Bill Dreiss' endless summer

Bg MarkEtzkorn , When asked why he moved from the United Slates to Australia sev€n years ago, CTA Bill Dreiss gives a short .3nd.s-ilpl-.e,,e!y"1''"1l came over here for the surf." Trading and surfing for over two decades,Dreiss, at age 53. is a veteran of both ocean and market waves. oceanand market waves53, After obtaining an an MBA from Harvard Dreiss worked at a thinl tank in the late 1960s using d1'namic game to "make mathematlca models of WrrJd War III.".,. colleague piqued his in est in trading and c
analysis, and he began Algorlthm (FWA) and the Choppiness Index (CI). Derived r fiom chaos-related fractal theories pioneered by Benoi( I .., Mandlebrot, the FWA is a pattern-based technique , i '

: o_"19t J f s).,[9eejtr9r,'. 1s.u-ss "thlse. i : :.- i Drei q gr 'o |111f"".q I

i^^id'^^l designed+^ rJ^.^+:€. -^-1,^+ to identifu market +.,*:-x tumins -^:-a^ noints. /n^ nr f:^. The CI basi- ': callimeasures h6w^mucrr a maltet is tr*ing.(see

,

i n the di recti on of a longterm trend, and [eventually] j ust sort of dropped t he :i ihort-term system and said I ,. ,

, I'll just trade the long-, ' :

re been around a while, :iss thinks the game is

:

rare thing in those days.) ;1,
His first hading.Job was a$o a broker with E.F. Hutton ir"ri

retty much the same as it was in the 1970s. "A couple years ago peoplewere talking
how the markets have undamental l y changed. I t believe that," he says.
::t a:,:.,.lalj)l

1973. In 1975 he formed his first trading grou Commodity Consultan
Inc., with a couple of o

,,,;;::,;,',
" r' :t'+ + :..r:t":-::

tends to be sort,of',ar'
-term shift between the .rkets trending well and t trendi ng so well. pically, if y-ou go inro a

:

brokers. The following year
he started a second CT.

San Miguel Associates
th r ough whic h h e tra d r u nt il 1984. F r o m I9 8 4

1990, Dreiss took time rrom managlng money (ne.., ffi ' still traded for himselfl to 'l:i'' :, " ' ' develop software and research somer'ofthe tleories he now incorporates in his trading strategr. He launched his current CTA, Dreiss ResearchCorp., in 1991. Trading roughly $8 million, he has a total return of 119.670/o since start date. with only one down year He {1992, :8.O2Vo). was up roughly 35% in 1995 through midJune. Despite his ow4 background, Dreiss is somewhat suspect of the current'love aflair between Wall Street and math whiz kids: 'You've got a lot of these guys who come out with degreesin mathematics and they 'say'iGee, I can beat the markets.'but if all it took to beat the markets was a Ph.D. in mathematics,there'd be a hell of a lot of rich mathematicians out there." he says. Dreiss compliments his own perspectivewith "a lot of experienceactually trading the markets." Dreiss,is a systematic trend follower and uses his ,.ownrproprietary: methodologies, the Fractal Wave
78 trttures August1995
Reprintedtrom Ftltltt8jS

ion. the' markets:tend .die down a bit las was the in the early'90s1.You're

for his initial positions),diversification is a key element of his risk control strate€X/: trades as many as 28 He markets in a half dozen commodity groups if market conditions are favorable. Dreiss doesn't worry about finding the next "hot" market. Incorporating relatively inactive markets in your portfolio isn't necessarily detrimental as long as they're non-correlaUng, says. he "They might improve your risk performance even if the markets themselves aren't making any money," he explains. "So I can justiSr carrying markets like cocoa or gold that probably haven't made money in a while because they tend to be uncorrelated with other markets that I'm trading. I've got no reason to believe that at some point those [marketsl won't come back into their own." Like the ocean,there's alwavs ano*rer wave coming. rrrt

Inc.,219 Parkade,Box 6, Cedar Falls,lA 50613 Copyright1g95 by Osler Communicalions,

it attemptsto build client capital by positioning its investors for the larger moves.03%. This conclusion is substantiatedby many studies on the effect of managed futures to an investment portfolio. Federation.98%to lD. The Efficient Frontier Chart (below) shows how this lack of correlation can benefit the investor.l6Yoit returns to the original standard deviation of 0. Dreiss Research Corporation offers its clients a widely diversified portfolio of both foreign and domesticfutures markets. Tt'h 1s% 3B' . In addition. in leveraged managed futures accounts shows substantially less risk at every possible level of expectedretum than portfolios ofstocks (or stocksand bonds) alone. Aduertisemen"t .0250 o.oz7s 0.0277 while the rate of return goesup from 9. the standard deviation begins to rise again reaching point D..."the combined portfolios of stocks (or stocks and bonds) after including judicious investments. EfficientFrontier of DreissResearchCorporationand the S&P 500 Index Composite based on monthly returns from May 1991to AuEust 1995 E 9 . Becauseof this long term approach. The rate of retum and standard deviation continue to enjoy this negative correlation up to point C.o3oo 0. This correspondsto an allocation of l4%oof assetsto DRC. Historically. including an analysis by Dr.0350 Monthly Standard Deviationof Portfolio Returns oN (EXCEPTaANDD].PAST PERFORMANCE IS NOT NECESSARILYINDICATIVE OF FUTURE RESULTS. John Lintner of Harvard University in which he states.B (! c rr* B 9% ! E A 0. the principal of these benefits is diversification."r The trading approach used by DRC is distinct from that of most other commodity trading advisors in that it is extremely long term in nature.0270 and return equals 12. where the standarddeviation hits a low of 0.0286.0375 0. Point D correspondsto an allocation to DRC of about 28Yo and represents an increase in return of approximately 42Vo over the portfolio consisting only of the S&P. Insteadofconsistently trading in and out of markets.9 o E o o.0286 to 0. Diversification Managed & Futures While there are severaladvantages adding a to managed futures account to your investment portfolio. 'Lintner." Annual Conference of Financial Analysts May. John. As the percentage of the investment allocated to DRC increasesfurther. transaction costs and slippage are relatively low. "The PotentialRole of Managed Commodity-FinancialFuturesAccounts (and/or Funds) In Portfolios of Stocks and Bonds. the standard deviation of the portfolio drof fiom 0. the correlation of a managed futures account to one composedonly of stocks or bonds is low to negative. When 5% of the equity of the portfolio is invested in Dreiss Research Corporation (DRC).7lYo.0325 0. 1983.0286 o. where at an annualizedROR of 14. Point A on the chart plots the annualized monthly return and the monthly standard deviation of returns of a diversified portfolio of stocks (represented the S&P 500 Index) over by the period May l99l to August 1995. plotted at point B.

Elliott Wave and Dow theorieswill find this month's article to be particularly enlightening. " We hopeyou enjoy our biggestand one of our bestissuesever.vn .' More Researchon Chaos Our readerswill recall that our May 1990 issuefeatured an interview with Art von Waldburg which introduced his Fractal Wave Algorithm for trading the Dow JonesIndustrial Average. many software packageshave addedtheseunique charts to their menu of technical studies.Good .Our readers who havean interestin keepingup with research Chaos.You will want to becomefamiliar with the basicsso you canbenefit from the more advancedtechniquesof using candlesticksthat SteveNison will provide in our Technical Toolbox section next month. We wish to thank the Merrill Lynch Futures Researchdepartmentfor allowing us to distribute this valuable publication to our subscribers.this is our biggestissueto date. trading. This month we go one step furtherinto Chaosandbringyou an outstandingarticle byBillDreiss which applies the Fractal Wave Algorithm to a diversified portfolio of futures into contracts.TECHI{ICALThIDERS BULLETIN Volume2 Number l0 October1990 SingleIssuePrice $20. To get everything in. Among the most interesting and topical technical charting methods thesedays are the ancientJapanese Candlesticks. As you may have noticed already. you will find the final segment in Tom D'Angelo's informative and practical serieson professionalmoney managemenL Tom explains more about the Kelly Criterion and passes along somevaluable tips and advice. In the past few months. Be sure to saveit. This well written booklet might be considered a homework assignment for our readers. In addition to our continuing serieson SystemTesting.q. we had to expandto twelve pagesthis month .we have made special armngementswith Menill Lynch to provide our subscribers with an excellenteducationalbooklet that will explain the basicsof this very old yet new methodof charting. In preparationfor the Candlestickarticle to be published in our November issue. Crrucr aNoD.

canbedividedinto two general pattern-recognition. containing waves.Thenumber nestings "levels"are limitedonly by theamount data provided. after several years of experience in trading systems mathematical and financial modeling. While it is etc. W. t@t'J64fily the with a BS in electrical engineering. The FWA is fractal in that it markswaves rvhcrehc trndcscommodilics srrrfs.F.it of expectedrisk per trade. In 1976 he established San patternrecognitionis far moredifficult. numerical basedon sophisticated ln 1973. structure similar to that found in the Ellioa Wave Principle. and originated the soon becameclear that it had a more general conceptof trading a short term systemonly in the application. Prior to the trends are identified by guidelinespertainiirgto widespread of computers. In 1975heleft to become of focusin thelast20years stochastics. The logic used in defining turning direction of the longer term trend.chart uponthe etc.which was an active and the usefulness the standardmethodsof pattern successfulCommodity Trading Advisor until recognition@ow Theory.Elliott WaveTheory. Therefore. oneof the first firms to manage easy to program a computerfor a wide variety of programming computer for calculations. of whereas be a simple example of a pattern-recognition levels trend: only with three of technique. Dreiss E. He has points proved identical to that used by the Dow of continued research innovative his into approaches Theoryto identify trendreversals. Hutton & Co. Mr.most rely ( primarily on either one or thi: other. attention to computer consulting and software d e v e l o p me n t. w h i l e co n ti n u i n g to tr ade TheFractalWaveAlgorithm (FWA) developed commoditiesfor his own account. While sometradingsystems employ a theDow Theorydeals primary. Dreiss then turned his patternanalysis.secondary minor Since and theDowTleory mixture of the two types of analysis. a principal and chief trader with Commodity oscillators. nnd waves. co-rnpor"r. Dreissnow lives in WesternAustralia. numerical . generalizes a fractal geometryand artificial intelligcnce.A drawback chart to and readingwas that it was more art than scienceand it by E. (Bilt) Dreiss graduated from the was difficult to prevent bias and emotion from Massachusetts fnstitute of Technology in 1964 cloudingthechartinterpretations.. starting at etc. individual skills of thepractitioner. FWA also the to commoditytradin g. use technical anaiysis was continuedon pagenine e Automatingthe Dow Theory with the Fractal WaveAlgorithm .. Dreiss is responsiblefor a number of provides basis objective technological innovations related to trading Note: see TTB Moy 1990 for interttiew with vpn managedcommodity accounts. with This waslargelyduetothedifficulty of testingandupdating me*rodsby hand. It anybut the simplest numerical wasmucheasierandmoreintuitive to usechartsfor identifyingpatterns trends. of Miguel Associates. Approaches thetechnical to analysis markets containing of the lowest level of price activity availableto the categories. he took a methods.virtually. Consultantsr lnc. The numberof price activity availableto and An of of or method themovingaverage. asa commodity broker.In theprocess Dow Theory reversals.) Although the FWA was originally in to CTA to balance diversifiedportfolioson the basis programmed assist countingElliott Waves.synonymous pattern-recognition.which could be traded objectively and positionwith E. a large amounts of risk capital using mechanical numerical trading methods.in SanFrancisco rigorouslytested. is whiletrendlines would theprogram. In 1966he irorriaing calculatingpowernffiffi-l6-develoflmechanical receivedan MBA from Harvard Business School. Editors Mr. momentum. Mr.This hasresulted a major shift in towards movingaverages.)continues depend to February of 1984. W. by Art von Waldburgis apowerful new tool which ( for a chartanalysis. He was the first Waldburg.developing tradingmethods automating Dow's modelby incorporating fractal basedon recent breakthroughsin chaostheory. example a numerical program.

thelowestlevel (LO) turningpoint can be markedon any day wherea down day follows an up day or an up day follows a down day. L2 of by apriorlowerlevel highthatis lowerthan previous on a weakL2tum.secondary primarytrendscanbe and usedto constructshort. afractal lookthan with theweakFWA. of in continued on page ten B . Notice that the strongmode 3. The simplestexampleof using the FWA to secondary andprimary(L3) trends (L2) (s#fechnical model classicalchart analysisis its applicationto Analysisof Futures Markets. Once these objectively determined each of the 4 levels. A Dow "failure swing" requiresthat the would be to combineweak and strong turns. however. for entrymightbeon a stnong turnwith exit penetiation a lower level low beaccompanied instance.intermediate long term or The FWA canbe setto opente in two different or "weak" and"strong". Second.If we definean"up" day as a s). this resultsin alternating highs and lows. This algorithmhasa sensitivityintermediate without entriesor exits being triggered. This allows simpleexamplewould be to rade lrvel I movesin of a trend turn to be marked on a Dow "nonfailure thedirection thelevel2 trend.Anotherpossibility swing". When this algorithm is appliedto stock and commodityprice charts. can be combinedto trade shorterterm modes. is moves in the direction of a longer term trend. t higherthantheprevious and a day which closes day a "down" day as a day which closeslower thanthe previousday. A describedaboveandmarksa turn on anypenetration of thehigMow for thenextlowerlevel. mechanically is constructed for Levels I through 3 were tabulated for each by applylngtheDow criteria to a simplepricepatternin combination.000 tradeequitystopis usedastheinitial stop but per the prevalence the strongpattern marketdata. At other times.labelingthe different commoditiesweremarkedusingthe weak. turns may be marked one. hybrid andstrongalgorithmsandthenumberofturns a ThAFWA.This is required theFWA operating yearsof commoditydataareshownin Tables2 and for in the strongmode. Mq$hy for . This givesthemarked chartmoreof wave turns are markedusing closing prices only.First.7 identifyingDow trends.but requtes a strongmarkafter a weak the close. lengthsused by Dow to identify the rqinor (L1).by JohnJ. rhe lowerlevelhighin orderto markatop( andviceversa The resultsof two such systemstestedon 6 for abottom)./ I continued m pagefo ur lro S^^years(1984-89) continuous of datafor 14 and duration notby a setof specificrules.they can be usedasthe basisfor presented Table 1. L2 marksidentify secondary the trendsand the L3 marksidentify primary trends. Theminor.Theweakversion as systems.eventhough particularlevel. of and so on'. The aggregate results are pointsaremarked. This means that sometimes turns are algorithmthat allows for a weakmark following a "anticipated" thesystem arenotconfirmed by that by strongmark. The next level (L2) is marked on penetrations the mostrecentLl highsandlows.the Ll marksidentify FRACTAL TRADING SYSTEMS Dow minor trends. Thesesystems incorporate following rulesto the requires alternating "zigzag" price patterns at a makcrhemrealistically tradable. closerto weakdueto $3.although the entries and exits are intraday penetrationsof the logic is fractal in both cases. Theseturn countswere then usedto mannerto constructprogressively arecursive higher computethe averageduration from low to low for level waves. The averagedurationsgiven in mechanicalsystems developing applyingclassical aboveroughly correspond the approximatetrend to methds of chart analysis. The next level (L1) turning point is markedwhen the most recent high orlow is penetrated amarkin the LO after oppositedirection. a between weakandstrong.It is alsopossible intradayhighsor lows corresponding themarked to to combinethe weak and strongturnsinto a "hybrid" turns. regdsremains matterof individualinterpretation.

Systemperformance a which particularcommodityis generallycompared that with moreconsistent thepastthanforsystems to are more complex and/orhighly optimized. exceilt by pure luck. a feature which markets in which it would have been virrually While impossibleto make money.onewouldexpectthefutureperformance be trend-following for system. The advantage these optimization.000 mechanical capitalized appropriate anaccount to to can systems bematched corresponding proportionately otheraccount fractal systems for andwouldbescaled which producesimilar resultsas to per sizes.)In addition. If ttrefractal system The results of these systems compare producestradesin roughly the sameplaces as the back-tested non-fractal system produces significantly gteatet favorablywith thoseof othermechanical (for listedin TheDow Jones. Cfhe $3000 €quity stop is canbeusedasauniversalsystem template. Resultsfor sucha and and commission slippage. BruceBabcock.profitsthanits fractalequivalent. in are system presented Table4 .). systems example. themfrom numericalsystems.The FWA lossfor thosecases of inordinately far away. that the non-fractal systemhasbeen?ata-fittedby is fractalsystems that excessive of Jr. those onglnight suspect by Inpin Guideto Trading Systems. of theyalesimple(alow numberofdegrees freedom) All commodity traders have experienced and virtually parameterfree. distinguishes in extensively real Othermarkets havenotbeen tested these systems would resultin profis for almostany to time.continuedfrompge nine can Fractal systems also be usedto confiirm wherethecalculatedstoplossis the performance non-fractal systems. $100 is deducted tradefor tradingfrequency duration. with other commodities or alternative achievable .andmany with $100.

dataif one fitting would be stronglY suspecL 11 . bY calculating the cumulative absolute price differences betwee'nturning Points of a given level. to it wouldbeunrealistic expect to anysystem do well.The investrnents. In fact. FTVAcanbe usedto determinea measure for of maximumPerformance a particular market. Actual or simulated performance for systemstrading with similar trade frequencyand duration to can then be comPared this upperbound of PerformanceIf the FWA Performance maximumis smallor negative. did performbetter.

CA 25550tlawthorncBlvd. Turning meansto carry on this work with gleaterprecision pattern-recognition the pointsfor aparticularlevel couldbeusedfor drawing andopens way to mechanical thoseusingnumerical as as or systems rich anddiverse uendlines(seecocoacharton page11). Suite 100.Torrance.. Elliott @1990TechnicalTradcrs Bulletin IslandView FinancialGrouP.o The FWA can also be usedto identify more andHenry WheelerChase.uiangles pennants identifyingpatterns suchashead-and.Most subsequent Dow's workas a staftingpoint.althoughthe numberof lower level ercellent article andfor sharing the results of his in wavescontained the next higherlevel wavewill researchwith us. moreof his work infuture issues.The FWA can assistin labelingElliott Editors note: We wishto than Billfor his Wave counts. The FWA providesthe complexchart patternsthan Dow trends. includingR. and shoulders.Inc.N. We lookforward to publishing not alwaysbe 3 or 5.methods. 90505 (2r3)79r-2r82 . The Dow Theory is the grandfather of technical analysis methods and is still widely chart analystshaveused respected.

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