TRADING SYSTEMS
Portfolio Optimization Techniques
Once you have a trading system, you still need to evaluate it. You can apply optimization strategies to increase profitability, reduce drawdowns, and enhance the stability of your system.
Despite opinions to the contrary, building a successful daily trading system for stocks isn’t all that difficult, especially if you have the right tools, tons of patience, and a sound understanding of why markets behave the way they do. Of course, 95% of all traders and investors probably are deficient in one or more of those three critical areas of market savvy, and as such they are most likely destined to trash their trading accounts within a given period of time unless they seek the guide of a market mentor or professional trading system developer. For the sake of argument, let’s say you do have all of these foundational tools and skills at your disposal and you have been able to piece together a reliable and profitable equity trading system for trading the market from the long side, one that you can use on individual stocks in both your cash and retirement (Ira or Roth Ira, for example) accounts.
Of course, now that you’ve gone as far as you can in fine-tuning your system to work well in a range of market environments, what else can you do to boost its profitability and reliability?
This article may offer at least a few answers to that question by showing how to use portfolio optimization strategies in order to increase profitability, reduce drawdowns, and enhance system stability.
A simple, yet sturdy system
First, let’s look at a simple trading system, one designed to enter a long stock position on a pullback in the five-period money flow index (Mfi) (5) with the goal of exiting with a profit on an anticipated snap back higher, using a five-period relative strength index (Rsi)(5) to exit with a profit or using a fixed stop-loss to exit with a loss.
| TEST 1 | |
|---|---|
| Maximum portfolio size | 9 |
| Maximum new positions per day | 1 |
| Equity allocation per trade | 11.11% |
| Number of trades | 1,258 |
| Average profit | $96,909 |
| Average profit per trade | $77.03 |
| Standard deviation | $7,791 |
| Winning trade % | 47.78% |
| Probability of profit | 100% |
| Maximum peak-to-valley drawdown | 15.91% |
Figure 1: test results for nine-stock portfolio with one new stock permitted per day. The average profit was over $96,000 with a maximum peak-to-valley drawdown of 15.91%.