Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

MECHANICS OF TRADING SYSTEM DIVERSIFICATION

Diversification of negatively and/or uncorrelated trading systems is one of the most effective methods of improving rates of return without proportionately increasing the risk assumed to achieve these enhanced levels of performance. To illustrate this point, let us examine a trend-following system from Chapter 3 (MACD) with our diversified futures portfolio, and a directionally biased intermediate-term mean reversion system from Chapter 4 (RSI Extremes with the 200-day moving average filter) with our mean reversion portfolio, and then compare these results with the combined performance of both trading systems.

In comparing Tables 9.3 and 9.4 to Table 9.5, the first and most important improvement is in the profit to maximum drawdown ratio. This is due to the fact that low correlations between the trend-following and mean reversion systems led to a smoothing of equity drawdowns for the performance of the combined trading system results. Although the maximum drawdown column shown in Table 9.5 was larger than in Table 9.3 or 9.4, it represented an increase only of roughly 17 percent and 20 percent respectively. By contrast, because Table 9.5 took all signals generated by both systems, its total net profits were additive, thereby leading to an overall improvement in performance results.

TABLE 9.3 MACD totals from 1993 to 2002.

TABLE 9.4 RSI ...