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Diversification - Correlation (Maximizing profit potential)

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  • Diversification - Correlation (Maximizing profit potential)

    Hi All!

    This is a compressed repost from a previous thread.

    Trend Fishing Strategy (Verified Myfxbook)

    How can YOU make THE MOST money through a copy portfolio?

    Let’s talk about how YOU can better position yourselves when allocating money in copying a trader. Doing this correctly can not only maximize your gains, but potentially reduce your exposure on the downside too. The key word here is “diversification” but with real and proper analysis done for you.

    I’ve decided to pick Trade Alerter in my cross analysis. All this simply means is that I am comparing his trading results from a statistical perspective against my historical and live results. What I found in my analysis is that our systems are very well matched because of how ‘different’ our approaches and results are.

    Let’s break this down to make it clearer by touching on some industry buzz-words in bite-size chunks!

    Correlation – What is it and why should I care?

    Correlation coefficient is a fancy statistical word that measures how two “securities” (e.g. markets or funds, FoF, Traders etc.) move in relation to each other. In your case – the copiers – it is a fantastic tool that can help guide you in making more informed decisions on which traders you should and shouldn't "pair up". Without this, you may well end up copying two or more traders that are similarly styled and in-turn unnecessarily increasing your risk to "blow-up" points.

    Please watch this very easy to understand video: Correlation - Simple Explanation (it's only 2 minutes long!)

    As you can see from that video, high positive correlation essentially forewarns us about pairing or grouping particular traders in a portfolio. This is easily avoided by carrying out this analysis on two or more traders.

    Lets break down these benefits to nail the point:

    Benefits:
    • Tells us if we should or shouldn't pair or group up particular traders in a portfolio.
    • Helps us to dial up or dial down the risk on select traders within a portfolio to mitigate future periods of amplified drawdown.
    • Is a tool to help us potentially reduce drawdown by pairing two traders with little to no correlation (i.e. “0”).
    • Helps us in seeing whether traders move in tandem (if so, do not invest in them both).


    Now, keep in mind this is just one statistical 'measurement' I am touching on. It's not the only variable when considering a portfolio of traders / investments. However, it is a simple and very powerful tool which should help you make more informed decisions to balance and average your drawdowns and returns over time.


    Let's see this in practice shall we!

    When comparing Trend Fishing with Trade Alerter between 01/04/2013 to 30/09/2014 we can find the following bits of valuable information:

    Starting balance: $10,000.00

    Trend Fishing
    Returns (Backtest + Live): +65.90%
    Drawdown (Backtest + Live): -9.1%(with floating equity drawdown, this number would realistically be slightly lower, albeit not by much as I always use hard stops).
    Chart (Backtest + Live):
    trend_fishing.png

    Trade Alerter
    Returns (Live): +153.3%
    Drawdown(Live): -26.0% (If it were just on closed trades and ignoring open equity drawdown, then it would be -16.3% DD)
    Chart (Live):
    trade_alerter.png

    Hypothetically, what would it look like copying both over this period?

    Correlation Analysis - Balance Daily Change (%): 0.0439 - Practically no correlation between each trader (really good!)
    Returns: +333.48%
    Drawdown:-17.2% (this DOES NOT factor in open equity drawdown - just on closed trades)
    Chart:
    trend_fishing_&_trade_alerter.png

    As you can see - and just scratching the surface in terms of the analysis I have carried out here - the two strategies compliment each other remarkably well.

    With that said, lets look at the limitations and variables to consider under the observations I have carried out. Here are but a few areas to consider and drawbacks to what we're looking at when copying both Trend Fishing and Trade Alerter:
    • Spreads with the broker the copier is using? Are they wider or over time roughly the same as the traders they're copying?
    • Slippage?
    • Latency from trader to copier?
    • A portion of Trend Fishing approach is back-tested results. This means that the drawdown over this given period may well have been slightly lower than what is otherwise observed above.
    • Off the back of the point above ^ - this means that in the analysis I have done - when copying both traders under one account - I have only observed closed trade drawdown on both systems. This is because it is nearly impossible for me to be accurate in relation to historical open equity. So keep in mind the draw-down would in fact be approx. -20% (or even a little less) over this period.
    • Technological errors or bugs - Unknown variable, but a factor that you must always consider when participating in the markets. This could be broker side, copy tech. side etc.
    • Market black swan events (moving forward, a factor to remember!)
    • Copying both traders (like the results above) would require the copier to copy from one trading account to compound and maximize their returns. Therefore you must consider all of margin, leverage, minimum lot sizing, lot step (minimum lot increments your broker allows) and of course the capital you copy with to closely emulate both of our accounts.


    Summary

    As you can hopefully see, through one statistical tool, we can quickly identify whether or not two traders (or more) are well suited in a portfolio. Just looking at equity curves and drawdown alone can really limit your understanding in what is actually going on under the bonnet.



    **In future posts I want to touch on other risk adjusted metrics that can provide further ample control when copying a trader. Regression is an important one - copying a given trader straight away is not the best way in reducing your risk and maximizing your returns. Waiting for a key "regression" point to jump in, is ideal.
    -"An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today"-

    Follow me on Quora for Q&A on Forex: https://www.quora.com/profile/Dominic-Gilbert-2

  • #2
    This is very interesting, Dom, and glad to see you on here as an admin, with a new name and a collaborative style. Look forward to your insights in future posts. Thanks for sharing your work.

    Comment


    • #3
      Who was Dom before?

      Comment

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