Forex Systems Risk Diversification

Forex Systems Risk Diversification - Introduction

Often at creation of new forex  trading strategies trades seek the maximum profitability of a forex system. However, sometimes it is more important to reduce possible risk, which is expressed in the maximum permissible drawdown, but not to raise value of expected profit

A simple, but rather reliable way of estimation of trading strategy efficiency is to identify correlation between profitability and the maximum drawdown of a forex system on the period under investigation – a so-called recovery factor. For example, if profitability of a forex system is 45% per annum and drawdown is 15%, the recovery factor will be equal 3.

If to compare two forex systems with different values of profitability and drawdown, the trading system with a higher recovery factor will be better. The forex system with 30% per annum and 5% drawdown will be better than the forex system with 100% per annum and 40% drawdown. It is easy to adjust profitability to a necessary size by means of margin lending, but it is impossible to change risk weighting of a ftrading system, because it is the integral feature of a system. Increase of profitability, accordingly, also increases risk.

Forex Systems - Risk Diversification

However, it is possible to reduce risk as a whole on a portfolio; for this purpose you need to use diversification, i.e. to trade using not a single separate forex strategy , but a whole set, having divided capital between systems. In this case it is not necessarily that drawdown of each separate system falls on drawdown of all other systems in a set, therefore, in general, we can expect smaller maximum total drawdown; at the same time, profitability of a system only be averaged. If forex systems are adequately independent from each other (different trading strategies and tools are used), then equity drop in one of systems, most likely, will be compensated by equity growth in any other system. The more independent trading strategies and trading tools are used, the lover is total risk.

Sometimes even such situations are possible, when it makes sense to add obviously unprofitable forex strategy to a portfolio. In spite of the fact that the total profitability of a portfolio decreases a little, it can appear that the risk will decrease even more, and efficiency of a portfolio as a whole will grow.

Theoretically, if you add more and more strategies and tools in a portfolio, you can achieve as small risk as you like, and, accordingly, as high efficiency as you like. However, in practice such intention will inevitably face the problem of correlation between various strategies and tools.

Here are the main directions of possible diversification:

•   Diversification according to trading strategies.
•   Diversification according to parameters of trading strategies.
•   Diversification according to trading tools.
•   Diversification according to markets.

Let’s consider each of directions in detail.

Diversification according to trading strategies

There is some general property of the market or trading tool at the heart of each trading strategy, which can be used for making a profit. For example, market property to form trends or price property to continue movement after breakout of strong resistance level.

If there are several forex systems , based on essentially different reasons, capital diversification between these systems can essentially reduce risk. After all, internal essences of forex systems can differ from each other indefinitely, and forex systems can correlate indefinitely. For example, if trend-following forex systems and level breakout systems are somehow similar and often show similar equity, then, on the contrary, trend-following and counter-trend systems will even show negative correlation. Counter-trend strategy will show profit whereat trend-following system works on flat; accordingly, general risk of a portfolio considerably decreases.

Theoretically, diversification of such kind has no restrictions on depth and depends only on trader’s creativity in development of a system. Therefore it is important to constantly continue work on search of new trading strategies, as the most reliable way to increase efficiency and profitability of trade lays in this direction.

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Diversification according to parameters of trading strategies

Let’s take a simple trend-following strategy , based on price channel breakout. Its main and unique parameter is a number of bars, on the basis of which maximum and minimum price are calculated. If the maximum is updated, we consider it as a signal to the beginning of a trend and buy. We hold a position until update of the minimum, that we consider as the beginning of a descending trend, and overturn a position to short.

This simple strategy shows quite good results on the tools, inclined to trend movements. For example, let’s suppose that this strategy shows satisfactory results in a range of parameter variations from 10 to 100 bars.

Usually traders confine themselves to detecting the parameter, at which strategy proves to be the most effective, and start to trade using one separate system with this parameter. However, if you divide capital and simultaneously trade using the same strategy, but with different parameters, it is possible to achieve more stable results.

For example, if you take three systems with channel lengths of 10, 30 and 100 bars, different systems will handle trends of various size. System with a long channel will be good at long trends, leaving small trends without attention. System with a short channel it will work well with short trends. As a result, market volatility will be processed more effectively, equities of all three systems will differ, which means that risk of such diversified portfolio will be lower.

Besides, by limiting trade by a single strategy with concrete parameters, we increase risk of that it will work unsuccessfully only because market movements have been unfortunate for this system. By diversifying capital on different parameters, it is possible to expect results close to a certain average efficiency of a strategy, without risk to run into an unsuccessful combination of concrete market circumstances.

If a forex  system for any reasons is strictly restricted by number of bars, and it is not possible to find the parameter, which can be changed, it is possible to try to change a timeframe.

As a rule, a successful forex strategy allows to build profitable systems in quite a wide range of parameters, which, nevertheless, is limited.

As transactions are not free and have their price (commission of the broker, slippage, spread), it is unprofitable to catch small market fluctuations, because a supposed profit becomes commensurable with a transaction price. On the other hand, too long market fluctuations will hardly be interesting to short-term speculators.

It turns out that diversification according to parameters has its limit of efficiency, as limitation of parameter space means limitation of market movements, from which one or another concrete forex strategy can make profit. The better the idea, put in the basis of a trading strategy, corresponds to market behavior, the higher this efficiency will be.

Diversification according to trading tools

It is logical to expect that prices of various tools will move differently. Share prices are strongly influenced by intracorporate news and changes in situation involving a company. Certainly, each company has its own situation, and it is developed individually for every company. Therefore, it is quite reasonable to divide capital and to trade on various tools using strategies, available in the arsenal of a trader

On the other hand, there is a general economic background, which leads to that various shares in the same market move more or less synchronously. Events and tendencies of the concrete economy influence mood of speculators and investors in much the same way.

Of course, this correlation is far from being full; otherwise there would be no sense to speak about diversification. Nevertheless, such interdependency sets a certain limit on efficiency of a whole portfolio.

Besides, each separate trading strategy can be used for trade on a limited number of tools. For example, possible tools will certainly be among quite liquid papers, which aren’t too much, in the Russian market. Probably, it is impossible to trade other papers because of high overhead charges, connected with their low liquidity.

The number of tools, appropriate for a concrete system, will be limited in one way or other even in a wider market, where the choice of shares is more various. It is hardly possible to create a profitable strategy, working on absolutely all tools of the market.

Diversification according to markets

Modern technologies allow a private investor, not to mention financial organizations, to participate in trade in various markets all over the globe. Our domestic share market is the most accessible to the Canadian  traders. Flexible commission and low prices for the most popular lots allow to begin trade, having a very small capital.

If you have enough money, there is a possibility to diversify trade on other markets: FOREX, share markets of the USA, Europe, and other countries worldwide, commodity markets. There is an undeniable advantage in such diversification: as a rule, separate markets are very poorly interdependent, therefore systems, used for trade in various markets, will be smoothed out well.

Therefore, diversification is a basic way to achieve maximum efficiency of trading strategies, which are available in the arsenal of a trader.

Even if you have only one sufficiently stable strategy, it is possible to raise effectiveness of trade manyfold; you only need to be consistent and have enough skills for finding new ranges of application for this strategy. And if you constantly search and find new strategies for trade in the market, you will broaden horizons of the achievable results even more. Persistence and creative abilities of a trader are the only limit on this way.

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