyrighted. Information or data, and specifically text, parts of text or graphic material may not be duplicated or distributed without the prior permission of FTC Capital GmbH or the relevant author.

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