Trade loosely correlated WealthSignals systems for stable growth

Trade loosely correlated WealthSignals systems for stable growth

Even the best system experiences drawdowns, and as traders we’re worried about the irregularity of our returns. It’s tempting to cancel subscription when the fortune turns away from us but it may end up displeasing to see the missed profits when the system returns with a vengeance. And if has a solid mathematical expectation, chances are in its favor.

We touched this subject in another article, When a mechanical trading system is having a drawdown what do you do? This time let’s approach it from a different perspective. Portfolio diversification comes to help here as the natural tool of risk reduction. The idea is to add another, carefully chosen system to trade to smoothen our equity curve.

When properly applying this technique you can benefit from different systems responding differently to different market conditions or from trading different assets. Like with a portfolio of stocks, the idea is to choose another system that rises or falls at different times from your “primary” subscription.

Suppose you’re subscribed to ETF Pairs Arbitrage whose equity curve is underwater after making an all-time high in May:

ETF Pairs Arbitrage - Mechanical Strategy

A quick inspection of other systems’ equity curves on the “Find a Strategy” page suggests that there are other candidate systems still making money. Take Saltamontes, for instance. Its equity curve has been on a steady rise, with ups and downs spreaded differently from the “EPA”:

saltamontes - Mechanical Stock Trading System

A choice of systems like this makes sense because they tend to support each other. What you have to care about is to avoid systems having a perfect negative correlation or it would be a zero sum game. If one system goes up 5% while the other loses 5%, there’s no benefit from diversification.

In this article there’s no room for discussion of complex concepts like correlation coefficients, covariance or efficient frontier. It’s a simple trading idea and should stay so. The takeaway is that it may be possible to achieve diversification through subscribing to loosely correlated systems to smooth out our returns.

When a mechanical trading system is having a drawdown what do you do?

When a mechanical trading system is having a drawdown what do you do?

Suppose you’ve subscribed to a “star” system and one day find your broker account losing money as the system has entered a drawdown. Volatile markets expose trend-following systems to a higher chance of false moves which lead to losing trades. You’re tempted to unsubscribe. Ironically, it’s when we give up on such system it frequently comes back with a big winning trade that pulls it out of its drawdown.

So should you pull the plug now or perhaps there might be a smarter option?

Sophisticated money managers use methods which seek to extract extra profits during a system’s down phase. For example, moving averages can be applied to a system’s equity curve. Called trading the equity curve, this technique marks the system out of sync with market conditions when its short-term average of the equity curve gets below above a longer-term average. “Paper trading” during this phase increases your odds of not taking trades which are likely to turn out losers.

ETF Pairs Aribitrage mechanical trading system

If you’re a WealthSignals subscriber, staying on the sidelines is not your only choice. As the odds of the winner trade appearing soon are increasing, the trade size can be added to each time a losing trade occurs. While this sounds counter-intuitive, backtesting suggests that variations of this Martingale money management may actually improve performance:

Losing streaks: After each losing trade, slightly increase the next trade’s position size step by step until some upper limit is reached. Stop the increase if the losing streak gets too big, and get back to original size after a winning trade.

Reverse trade: When the next trade has a higher chance of failure, be it a losing streak or system’s equity staying “under water”, don’t suspend trading. Instead, execute the signal in reverse — go short when a buy signal occurs and vice versa. Those with appetite for risk may increase the trade size.

Not every type of system can be “reverse traded” like that, and “over managing” is a double edged sword. Professional traders know that for a robust system with positive mathematical expectation, every losing streak or drawdown will eventually end. If a WealthSignals system has a proven track record, an equity dip may give you the edge and offer a lucrative opportunity to subscribe!

The odds on having an upturn are increasing every day!

What is a drawdown?
What is a drawdown?
Drawdowns are important for measuring the historical risk of a mechancial trading strategy, comparing fund performance, or monitoring personal trading performance…
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Disclaimer
WealthSignals™ information is based on hypothetical performance results which have certain limitations. They do not represent actual trading and therefore do not have financial risk. Any interpretation of data presented that leads to an investment is at your own risk and WealthSignals™ or its affiliates will not be responsible for any losses that occur from such investments. Past performance is no guarantee of future returns.