Ultimate Algorithmic Trading System

66
STOCHASTICS AND AVERAGES AND RSI! OH, MY!
risk measure and modify version 1 to make it more risk averse. Looking back at
the results you will notice a relatively high maximum drawdown at the portfolio
level—greater than 30 percent. In the world of hedge funds, this is an acceptable
level—I am not kidding! Some of the most successful hedge fund managers have
taken their clients down more than 40 percent before rebounding. This is the main
difference between hedge fund participants and the typical investor. The trade-off
for higher returns is, of course, higher risk. Let’s see if we can be a better hedge
fund manager and reduce that 30 percent plus drawdown. Let’s assume we have a
million-dollar allocation (remember, we are in a dream world), we only want to
risk 0.2 percent (0.002 or $2,000 per trade), and we don’t want to reinvest profits
(at this point). How can we use this information to reduce drawdown in version 2
of our trading algorithm?
Version 1 buys on penetration of upper Bollinger Band and gets out on the
penetration of the moving average. So our initial trade risk can be defined as
the distance between the upper band and the moving average. If we equate this
distance to dollars, then we can filter out any trades that exceed our acceptable risk
amount of $2,000. Now, will this guarantee that our largest loss will be $2,000
or less? No! Remember when I stated the bands were self-adapting? During the
life of any given trade, the bands could expand and the distance between the outer
bands and the moving average could grow well beyond our $2,000. This could
result in an individual trade loss greater than that amount. Well, can we at least
guarantee the maximum drawdown will decrease? Again, no! Maximum drawdown
is a consequence of a losing streak. Even though we are filtering trades (eliminating
what we consider too risky), that doesn’t necessarily mean the trades involved in
the losing streak will be eliminated. The filtering process might even eliminate the
trades that pull the equity curve out of the drawdown. So, theoretically the risk
aversion overlay might not help at all and might even make matters worse. Let’s see
for ourselves and use the following pseudocode on the same 35 markets:
‘Trend Following with Bollinger Bands
‘Utilizing 60-day average and 2 standard deviations
‘Version 2 - don’t take any trade with risk > $2,000
myAVG = SMA(C,60)
myTopBand = BollingerBand(C,60,+2)
myBotBand = BollingerBand(C,60,-2)
filterTrade = false
‘convert price range to dollars by multiplying by dollar value of points
If (myTopBand - myAvg) * BigPointValue > 2000 then
filterTrade = true
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