The following is adapted from Automated Stock Trading Systems.
Let’s say there’s a roulette wheel with only red and black pockets and a payout of 1.2: 1. If you bet $10 on red and it lands on red, you make $12, but if it lands on black, you lose your $10. If you instead bet $10 on both red and black, then no matter where the ball lands, red or black, you will make $2, as you will lose $10 on one bet and gain $12 on the other.
Obviously, casinos don’t set the odds up this way, but this is a simplistic representation of what can happen when you use multiple systems of trading.
Most traders I know spend far too much time filled with anxiety, worried that the market is going to turn and they’ll lose big. By utilizing multiple noncorrelated systems, you don’t have to worry about market changes, because you can make money in bull, bear, and sideways markets alike.
For this strategy to work, you must avoid falling into the trap of your systems replicating each other’s performance. Let’s take a closer look at how to properly add additional systems to your trading strategy.
Direction and Style
The most fundamental way to differentiate systems is based on direction and style. There are two directional positions we can take in a market: long and short. There are also two different styles: trend following and mean reversion.
We can combine these different directions and styles to create four unique, noncorrelated systems:
- long-term trend following long-buying stocks that are trending up
- long-term trend following short-shorting stocks that are trending down
- mean reversion long-buying oversold stocks that have a better than average statistical likelihood of rising back to their mean price
- mean reversion short-shorting stocks that have been overbought, expecting them to drop back to their mean
These four styles may seem limiting, but the US markets have a tradable universe of approximately 7,000 stocks to work with. (The exact amount depends a little on your requirement for a stock’s liquidity.) This gives us the opportunity to create many different systems to get into different stocks at the right time to make money by using different buy-and-sell rules.
We can bring in additional noncorrelated systems by building new trading systems that employ different entry criteria.
Take a trend following system as an example. What kind of stocks do we want to be in? For one system, we might want to filter in favor of highly volatile stocks. For a conceptually different system, we can filter for low volatility stocks, which will behave differently. We will have different candidates to trade, and the results will be different. That alone is a big differentiator.
We can also split the market based on volume and pricing. If you build a system to trade stocks that are priced below $10, you will be up against very different market participants, and see very different behaviors, than if you trade more expensive stocks. The same thing is true for low-volume and high-volume stocks.
We can also use simple trend filters. One way to look for different stocks is to use lookbacks of different durations. We may seek stocks that are above the 50-day simple moving average, or the 100-day, or the 200-day. These indicators show short-, medium- and longer-term uptrends.
Then we can combine with filters that look at pullbacks-for example, a three-day relative strength index (RSI) below ten shows a strong pullback; below thirty, a medium pullback; below fifty, a weak pullback. These pullbacks again give us a larger chance to be in different stocks than a system without a pullback.
Ranking and Exits
Even employing these variables as filters, we might still end up in the same stocks, so we can further differentiate using ranking and exits.
Ranking is a very important part of a system. We can rank stocks by highest or lowest historic volatility, most overbought or oversold, and strongest versus weakest trend. You’re almost certain to get into different stocks using different rankings.
The market can cause systems to be correlated, so we also want to be sure we have different exit systems. Sometimes when the market drops some systems will be stopped out, but others won’t, and then the market recovers again. You can set different sizes and types of profit target (average true range or percent return, for example). You also can have trailing stops of different sizes.
Finally, for a mean reversion system you can vary your days-in-trade limits so no two systems exit the same way.
A New Approach to Trading
With so many variables to work with, you can see how you could easily build multiple trading systems that work together in an additive fashion, yet generally don’t correlate in negative ways.
When you use a handful of noncorrelated systems together, you can almost guarantee that no matter what the market does, at least some of your systems will be making money.
So say goodbye to the old method of trading where you spend all day glued to your computer screen, biting your fingernails as you watch stock prices go up and down. Combine noncorrelated systems, then sit back and watch the consistent profits start to roll in.
For more advice on trading noncorrelated systems, you can find Automated Stock Trading Systems on Amazon.Laurens Bensdorp is an expert at combining multiple non-correlating trading strategies to achieve a high risk-adjusted return regardless of what the market does. He shares that knowledge with a group of brilliant and dedicated students in the exclusive Elite Mentoring Program that’s part of his Trading Mastery School, of which he is the founder and CEO.
What Laurens has found is that teaching has helped him exponentially grow his skills as a trader. Author of the bestselling book The 30-Minute Stock Trader, Laurens has lived in eleven different countries and travels the world as he pleases. He currently resides in Spain with his beloved wife and children.