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System Trading 104

System Trading 104

Over this four-part article series, we’re going to introduce and explain the basics of system trading. In our first article, System Trading 101, we introduce the concept of using systems to speculate in the FX market. In System Trading 102, we looked at risk management of such an approach. In System Trading 103 we examined system evaluation, and in this article we delve into the concept of diversification.

When a trader places their entire account’s risk into a single strategy, they take on a large amount of exposure into that specific style or strategy.

Let’s say, for instance, that a trader decided to use a system trading approach, and employed a breakout-related system on USDJPY.

If USDJPY exhibited massive volatility, this trader may end up being very happy. However, if USDJPY does anything else – such as showing range-bound price action, or even a long-term trend accented with pullbacks and retracement; the trader may end up looking at undesirable losses.

For the same reasons that investors often want to invest in multiple stocks in a portfolio to diversify their interests, system traders often want to look at employing multiple systems to help balance the risk of their overall strategy.

The desire to diversify can be summed as the following:

Randomness is a part of trading, as the future is unpredictable and future price movements can exhibit a type of random nature. By employing multiple systems, the trader can aim for an ‘offsetting effect’ of this randomness for the overall portfolio.

Just like an investor saving for retirement wants to own more than just one stock in their portfolio, so that they can avoid the potential for catastrophe in the event that the one company they are invested in doesn’t perform well; the system trader should look to employ multiple systems in an effort to mitigate the damage should the system(s) underperform.

This is the genesis behind the axiom that traders should avoid ‘putting all of their eggs in one basket,’ because if that one basket falters, the trader may lose all of their eggs.

Traders, like investors, should avoid putting all of their eggs in just one basket

By employing multiple baskets, traders hedge the risk that any one ‘basket’ or strategy underperforms

Risk Management from a Portfolio Perspective

As we outlined in System Trading 102, risk management is of extreme importance to the trader. Diversification can be a part of that risk management, and as outlined above – it may help eliminate some of the random nature that is involved with trading on future price movements.

However – it is important to state that diversification cannot completely eliminate the risk of a portfolio; nor can it allow the trader to employ exorbitant amounts of leverage with the expectation of being able to completely avoid the catastrophic impacts that can be brought upon by such approaches.

In System Trading 102, we offered the guideline of 5:1 leverage for system traders. This can be looked at as the total leverage of the overall portfolio.

Effective Leverage can be monitored through the Exposure feature of Mirror Trader

Notice that while this trader has effective leverage inside of the 5-to-1 guideline, they also have all of their risk concentrated into the USDJPY Breakout strategy. This is not diversified.

If a trader wanted to use just one system, and avoid diversifying – they can employ their single system at 5:1 leverage and their portfolio value will be dependent on the performance of that one, individual system. If the trader felt really good about that single system, and didn’t mind taking on the risk of trading with a single strategy, this could be an option.

However, if the trader wanted to offset the risk that this single system may not outperform, they can look to spread their portfolio amongst multiple systems, keeping total or overall leverage to 5:1 or less.

How Many Systems Do I Need for a Diversified Approach?

This is a question that, unfortunately, doesn’t have a clear-cut answer. While diversification can offer some massive advantages to traders, there is such a thing as being overly-diversified and this is something that we’ve seen happen for many mutual funds.

Diversify too much, and the trader runs the risk of removing the top-end potential from the portfolio; just as we had outlined earlier, like mutual funds beginning to track the performance of the S&P because they contain so many stocks.

It is possible to be too diversified

While this trader may have removed the risk of trading just a single system, they may now have difficulty keeping track of the portfolio, and where exactly their exposure lies. This can create complications when re-balancing, or re-allocating the portfolio equity.

Diversify too little, and the account’s performance is becomes contingent on the performance of one or two strategies.

Diversification can be accomplished by choosing more than one system. By allocating risk across 2 or more strategies, the trader’s account performance isn’t contingent on any single strategy. So, as a starting point, traders should look at balancing two strategies in the portfolio.

The more systems that are added, the more difficult that continued management of the portfolio may become. Selecting 20 systems can become a confusing prospect in which the trader has the unenviable task of managing all of the systems.

So, rather than focus on the ‘number’ of systems, traders should focus more closely on the effective leverage of the portfolio.

Avoid ‘Doubling Up’

A common pitfall when traders begin to approach diversification is ‘doubling up’ on their systems. So, if a trader is using a breakout system on USD/JPY, employing a breakout system on EUR/JPY merely doubles up the exposure that the trader has on JPY. If the Yen begins to trade in a range-bound fashion, the trader runs the risk of seeing larger losses than they might be comfortable with.

A Diversified Approach on Mirror Trader

Notice that there are 3 different strategies (Range, Breakout, and Momentum) applied to 3 different currency pairs

Effective Leverage

As we’ve mentioned throughout this series, traders should look to employ leverage of 5-to-1 or less on the overall portfolio being traded. This would mean that a trader with a $2,000 account would want to keep their total position size of all the systems in a portfolio to $10,000 or less ($2,000 X 5 = $10,000). This could be $5,000 into 2 systems or $2,000 into 5 systems. Regardless of the number of systems being used, the trader is keeping the overall leverage of the portfolio in check.

It’s important that the trader is selecting quality systems based on the guidelines given in System Trading 103. This is far more important than picking systems just to diversify for the sake of diversification.

-- Written by James Stanley

James is available on Twitter @JStanleyFX

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