Making money with a losing strategy

Discussion in 'Strategy Development' started by jcl, May 17, 2012.

  1. jcl

    jcl

    Theoretically, it should be possible to make money even with a strategy that is not profitable. I don't mean selling it to newbies for $10000, but by using it in a compound system.

    Suppose you have two uncorrelated strategies A and B, with A returning 80% profit and B 40% profit. A compound system of both strategies will not return 60%, but likely more than 100% - the whole is greater than the sum of its parts. I think this is commonly known. But surprisingly, this should even work when strategy B is slightly losing, f.i. -10%. As long as it has some negative correlation to the other strategies, adding it to a compound system can theoretically improve the overall return by reducing drawdown.

    Has someone already made experiences with compound systems from uncorrelated or negatively correlated strategies and assets? What's the best money management for such systems - covariance based or optimal f?
     
  2. m2c: Sure, it can be viewed as a cost of hedging and if it improves r/r, then that's great. That said, you should usually be able to find a similar strategy that provides the same diversification yet has a positive expectancy (or at least, not negative).
     
  3. John Patrick's Regression System for gamblers can probably be adapted to trading in order to turn a 50% winning 1-to-1 risk-reward system profitable....

    ...working my way through his book as we speak...


    Money Management for Gamblers
     
  4. Not sure how you derived this. By your reasoning, if I run the compound of two uncorrelated strategies A and B, which are both coin-flip types of strategies with the expectancy of each being correct is 50% of the time, my expectancy becomes greater than 50%?
     
  5. He is right, possibly - if the signals from winning strategy a happen mostly at the time strategy b looses a lot, it could be used as a filter, which may pull strategy b into winning territory. Something along those lines.
     
  6. kauflaune

    kauflaune

  7. I agree.

     
  8. jcl

    jcl

    That's right, but you need not use one strategy as a filter. Both strategies can be traded independently.

    When the strategy returns are uncorrelated, you'll get a lower drawdown from the compound strategy than the sum of the drawdowns from every single strategy. Profit is return per capital, and the required capital for a system is the sum of margin and drawdown - therefore the profit of the compound strategy is higher than the profits of the separate strategies. The same goes for games with tossing coins when you can select the amount to wager.
     
  9. You would still be subject to the risk that correlations between the strategies are dynamic and could reach a threshold where the diversification effect wasn't there.

    Of course, this only happens in extreme environments. I recall a discussion I had in the Fall of 2008 with a colleague who was VERY experienced in the field of financial risk management and he said he had never seen correlations get to that extreme where almost every attempt at diversification failed.
     
  10. ssrrkk

    ssrrkk

    Mean and variances add for uncorrelated RVs. I don't see how -10% added to +40% will improve the results if they are completely uncorrelated: It should give you 30% return. Your variances will add too so it shouldn't help your draw down either. If there is a anti-correlated component, then the variance of the sum will be reduced by the covariance of the two.
     
    #10     May 18, 2012