Thursday, December 6, 2012

Optimisation and simultaneous entry signals

One thing I noticed in my optimisation is the occurence of simultaneous entry signals.
Depending on your system, trading simultaneous entry signals may improve or detract the profitability of your system. If it does improve profitability, it can be problematic if you don't adjust your % risk per trade.
For example, suppose the current day ends and you see five juicy entry signals on different pairs eg. EURUSD, USDJPY, AUDUSD, NZDUSD, XAUUSD. Your backtest shows that it is favourable to trade every entry signal on the market. If we risk 2% of our equity per trade, we will end up risking 10% altogether if we take all five entry signals. Because we can expect some moderate correlation between all pairs, trading simultaneous signals usually ends up as an "either or" affair. We usually either win or lose all trades.
10% risk is high. Is there a way of being to trade all entry signals without excessive risk?
Here are our options...
Option 1 - Continue with the status quo and stack on the risk
We typically risk 2% equity per trade. If we see five entry signals, we trade all five and risk a total of 10% equity. If we see ten entry signals, we risk a total of 20% equity etc.
Option 2 - Split the risk among the trades
If we typically risk 2% per trade and see five entry signals, we may split that 2% among the five trades. In this case, we will risk 0.4% equity per trade.
Option 3 - Reduce our risk in general, stack on the risk when multiple entry signals appear
This is much more system-specific. If your backtest shows significant improvement in profitability when trading multiple simultaneous signals, wouldn't it make more sense to reduce your risk when you have a solitary entry signal? That way, should multiple signals appear, we can stack on the risk without it being too excessive.
Suppose we reduce our risk per trade to 1% when trading a solitary entry signal. Should five entry signals appear simultaneously, we can stack on this reduced level of risk. In this case, we will risk a total of 5% equity for these trades. While 5% risk is high, it isn't insanely high.
Option 4 - only trade the pair with the highest expectancy
Of the five pairs signalling an entry (EURUSD, USDJPY, AUDUSD, NZDUSD, XAUUSD), your backtest shows that the EURUSD has the highest expectancy. We may decide to trade the EURUSD only and ignore the rest.
My thoughts
There is obviously no "right" answer, although there are wrong answers. Blindly stacking on risk is a sure-fire way of busting your account when the stars align and the gods conspire against you in the perfect nightmare trade.
However, if there is a significant improvement in profitability from simultaneous entry signals, we want to make the most of this. Another way of looking at it is that we may see a decrease in profitability with solitary signals, hence we should risk smaller during these situations. When multiple signals appear, we ramp up the risk, but not too much. Some variant of Option 3 may be ideal, with perhaps a total risk limit of 5% or some other value.
Option 4 is straightforward. We trade as normal, but when multiple signals appear, we cherry-pick the best pair to trade from our backtest results. The danger stems from curve-fitting, although if our system is robust, this shouldn't be a real problem and we'll approach a result similar to our backtest.

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