Creating Non-Correlated Trading Systems
Paul King, July 14th 2006
If you're going to trade multiple trading system for diversification reasons
(in the hope they will have losing periods at different times) in order to get a smoother equity curve then it is a good idea
to know how and why your systems are not correlated with each other.
The main ways a system can be diversified are listed below:
Trading a system that operates on markets in different countries can help
since regional macro-economic conditions are rarely similar.
Trading systems that operate on different time frames (tick, hourly, daily,
weekly, monthly etc.) works because of the fractal nature of markets. A system can work in many timeframes, each one
having similarities of behavior but which are not directly correlated.
The instrument a system is designed to trade can offer some diversification
- systems that trade equities, options, futures, fixed income, or foreign exchange all have their own different 'personalities'.
Systems that have differing trade frequencies are generally not correlated
with each other. A system that generates a signal once per day will have a different profile to one that trades once
per month even if the core system is identical.
The idea behind a system can be completely different to the other systems
you trade. This will mean even if it is trading in the same markets and instruments, your results may not be correlated.
Systems that trade long-only, short-only, or long-short will all have different
performance profiles even if there are many similarities between them. Creating systems that can simultaneously be long
and short in the same market can reduce overall market exposure (and therefore risk and correlation with the overall market
A system that has an average trade duration of one week will perform
differently than one that holds positions for a month. Your average trade duration is determined by how wide your stops
are in relation to the volatility of the instrument you are trading so it is relatively easy to manipulate.
In all cases it is important to remember that sometimes (during panics for
example) all financial instruments can move in "unexpected" directions at the same time even if they are not normally
correlated. Trading multiple non-correlated systems is only a partial remedy to this problem - the other part is never
trading so big so that your account will blow up if the 'perfect storm' hits all your positions at the same time.