Building a Diversified Portfolio of Trading Systems

Introduction

 

In the pursuit of consistent profitability in forex trading, relying on a single trading system, no matter how robust, can expose a trader to significant risks. Markets are dynamic, and a strategy that performs exceptionally well in one market regime (e.g., trending) might struggle or even fail in another (e.g., ranging). The solution lies in building a diversified portfolio of trading systems. This approach, borrowed from traditional investment portfolio theory, aims to smooth out equity curves, reduce overall portfolio volatility, and enhance risk-adjusted returns by combining different strategies that perform well under varying market conditions. This article explores the rationale behind diversification, how to combine different strategies, the importance of correlation, and effective risk allocation across multiple systems.

Why Diversify Your Trading Systems?

Just as investors diversify across different asset classes (stocks, bonds, real estate) to mitigate risk, traders should diversify across different trading systems. Here are the key benefits:

1. Reduced Volatility and Smoother Equity Curve: A single system will inevitably experience drawdowns. By combining multiple systems that are not perfectly correlated, the losses of one system can be offset by the gains of another, leading to a more stable and less volatile overall equity curve.
2. Enhanced Risk-Adjusted Returns: Diversification can improve metrics like the Sharpe Ratio or Sortino Ratio, as it aims to achieve a similar return with less risk, or a higher return for the same level of risk.
3. Adaptability to Market Regimes: Different strategies thrive in different market environments. A trend-following system excels in trending markets but struggles in choppy, ranging conditions. Conversely, a mean-reversion system performs well in ranging markets. A diversified portfolio can maintain profitability across various market regimes.
4. Reduced Reliance on a Single Edge: If one system’s edge diminishes due to market changes or increased competition, the overall portfolio is protected by the continued performance of other systems.
5. Psychological Comfort: A smoother equity curve and reduced overall risk can significantly alleviate the psychological stress of trading, helping traders stick to their plan during inevitable losing periods.

Combining Different Strategies: The Art of Synergy

Effective diversification isn’t just about adding more systems; it’s about combining systems that complement each other. Consider diversifying across:

1. Strategy Types

• Trend-Following: Systems designed to capture long-term price movements (e.g., moving average crossovers, breakout strategies).
• Mean-Reversion: Systems that profit from prices returning to their average (e.g., Bollinger Bands, RSI overbought/oversold).
• Momentum: Systems that capitalize on the continuation of short-term price movements.
• Breakout: Systems that trade when price breaks out of a defined range.
• Scalping/Day Trading: Short-term strategies focusing on small, frequent gains.
• Swing Trading: Medium-term strategies capturing larger price swings.

2. Timeframes

Combine systems that operate on different timeframes (e.g., a long-term trend-following system on daily charts with a short-term mean-reversion system on H1 charts). This reduces the correlation between trades and allows for exposure to different market cycles.

3. Currency Pairs/Instruments

Trade different currency pairs or even different asset classes (e.g., forex and commodities, or forex and crypto if your broker allows). Ensure these instruments are not highly correlated. For example, trading EUR/USD and GBP/USD might not offer significant diversification if they tend to move in similar directions.

4. Logic and Indicators

Even within the same strategy type, use systems that employ different underlying logic or indicators. For instance, two trend-following systems, one based on moving averages and another on ADX, might offer better diversification than two systems both relying solely on moving averages.

The Importance of Correlation

Correlation is a statistical measure that indicates how two variables move in relation to each other. In the context of trading systems, it measures how the equity curves of different systems move together.

• Positive Correlation (close to +1): Systems tend to move in the same direction. Combining highly positively correlated systems offers little diversification benefit.
• Negative Correlation (close to -1): Systems tend to move in opposite directions. These are ideal for diversification, as one’s losses are often offset by the other’s gains.
• Zero Correlation (close to 0): Systems move independently of each other. These also offer good diversification benefits.

The goal is to combine systems with low or negative correlation. Regularly analyze the correlation between your systems’ equity curves to ensure they are still providing diversification benefits. Tools and software can help calculate these correlations over time.

Risk Allocation Across Systems

Once you have a portfolio of systems, proper risk allocation is paramount. This involves deciding how much capital to allocate to each system and how much risk each system is allowed to take.

1. Equal Risk Allocation: A simple approach where each system is allocated an equal percentage of the total portfolio risk. For example, if you have 5 systems and want to risk 1% of your total capital per trade, each system might be allowed to risk 0.2% per trade.
2. Performance-Based Allocation: Allocate more capital or allow higher risk to systems that have demonstrated superior risk-adjusted performance over time. Conversely, reduce allocation to underperforming systems.
3. Volatility-Based Allocation: Allocate less capital to more volatile systems and more to less volatile ones, aiming for a more balanced risk contribution from each system.
4. Dynamic Allocation: Adjust allocations based on current market conditions or the performance of individual systems. For example, if a trend-following system is struggling in a ranging market, its allocation might be temporarily reduced.
5. Overall Portfolio Drawdown Limit: Set a maximum drawdown for the entire portfolio. If this limit is approached, consider reducing exposure or temporarily disabling underperforming systems.

Practical Considerations for Implementation

• Centralized Management: Use a master account or a portfolio management tool to oversee all your systems. This allows for consolidated reporting and easier risk management.
• Broker Compatibility: Ensure your chosen broker can handle multiple EAs or strategies running simultaneously on the same account, or consider using multiple accounts.
• VPS Hosting: Run all your automated systems on a reliable Virtual Private Server (VPS) to ensure continuous operation and minimize latency.
• Continuous Monitoring: Regularly monitor the performance of each individual system and the overall portfolio. Be prepared to adjust or remove systems that are no longer performing as expected.
• Start Small: When introducing new systems, start with small position sizes to validate their performance in a live environment before scaling up.

Conclusion

Building a diversified portfolio of trading systems is a sophisticated yet highly effective approach to achieving more stable and robust returns in the forex market. By strategically combining different types of strategies, operating on various timeframes, and trading uncorrelated instruments, traders can significantly reduce overall portfolio volatility and enhance their risk-adjusted performance. The key lies in understanding and managing the correlation between systems and implementing intelligent risk allocation strategies. While it requires more effort in development and management, the benefits of a well-diversified portfolio—including increased resilience to changing market conditions and greater psychological comfort—make it an indispensable strategy for serious automated traders aiming for long-term financial success.