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.
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 = 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.