Ultimate Algorithmic Trading System

stops in the development and testing of the algorithms. Are there better ways
to manage a trade than waiting for a liquidation on a system-derived exit or a
disaster stop? Also, is using a function of the market such as average true range
better than a pure $ stop? Trade management is very important and it covers the
concepts of dollar- or volatility-derived stops, profit objectives, and trailing stops.
Trend-following mechanisms do not usually work with pure profit objectives unless
they are sizable. You can’t limit the upside, because the truly big winners don’t
occur all that often. Most trend-following algorithms have an inherent trailing stop
mechanism built-into their logic. When the market moves up so does a moving
average, a Bollinger band, and a Donchian channel. You can incorporate a more
aggressive trailing stop, but again be aware that limiting the big winners will be
counterproductive.
■ Portfolio Composition
100
COMPLETE TRADING ALGORITHMS
Picking a small but diverse portfolio isn’t brain surgery. The key to a good portfolio
is a selection of markets that are somewhat noncorrelated and cull from different
market sectors. A good portfolio should have representation from at least five
sectors: currencies, financials, energies, grains, and metals. You could just randomly
pick one or two markets from each sector and be done with it, but more thought
should be applied to the selection process. Why not just cherry-pick the very
best markets from the backtested results and use these as the future portfolio?
Unfortunately, this is curve fitting even though you are wanting a portfolio with
high positive expectancy.
A test on market correlation should be carried out prior to a selection of any
portfolio component. Figure 3.3 shows a snapshot of a portion of the current
portfolio correlation matrix. As you can see the diagonal is set to one. The diagonal
represents the correlation of each market to itself.
FIGURE 3.3
A snapshot of a portion of the current portfolio correlation matrix.
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