Ed Seykota, 2003 - 2006 ... Write for permission to reprint.

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TSP Diversification Study

 

Drawdowns are a critical limiting factor in trade sizing.  Markets that move up and down a large amount take out system traders' protective stops and  take out discretionary traders' stomach linings. 

Diversification is a valuable tool in trading. The effect of diversification is to average out the gains from individual instruments while reducing the total portfolio drawdown below the individual instrument drawdowns.

This presents the trader with the advantage of having to handle less downside heat, or alternatively, if he can handle the heat, he can upsize his portfolio and capture more profit for the same heat.

I call the ratio of Instantaneously Compounding Annual Gain / Worst Drawdown the Bliss.

 

Bliss = ICAGR / DD

 

Panel #1 shows a simulation of a double Support-Resistance System trading a continuous contract of copper.  The Long-Term Support Length is 200 days and the Short-Term Support Length is 100 days. The Bliss is .13 / year.

Panel #2 shows a simulation of an Exponential Average Crossover System trading a continuous contract of crude oil.  The Averaging Times are 150 days and 15 days. The Bliss is .17 / year.

Panel #3 shows a simulation of running both systems above simultaneously. The Bliss is .26 / year.

The magic of diversification is that together, the instruments have higher bliss than they do separately.

 

  Copper Crude Oil Combination
Method SR EA SR + EA
Starting Equity 1,000,000 1,000,000 2,000,000
Heat 10% 10% 5%
ICAGR .051 .071 .065
DD 0.389 0.398 0.252
Bliss .13 .17 .26