Does Your Trading Strategy Complement Your Portfolio Of Strategies? (Correlation)

Last Updated on May 21, 2022 by Quantified Trading

Does your trading strategy complement your portfolio of strategies? That is the first thing you should address if you are considering adding more trading strategies.

Perhaps surprisingly, many strategies don’t complement each other because they are too similar and overlapping. Thus, you might end up adding more losing trades to your already winning trades. 

How do you complement or add value to a portfolio? This article shows via some naive examples why this happens.

Trading strategies and diversification

If you are a short-term trader you need many strategies to make it worthwhile – you need a portfolio of strategies. Furthermore, you need uncorrelated strategies. The key to successful trading is to understand correlation in trading and understand how the strategies interact in both good and tough times.

The most difficult task as a trader, alongside finding new strategies, is finding strategies that work well together. Unfortunately, two strategies that work well on their own don’t necessarily translate into an improved “portfolio” of strategies for many different reasons.

We have written multiple times that the only holy grail in trading is to spend time developing strategies that complement each other. You can’t add ten mean-reverting strategies in stocks, for example, you need to have different types of strategies.

Two mean-reverting strategies

Let’s make an example to easier illustrate what we mean. On our landing page of free trading strategies we have backtested several of Larry Connors’ trading strategies, taken from his book called High Probability ETF Trading, published in 2009.

Let’s pick two of Connors’ strategies:

How do these strategies perform together? Both strategies are tested on a basket of different ETFs:

DIA, EEM, EFA, EWH, EWJ, EWT, EWZ, FXI, GDX, GDXJ, GLD, ILF, IWM, IYR, QQQ, SPY, TLT, XHB, XLP, XLE, XLF, XLI, XLP, XLV, AND XME.

The first strategy, multiple days up and down, returns these numbers:

 

The second strategy, 3-day high/low, returns these numbers:

As you can see, both strategies perform reasonably well and have ending capital of 368 000 and 322 000. In other words, they yield the same results (in the ballpark at least).

If we add the two strategies together the strategy and system performance metrics look like this:

If we trade both strategies (taking only one trade at the same time), the combined result is worse than if you only traded the first strategy!

Example 2: Add one strategy to an existing portfolio

Let’s assume you already have a few strategies that you are trading and that they have the following equity curve combined:

The average is 0.3% over more than 1 500 trades. The above equity curve is based on overnight trading strategies and some of them will later be revealed as monthly trading edges.

Then you come across a promising mean-reverting strategy that has the following equity curve (and you consider adding it to the other strategies):

The average gain is 0.33% and the win rate is 65%.

What happens when you add the extra strategy together with the other strategies? Something surprising happens – the trading metrics deteriorate:

The last strategy makes your overall portfolio of strategies perform worse despite having such good trading statistics. The average gain per trade goes down from 0.3 to 0.26% and the overall equity is reduced.

Why does this happen?

It happens because most of the trades are overlapping. The extra trades you get are the ones that are more likely to turn out to be losers.

This is why you must always backtest how your strategies perform together as a portfolio overall.

Does your trading strategy complement your portfolio of strategies?

Remember, even mediocre trading strategies can improve portfolio performance metrics if they mitigate risk, something Mark Spitznagel has explained well. Instead of spending (wasting?) time on finding something perfect, most traders are much better off by trading “mediocre” systems that might complement each other.

Always ask yourself:

Does your trading strategy complement your portfolio of strategies?

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