📖 Diversification in trading strategies. Part 1
Often, traders are pursuing the system's maximum profitability, upon creating trading strategies. However, it is more important not to increase the value of the expected profit, but to reduce the possible risk, which is expressed in the maximum allowable drawdown.
A simple, but relatively reliable way to assess the trading strategy effectiveness is to determine the profitability ratio to the system's drawdown maximum in the period under study, the so-called recovery factor. For example, if the system's profitability is 45% per annum, and the maximum drawdown is 15%, the recovery factor will be 3.
If we compare two systems with different profit values and drawdowns, then the system with a higher recovery factor will be better. A system that allows to earn 30% per annum with a 5% drawdown will be better than a system with 100% per annum and a 40% drawdown. The profitability can be easily adjusted to the required value using margin lending, but the risk level in the system profitability cannot be changed, these are integral terms of the system. By increasing the yield, we increase the risk accordingly.
However, it is possible to reduce the portfolio risk at all applying diversification, that is, trade not one separate strategy, but a whole set, dividing the capital between the systems. In this case, the drawdown of each individual system does not necessarily coincide with the drawdowns of all other systems in the portfolio, therefore, in general, we can expect a smaller total drawdown maximum, while the system's profitability is only averaged. If the systems are sufficiently independent of each other (different trading strategies are used, different instruments are traded), then the drop in equity in one of the systems will most likely be compensated by the increase in equity in some other system. The more independent trading strategies and trading instruments are, the more the overall risk is diluted.
There are even situations when it makes sense to add a knowingly unprofitable strategy to the portfolio. Although the overall portfolio profitability will decrease slightly, it may turn out that the risk will decrease even more, and overall portfolio performance will improve.
Theoretically, if you add more and more strategies and instruments to your portfolio, you can get as little risk as you want, and, accordingly, as much efficiency as you want. However, in practice, such an intention will inevitably face the problem of correlation between different strategies and tools.
The main ways of possible diversification are as follows:
Diversification by trading strategies
Diversification by parameters of trading strategies
Diversification by trading instruments
Diversification across markets
🧐In this part we will take a closer look at the first option.
📌 Diversification by trading strategies
At the heart of every trading strategy is some general market attribute or traded instrument that can be used to make a profit. For example, the ability of the market to form prices trends and continue moving after a breakout of a strong resistance level.
If there are several systems based on fundamentally different considerations, then capital diversifying between these systems can lead to significant risk reduction. Indeed, in terms of the internal essence of the system, they can be as different from each other as you like, and as weakly correlated with each other. If, for example, trend-following systems and systems on level breakouts are somehow similar to each other and often give similar equity, then trend-following and counter-trend systems, on the contrary, will even show a negative correlation. Where the trend-following system will be sawn, the counter-trend system will show profit, respectively, the overall portfolio risk will significantly decrease.
Diversification of this kind, in theory, has no limits in depth and depends only on the creative ability of the trader to create systems. Therefore, it is important to constantly continue to work on the search for new trading strategies, since it is in this direction that the most reliable way to increase the efficiency and profitability of trading lies.
A simple, but relatively reliable way to assess the trading strategy effectiveness is to determine the profitability ratio to the system's drawdown maximum in the period under study, the so-called recovery factor. For example, if the system's profitability is 45% per annum, and the maximum drawdown is 15%, the recovery factor will be 3.
If we compare two systems with different profit values and drawdowns, then the system with a higher recovery factor will be better. A system that allows to earn 30% per annum with a 5% drawdown will be better than a system with 100% per annum and a 40% drawdown. The profitability can be easily adjusted to the required value using margin lending, but the risk level in the system profitability cannot be changed, these are integral terms of the system. By increasing the yield, we increase the risk accordingly.
However, it is possible to reduce the portfolio risk at all applying diversification, that is, trade not one separate strategy, but a whole set, dividing the capital between the systems. In this case, the drawdown of each individual system does not necessarily coincide with the drawdowns of all other systems in the portfolio, therefore, in general, we can expect a smaller total drawdown maximum, while the system's profitability is only averaged. If the systems are sufficiently independent of each other (different trading strategies are used, different instruments are traded), then the drop in equity in one of the systems will most likely be compensated by the increase in equity in some other system. The more independent trading strategies and trading instruments are, the more the overall risk is diluted.
There are even situations when it makes sense to add a knowingly unprofitable strategy to the portfolio. Although the overall portfolio profitability will decrease slightly, it may turn out that the risk will decrease even more, and overall portfolio performance will improve.
Theoretically, if you add more and more strategies and instruments to your portfolio, you can get as little risk as you want, and, accordingly, as much efficiency as you want. However, in practice, such an intention will inevitably face the problem of correlation between different strategies and tools.
The main ways of possible diversification are as follows:
Diversification by trading strategies
Diversification by parameters of trading strategies
Diversification by trading instruments
Diversification across markets
🧐In this part we will take a closer look at the first option.
📌 Diversification by trading strategies
At the heart of every trading strategy is some general market attribute or traded instrument that can be used to make a profit. For example, the ability of the market to form prices trends and continue moving after a breakout of a strong resistance level.
If there are several systems based on fundamentally different considerations, then capital diversifying between these systems can lead to significant risk reduction. Indeed, in terms of the internal essence of the system, they can be as different from each other as you like, and as weakly correlated with each other. If, for example, trend-following systems and systems on level breakouts are somehow similar to each other and often give similar equity, then trend-following and counter-trend systems, on the contrary, will even show a negative correlation. Where the trend-following system will be sawn, the counter-trend system will show profit, respectively, the overall portfolio risk will significantly decrease.
Diversification of this kind, in theory, has no limits in depth and depends only on the creative ability of the trader to create systems. Therefore, it is important to constantly continue to work on the search for new trading strategies, since it is in this direction that the most reliable way to increase the efficiency and profitability of trading lies.
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