Northfield Trading: Upward bound

Futures, Feb 2008 by McMahon, Chris

Just about everything that Douglas Bry does is systematic and back-tested; so much so that his decision to become a trader seems almost impulsive by comparison. He remembers sitting on a plane in 1985, picking up a copy of Investor's Business Daity and seeing an advertisement for a software program that would value options. "I knew at that point that I was very interested in seeing if I could come up with systematic ways of trading," Bry says. "I was so interested that I ordered the software from the airport."

Even back then, Bry had a knowledge of computers, programming and statistical analysis that he had developed as a sociologist working with complex databases. "My original work with statistics involved a study about television watching and violence at Holmesburg Prison in Philadelphia," he says. Applying his knowledge to the markets was not a huge leap. Bry and eventual business partner Philip Spertus began experimenting with computer based simulations, developed The Volatility Breakout System and launched a software company to market it in 1987. They went on to develop an automated out-of-sample testing platform and a method for conducting research across markets. The original firm, Technical Trading Strategies Inc., evolved into the managed futures firm Northfield Trading LP.

As a sociologist and later as a public defender, Bry learned the importance of discipline and overcoming the emotional tendencies of human behavior. Having a system, and die discipline to follow it, enables him to take losses when he should and stay with bigger moves when they are occurring without die fear of giving back profits.

"We are 100% systematic and 100% disciplined. There is a lot of judgment and discretion that go into what we do, but they go in at a higher level in the research and development. At the point of implementing our strategies, we follow them 100%. In more than 18 years of trading we have never second guessed or overridden a trading signal."

Bry approaches the markets as if he were studying human behavior, and volatility is the hallmark of that behavior. "For three of the five strategies in our portfolio, we are using subtle changes in volatility to generate signals," he says. "Some of the best opportunities come when volatility has been dropping and then starts to increase. This is over very short look-back periods, and it's not something that is apparent when looking at a chart. The way we [measure volatility] is probably one of the more proprietary and valuable diings we have developed.

"The goal is to detect opportunities early. There are some game theory principles at work here. Once we take a position, it's other people's buying and selling that's ultimately going to move the market. So if we can get in early, before other people, we are in a stronger position once a market starts to move," he says. Many of Northfield's entry signals occur when the markets appear rangebound. At that point, when something significant develops, Northfield is already in the market. "If you wait until an obvious trend is underway, other people are already in, and that may be the end of the move."

Northfield was up 24.3% in 2007, its first double digit performance since 2000. The program compiled a compound annual return (CAR) of 16.56% in the 1990s, but has struggled of late pushing its CAR to just below 10%. Bry attributes the recent success to new automated portfolio-level risk and profit protection controls. "We added a strategy to our portfolio that will, when certain conditions exist, start to de-leverage some of the trades, realize some of the profit and reduce some of the risk. It took three years to develop," he says. Northfield takes fewer than 400 trades per year, and risks between 0.3% to 0.4% on each trade, so the risk is spread across a lot of opportunities.

"In this business it's easy to fool yourself with research results," he says. But with out-of-sample testing, you can compare results with and without various parameters, which has led to Bry simplifying systems, making them more robust. In 2001, such out-of-sample testing got Bry in trouble.

"We traded based on tuning our systems to just the past three years of data," Bry says. That worked well for about three and a half years, but it ran into some trouble after 9/11. Since then, Bry has developed a hybrid research approach in which all strategies must first pass the out-of-sample tests and then pass further validation by producing good results across a large number of markets with one parameter set, which is how they're traded in real-time.

"Markets are evolving all the time, although there is the common element that we are really studying human psychology, and that may not change that much," he says, stressing the importance of discipline and persistence to his long-term success. "There are always plenty of opportunities; there are no bad markets and it's our challenge to figure out how to be profitable in almost any environment," he says.