Monday, May 3, 2010

Some tips on building winning trading models and trading systems, part 3

This is the third article in a series on how to build profitable and winning trading models and trading systems. The topics to be discussed include: drawdowns, the number of models used, correlations, hedging, and money management.

Let us begin with the negative and inevitable; drawdowns. In my opinion, no system trader uses models that do not experience drawdowns. All trading models have drawdowns. Nonetheless, what is important to consider is the length and depth of the drawdowns, in relation to the type of trading model they occur in. For example, models that trade very frequently may have a larger number of occurrences of drawdowns, than models that trade less frequently. One should also have a good understanding of how long drawdown periods last. Answering the following questions when building trading models will help you understand the risks that exist. What was the longest drawdown? The shortest drawdown? How deep did it go? How long does it take to come out of a drawdown?

My best advice in regards to understanding drawdowns is to completely analyze each and every drawdown period that has occurred in your system. It is also very important to understand what the underlying conditions of the market were when the drawdowns occurred. In this regard, I like to look at the drawdowns in relation to a mix of direction and volatility of the market. For example, try to understand if your drawdowns occurred in bearish, volatile markets, or bullish, quiet markets, etc.

The next topic I would like to address is the trading system. When we say trading system we may define it as only one trading model, or the system can be comprised of a number of different trading models. What is important with trading systems is to analyze the combined effects of adding more trading models to the overall system. It is not necessarily true that adding another profitable model will make you more money. The risks, drawdowns, gains, and losses have to be analyzed of all the models together. This can become very complicated if one keeps adding more and more models to trade. I believe there is an optimal point and number of models to trade, and once a trader crosses that point, the utility of adding another model can drop off significantly.

Adding more trading models to your system can, however, be of value from the perspective of understanding and minimizing overall risk. This is where correlation and hedging need to be considered. For example, if a trader is using two trading models, it is very important to understand how the returns from those models are correlated. Not only is the general correlation important, but the correlation in relation to the general underlying conditions of the market. For example, how do the correlations of your models’ returns change in relation to a bullish, volatile market or a bearish, less volatile market? Understanding these kinds of risks can be useful.

Adding more models to your trading system can also be useful in terms of hedging your returns. Hedging, in general, is a two edged sword. Hedging can help minimize losses, but it can also reduce gains. Nonetheless, by trading multiple models, one can hedge themselves if one model is performing poorly, assuming the other models are performing well.
I saved the best, and most important topic for last; money management. I figure if the reader does not remember anything I wrote above, then maybe he or she will remember the last point I make. No matter how good your trading models or trading systems are, you will never succeed in trading if you have poor money management. A good trading system must include a disciplined, money management system. Disciplined money management is even more important than the trading models you are using.

Good luck in your endeavors, and if you have any questions please feel free to contact me. Thanks for taking the time to read my article.

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