Stocks & Commodities V. 22:1 (56-58): Boosting Rates Of Return With Noncorrelated Systems by Richard L.

Weissman
SYSTEM DESIGN

Combining Noncorrelates

Boosting Rates Of Return

With Noncorrelated Systems
Here’s how adding noncorrelated assets
within a trading system and combining
noncorrelated systems can help your trading.

by Richard L. Weissman
echanical trading systems
offer traders and risk man-

M agers a distinct alternative

to more commonly used
discretionary methods.
Many mechanical trading
systems use mathematical technical analy-
sis, also defined as the mathematical study
of past price history. I will explore meth-
ods of improving rates of return using
mechanical trading systems without sig-
nificantly increasing drawdowns. I will
demonstrate how to use noncorrelated
assets within a single trading system as
well as the combination of noncorrelated
trading systems.
One of the simplest examples of a me-
chanical trading system is the two–moving
average crossover system. My intention in
this article is purely to show how traders
can improve their rate of return via diver-
sification; as a result, I have purposely
chosen two systems whose performance
is only marginally profitable.
Using a seven- and 29-day moving av-
erage crossover trading system, the fol-
lowing results were achieved through the
trading of dated Brent crude oil.
■ Percent winning trades: 43%
■ Instrument studied: Dated Brent (dollar value equals ■ Profit/loss ratio: 1.44
1,000 barrels)
■ Worst drawdown: -$9,050 (8/01–6/02)
■ Time frame analyzed: 3/1/93–3/1/03
■ Number of trades: 98 (typical duration: zero to four Although the moving average crossover system was prof-
months) itable for dated Brent, if you assume an account value of
■ Average trades per year: 9.8 $100,000, the annualized rate of return produced by the
■ Net profit: +$22,910.00 (includes $75 deduction system was only 2.29% ($22,910 divided by 10 years equals
per round-turn trade for slippage and commissions) $2,291 per year on our $100,000 investment). Note also that
the worst peak-to-valley drawdown was $9,050 or 9.05% of
■ Average trade result: +$233.78
the $100,000. Such a risk/reward level is unattractive to the
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 22:1 (56-58): Boosting Rates Of Return With Noncorrelated Systems by Richard L. Weissman
majority of investors.
Now let’s look at the results achieved by trading yen–US
dollar using the same moving average crossover system:
■ Instrument studied: Spot yen–dollar (12,500,000
yen equals one contract, one tick = $12.50)
■ Time frame analyzed: 3/1/93–3/1/03
■ Number of trades: 103 (typical duration: zero to
four months)
■ Average trades per year: 10.3
■ Net profit: +$57,312.50 (includes deduction of $75
for slippage and commissions per round-turn trade)
■ Average trade result: +$556.43
■ % Win: 38%
■ Profit/loss ratio: 1.57
■ Worst peak-to-valley drawdown in equity:
-$15,462.50 (3/94–11/94)
Using the same assumption of a $100,000 account, you
see that trading in the yen–US dollar generated a larger
annualized rate of return (5.73% vs. 2.29% for dated Brent),
but also entailed the weathering of a greater equity draw-
down (15.46% vs. 9.05% for dated Brent).
As stated earlier, the inclusion of various noncorrelated
trading instruments into your mechanical trading system’s
portfolio was intended to increase the overall rate of return
without significantly increasing risk. Now let’s examine the
results achieved through trading of both dated Brent and
yen–US dollar over the same 10-year time frame.
■ Combined instrument results: Dated Brent and
yen–dollar
■ Time frame analyzed: 3/1/93–3/1/03
■ Number of trades: 201 (typical duration: zero to
four months)
■ Average trades per year: 20.1
■ Net profit: +$80,222.50 (includes deduction of $75
for slippage and commissions per round-turn trade)
■ Average trade result: +$399.12
■ % Win: 40%
■ Profit/loss ratio: 1.53
■ Worst drawdown: -$15,710 (3/94–11/94)
Note that the annualized return on investment achieved by
trading both instruments was significantly higher. This is
because rate of return for the portfolio is additive: 5.73% for
yen–dollar plus 2.29% for dated Brent gives a combined return
on investment rate of 8.02%. Perhaps even more significant is
how the low correlation between these instruments resulted in
Copyright (c) Technical Analysis Inc.
the worst peak-to-valley drawdown level for the combined
portfolio’s performance that is not significantly higher than
that of the yen–dollar (15.71% vs. 15.46% for yen–dollar).
COMBINING NONCORRELATED SYSTEMS
Having demonstrated how rates of return on investment can
be improved through combining noncorrelated assets within
a single trading system, let’s see how performance can be
further enhanced through the combination of noncorrelated
trading systems.
You have seen the results achieved with the trend-follow-
ing system through the study of the two–moving average
crossover system on yen–dollar and dated Brent. Now take a
look at the performance generated from implementing a mean
reversion trading system.
Unlike the two–moving average crossover system we ex-
amined, J. Welles Wilder’s relative strength index (RSI) is
merely a technical indicator that generates buy and sell
signals and not a comprehensive mechanical trading system.
Since RSI attempts to identify when markets are overbought
or oversold in hopes of exiting when mean reversion occurs,
it is unrealistic to simply buy whenever RSI closes below 30
and sell when it closes above 70. As a result, to turn this
indicator into a mechanical trading system, two issues were
addressed: Exiting with profits and exiting with losses.
The first part of the exit plan can be accomplished by
deciding to exit long positions whenever the RSI closes above
35 and exit short positions whenever the RSI closes below 65.
But what if you initiate entry positions and the market
continues to trend? If this happens, it could take months for
RSI to achieve either closes above 35 or below 65 and you
would have failed to quantify and limit risk successfully.
As a result, you need a fail-safe exit strategy in order to
limit risk if the market does not revert toward the mean. There
are many ways of accomplishing this, but perhaps the simplest
is using a stop-loss exit based upon a percentage of the trading
instrument’s value anywhere from 1% to 30% at the time of
entry. I used 7.5% for the Standard & Poor’s 500 and 20% for
dated Brent to allow for normal market fluctuations. This
allows you to do so without prematurely stopping you out of
positions prior to mean reversion, while ensuring that a single
trend does not wipe out several years of profitable trading.
■ Combined instrument results: Spot S&P 500 ($
value = emini S&P 500 x 2) and dated Brent
■ Time frame analyzed: 3/1/93–3/1/03
■ Number of trades: 125 (typical duration: zero to two
weeks)
■ Fail-safe stop levels:
S&P 500 — 7.5%
Dated Brent — 20%
■ Average trades per year: 12.5
■ Net profit: +$39,505 (includes deduction of $75 for
slippage and commissions per round-turn trade)
Stocks & Commodities V. 22:1 (56-58): Boosting Rates Of Return With Noncorrelated Systems by Richard L. Weissman
■ Average trade result: +$316.04
■ % Win: 65%
■ Profit/loss ratio: 1.55
■ Worst drawdown: -$10,755 (10/00–1/01)
Despite enjoying a higher percentage of winning trades
(65% vs. 40% for the trend-following system), this
countertrend trading system proved considerably less profit-
able. This was because the system only attempts to benefit
from mean reversion, so the amount of profit generated on a
per-trade basis is significantly lower.
To enjoy the same additive returns on investment demon-
strated in the examination of combining noncorrelated assets
within a single system, you would need to take every trading
signal generated. But what if your trend-following system
generates a buy signal, while our mean reversion system
simultaneously gives you a sell signal? As long as there are
actively traded derivative contracts on these instruments, you
can execute your mean reversion trade with a contract month
closer to expiration and use a deferred contract for your trend-
following system, thereby enabling participation in all sig-
nals generated by both systems.
For example, if your trend-following system triggered a
buy signal in natural gas futures and the mean reversion
system already had you short the December NYMEX contract,
you would buy the more deferred January contract. The
temptation is to wait for your exit of the mean reversion
system in hopes of obtaining a lower risk/higher reward entry
level, but such a strategy could result in missing a major
trend. On the other hand, if you are already in the trend-
following trade and ignore the mean reversion signal, the
market could revert to the mean, then reverse direction
without hitting your trend-following stops.
Here are the results achieved through the combination of
the trend-following and mean reversion trading systems:
■ Instruments studied: Dated Brent, yen–dollar, and
spot S&P 500
■ Time frame analyzed: 3/1/93–3/1/03
■ Number of trades: 326 (typical duration: zero to
four months)
Copyright (c) Technical Analysis Inc.
■ Average trades per year: 32.6
■ Net profit: $119,727.50 (includes -$75 slippage &
commissions per round-turn trade)
■ Average trade result: +$367.62
■ % Win: 50%
■ Profit/loss ratio: 1.49
■ Worst drawdown: -$14,980 (3/94–4/95)
By combining these noncorrelated trading programs, you
have reduced many of the deficiencies of both as stand-alone
systems. One of the drawbacks to the trend-following system
was that it experienced more losing trades than winners.
Now, through the combination of these two systems, the
winning trade percentage has increased from 40% from
trading the trend-following system alone to 50%. More
important, your risk-reward ratio has improved significantly.
Assuming an account value of $100,000, you have reduced
your worst drawdown from 15.71% for the trend-following
system alone to 14.98% while simultaneously increasing
your overall annualized rate of return from 8.02% to 11.97%.
Although this particular study did not demonstrate faster
recovery from peak-to-valley drawdowns in equity through
the combination of noncorrelated trading systems, in general
this is a reasonable assumption. Finally, another benefit to
combining noncorrelated systems is that it should significantly
decrease the positive correlation of your portfolio’s perfor-
mance with both trend-following and countertrend traders.
Florida-based Richard Weissman is a trading consultant and faculty
member at The Oxford Princeton Programme in Princeton, NJ.
SUGGESTED READING
Weissman, Richard [Forthcoming]. Mechanical Trading
Systems: Pairing Trader Psychology With Technical Analy-
sis, John Wiley & Sons.
Wilder, J. Welles [1978]. New Concepts In Technical Trad-
ing Systems, Trend Research.
S&C