“From my previous failures, I knew that no matter how confident I was in making a bet, I could still be wrong and that proper diversification was the key to reducing risk without reducing returns. If I could build a portfolio full of High-quality return flows that are properly diversified could offer customers a much more consistent and reliable overall portfolio return than what could be obtained elsewhere.”- Ray Dalio, Principis
Most aspiring traders spend too much time trying to perfect 1 method. Even worse than that, most traders tend to use a trading strategy for all markets, acting like a man armed only with a hammer that sees everything as a key.
Unfortunately, this happens to the best of us: when things get difficult and we get into disadvantages, the mind begins to think about what went wrong and how to “fix” things. At FXRenew we faced the most difficult period of last year and we also spent time reviewing our trading model. It’s a natural thing to do and maybe there are some things that require adjustments from time to time.
Despite this, our improved performance is not really due to the “broken” model. We were visualizing all the markets as “keys” and we asked the system to deal with situations for which it is not suitable. This can also be a problem you encounter.
The real solution is to diversify – create alternative models taking advantage of alternative edges. That’s how we did it.
How to diversify effectively
“My goal is that I want to trade more than 15 uncorrelated assets.” – Ray Dalio
In order to get out of our withdrawal phase, what we did with the London Open Signals was to finish undoing the basics:
- what is our model designed for?
- in which environments do you want to operate better?
So we ended up making the decision to negotiate less, but only negotiate when the conditions were absolutely clear (for the existing model).
On the other hand, we started working on different models that addressed some of the opportunities that we “thought” we could take advantage of, only that the London Open model was not appropriate. We needed to diversify from the classic short- and medium-term trend-tracking approach.
A quick note about diversification. Many people think that in order to diversify, you only need to put together two things that are negatively correlated. There is truth in this statement, but we need to clarify if it is more. We’ve talked about correlation before and observed that, depending on the underlying engines, correlations can (and can) change.
The chart above illustrates futures vs. gold bonds. Normally, gold and bonds should be inversely related because inflation will be bullish for gold and negative for bonds (because higher inflation usually involves higher interest rates). However, when central bank relief (or direct fears of deflation) begins, both gold and bonds may move forward together as interest rates fall (i.e., rising prices bonds), while expectations of easy money will lead to a depreciation of the currency, which will raise gold prices.
Dalio said “the correlation does not imply causality ”. What this means is that each market behaves logically based on its own determinants, and as the nature of these determinants changes, so do what we call correlation.
Therefore, true diversification does not come from astute mathematics, but from an understanding of the fundamental engines. As the engines change, the correlation changes.
When it comes to Alpha (ergo: active trading rules that deviate from passive indexing) and diversification, the key is to develop models that exploit different advantages. And that is precisely what we ended up doing. The two new models we implemented exploit very different scenarios compared to the London Open model.
- The news flow model capitalizes on key market events that somehow capture the market with distrust. The consequent change in participants ’expectations can offer very attractive returns compared to the expense of risk.
- The end-of-day model diversifies internally as it deploys separate rules for at least 4 different market types. In addition, it works on longer horizons than our other models.
Together as a single portfolio, the 3 models significantly decrease total volatility while smoothing (but not compromising) the return curve. This is the beauty of true diversification.
More to you
Of course, each trading model must have a solid advantage in itself. Diversification cannot overcome incompetence. If you mix a winning system with a losing system, the results will not be satisfactory.
The lesson here is that the Holy Grail of trade (if any) is to find multiple rules of trade that exploit “quite well” specific market conditions. Models must be simple and effective. Each model will go through its own ups and downs and this can be burdensome if you are only operating one model (for example, a next trend model can stay flat for a whole week or twice).
However, combining the models together provides more opportunities, but at the same time isolates you from the loss, as (hopefully) not all models will be broken down at the same time.
About the author
Justin is a forex trader and coach. He co-owns www.fxrenew.com, a Friday signal provider of banks and hedge fund traders (get a free trial), or get FREE access toT the advanced currency exchange course for smart traders. If you like writing it, you can subscribe to the newsletter for free.
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