Curtis Arnold To Pay $100,000 For Using Hypothetical Returns in Trading Systems
Curtis Arnold, a fairly well known person in the futures industry, was nailed for a $100,000 fine, barred from trading for 3 years and barred from registering in the futures industry for life. What was his mistake? Arnold was the man behind the Pattern Probability System (“PPS”). This system has some good points to it, however, Arnold made it appear to perform better than it actually did. The keywords here are “hypothetical results.” Anyone can make a trading system show spectacular results on paper, but trading it in the real world usually causes some dismaying losses. The CFTC is cracking down on trading system vendors that use hypothetical results and try to make it look as if they actually made these returns trading a real account.
Read through the details of the case from CFTC Docket No. 97-12 and we will discuss it more at the end of the article.
Since at least 1992, Arnold and London Financial have acted as commodity trading advisors ("CTAs") by offering and selling to the public the Pattern Probability Strategy ("PPS") trading system, a video, a book and a training manual teaching PPS, and various advisory services offering the trading signals generated by PPS, including facsimile services. Respondents also acted as CTAs by providing PPS trading signals to two commodity pools, one from 1990-1994 and one from 1993-1994. Since at least 1996, Respondents also have offered and sold to the public a publication entitled Systems USA, distributed by mail and over the Internet. Systems USA purports to "track" the performance of various trading systems authored by Arnold and other vendors, and offers and sells these systems and services related to these systems.
Respondents distributed direct-mail promotional literature through two publishers in 1994 and 1995 and directly in 1995. The Promotions misrepresented the profits and rates of return generated by Arnold's trading pursuant to PPS and failed to disclose that many of the representations concerning the performance of PPS were based on hypothetical trading of PPS rather than actual trading. Respondents' direct Promotion and the Systems USA publication also failed to disclose that many of the representations concerning the performance of PPS were based on hypothetical trading and further failed to provide the warning regarding the limitations of hypothetical trading required by Section 4.41(b) of the Regulations.
1. Arnold's Trading System
In 1987 Arnold developed the PPS, a trend-following commodity futures trading system. PPS and the advisory services based on PPS provided specific buy, sell and stop recommendations. Arnold, both individually and through LFI, has been marketing PPS since at least 1989. Arnold has periodically engaged in mass-mailings to promote his system, and has sent out, or caused others to send out, promotional material for PPS products to at least 50,000 prospective clients.
2. The 1994 Promotion
In 1994, a publisher distributed promotional literature to between 20,000 and 40,000 people offering for sale Arnold's book, entitled "Timing the Market," and a PPS training video and workbook. The promotion contained the following materially false statements concerning PPS and the results of trading pursuant to PPS: (1) Curtis Arnold made over 2500% actual profits in 5 years; (2) Curtis Arnold increased a "$7500 small, conservative trader's account to over $200,000 in a 5 year period"; (3) the purported profit figures were supposedly based on "real trading, with real dollars"; and (4) Curtis Arnold's worst year ended with an 81% profit. In fact, Arnold's $7500 account never increased to $200,000 nor ever made 2500% "actual profits." Moreover, during the five year period from 1988 to 1993, Arnold's worst year resulted in less than an 81% gain.
3. The 1995 Promotion
A second publisher prepared and distributed promotional material to between 45,000 and 90,000 people in 1995, which offered for sale the PPS training video and computer software. This promotion contained the same three fraudulent representations discussed above that were made in the 1994 Promotion.
In addition, the 1995 Promotion represented that a client could increase a $20,000 account to $646,944 in seven years by making 50% per year, and that "PPS profits are double that." In fact, a $20,000 account, over seven years at a 50% annual return, would grow only to $341,719. More importantly, PPS' profits were not double this seven-year result.
The 1995 Promotion also included two charts with accompanying captions which described two supposedly successful trades as follows: (1) A chart titled "British Pound December 1992" and captioned "This British Pound trade nailed the high and low while generating $29,487 income per contract; " and (2) A chart titled "S&P 500 Composite Future December 1987" and captioned: "The October `87 market crash was no problem for PPS. Profits of $76,000 per contract illustrate the power and safety of PPS trading." In fact, neither of these trades was generated by PPS or made in Arnold's account.
Finally, the 1995 Promotion contained a series of statements referring to "returns" or "profits," including: (1) "In each of 10 years, the fledgling system had achieved returns between 100% and 200% based on a twenty-five thousand dollar account trading one contract"; and (2) "PPS can offer you consistent profits with minimal risks. Imagine making 123% per year for the last ten years trading single contracts with a maximum drawdown equal to 4% of profits. Imagine turning $25,000 into $1,487,184 in five years while risking only 2% per trade." In fact, Arnold did not actually trade pursuant to PPS for 10 years, PPS never actually made 123% per year for ten years, never made between 100% and 200% for each of 10 years; and never turned $25,000 into $1,487,184 in five years.
4. Respondents' 1995 Direct Promotion
Respondents prepared and disseminated their own direct mail promotion in 1995, which offered a copy of Arnold's book and a PPS training video. The Respondents' Promotion contained the same materially false statements concerning PPS and the results of trading pursuant to PPS which were contained in both the 1994 Promotion and 1995 Promotion, as follows: (1) "Curtis Arnold made over 2500% actual profits in just 5 years"; (2) Curtis Arnold increased a "$7500 small, conservative trader's account to over $200,000 in a 5 year period. This is real trading, with real dollars"; and (3) "Curtis Arnold's worst year ended with an 81% gain in profit."
In fact, as previously discussed, Arnold's $7500 account never increased to $200,000 and never made 2500% "actual profits." In addition, Respondents' Promotion, sent out in 1995, failed to disclose that in 1994 Arnold suffered a loss of 16% in his own account, and that two commodity pools that traded pursuant to PPS signals lost approximately 15% and 16%, respectively, of their value in 1994.
Respondents' Promotion also included a chart captioned "PPS Time Line" that reflected results based on hypothetical trading; however, the promotion failed to disclose that that the results were hypothetical and also failed to include a statement regarding the inherent limitations of hypothetical trading required by Commission regulation.
5. Systems USA
Starting in 1996, Respondents offered and sold a monthly publication, Systems USA, which purported to track the performance of various commodity futures trading systems, including PPS and numerous other systems created by Respondents. Respondents also offered and sold to the public these systems and facsimile services for each of the systems. The performance results reflected in Systems USA were based completely on hypothetical trading. However, Systems USA never disclosed that and failed to include the required cautionary statement concerning the limitations of hypothetical trading results.
The most important thing to learn from this case is to distinguish between hypothetical and real world returns. People who design systems can run literally millions of combinations of technical entry and exit signals to develop a great looking system. Obviously, if you test enough combinations, some of them will show hefty returns. So they take these returns over the last 2 years and they can even list every trade the system made. It all looks very impressive on paper and the customer is led to believe he will see the same type of returns in the years to come. Unfortunately, it isn’t that simple. First of all, the computer model probably did not include the normal slippage a real trade would experience and there are also commissions that need to be factored in. The customer also has to be disciplined enough to take every trade. There are also very important times when the market will make big gaps at the open and the system won’t account for them. The biggest factor is probably the huge drawdowns that most trend following systems encounter. Even though the system may be very good, if you start trading after it has shown some dramatic returns and then the markets stop trending-you will most likely get burned.
So, be very careful when you are looking to purchase a trading system. If the company claims to have returns that seem to good to be true, they very well may be. Also, I like to known what indicators it uses to produce the trading signals and have a good understanding of how it works. System vendors will not disclose the exact details, because there would be no reason to buy their software if you knew the trading signals. There are some good systems out there for sale that would probably show you a profit. Although, you have to ask yourself why someone would sell you a system and not just trade it themselves and get rich? The fact is that the best systems are owned and traded exclusively by the best in the business and some of the systems for sale or in publications are probably their B or C systems-although they are still good systems. The best resource that I have found on the Internet for learning about systems is at www.tradersclub.com