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Tim,
In Watergate, Deepthroat said to follow the money.
Follow the drawdown.
When I create a diversified system that is designed to trade multiple
markets I focus on a size or quantity of trading that produces a level of
risk ( drawdown) that I can tolerate (say,about 30%). Unless the system is
miraculous(overfitted), the size of positions traded dictated by tolerable
drawdowns will make any discussion of margin moot. A margin of 10-30% of
equity will result. I look at this figure at the very end of the process and
then it is only out of curiosity.
IMHO, the only people who watch margin exposures closely are traders trying
maximize their thrill exposure (and blow out risk) and brokers trying to
maximize their commissions. The sole exception being arbitrage type trading
where cross exchange margins don't accurately reflect the true risk of the
trades.
If politics called for a 50% increase or decrease in margins across the
board, and markets had the same volatility, it shouldn't affect your
trading.
The harder part of the job is once you have created your comparable risk
units to decide how to "allocate" amongst them. Clearly, there will be some
markets which are more attractive than others. Cross correlation of returns,
liquidity, risk adjusted returns, safety and ease of use of exchanges will
all impact how to decide to trade more or less from your risk unit table
(which I see as a good starting point). Unfortunately, some of the issues
don't lend themselves to quantification. Even when you invert the matrices
to evaluate the correlations and do a lot of number crunching, unless you
are trading single accounts of greater than $5 million the rounding issues
in a portfolio of more than 25 markets becomes a real problem.
At the end of the day, I don't believe that there is an elegant solution to
the allocation problem. I have created complicated rating systems to judge
this beauty contest taking into account my tastes and given a greater share
to those that scored well. In the end, however, it made me feel more
confident that I have systematized it but I could have done it in an hour
with a hand held calculator and gotten similar results.
Jim
Jim McConnon
jmcconno@xxxxxxxxxxxxx
"This is the life you have chosen" - The Godfather
-----Original Message-----
From: Timothy Morge <tmorge@xxxxxxxxxxxxxxx>
To: omega-list@xxxxxxxxxx <omega-list@xxxxxxxxxx>
Date: Thursday, August 06, 1998 5:19 PM
Subject: Portfolio Trading and trade allocations
>Hi folks!
>
>I am playing with a spread sheet exercise and thought I'd ask for input
from
>people on this list. In my current longer-term trading, I use what I term
>'equivalent trading units' that allow me to risk similar amounts on a given
>trade, relative to my capital and the average true range of X for each of
the
>commodities I trade. Now, In my normal trading, I never even approach a
level of
>margin use where I'd ever get a margin call. And when looking at several
papers
>and a few books, I see that most people use something similar when
determining
>how many contracts to trade of a given commodity. I also take this
information
>into consideration when looking at my maximum stops, which means I won't
take a
>trade that has a percieved risk that is larger than one I am comfortable
[and
>those maximum risks per trade are all equal].
>
>But this exercise is slightly different [I think]. And my guess is that
some of
>you out there, systems traders perhaps, may already have elegant solutions.
So
>here goes:
>
>You have a methodology that you are able to code and back test. It works
well
>across a broad spectrum of commodities, financials and indexes. If, for the
>basis of this discussion, it helps you to be able to envision a technique,
>assume it is th trend trading technique of your choice. Assume it will be
traded
>on ten seperate commodities and that for each of these commodites, it's
equity
>curve is positive in slope. To make it easier to visualize, let's say that
all
>ten commodities win an average that hovers around 50 percent, and the
average
>wins hover around 2-3 times the average losses. I don't think these matter
for
>the sake of the exercise--I am simply adding them in here to make it easier
to
>visualize.
>
>Now, also assume you will always take a trade in each of the commodities
and
>that the system is such that 95 percent of the time, you are in the market
in
>each of the commodities--the only time you will not have a position is when
you
>have hit a disaster stop, and then you will be flat in that market until a
new
>signal is generated.
>
>The question is: If you have already determined how to relate each
commodity, so
>that the risk asociated with each trade is set to an equal amount, how do
you
>decide how trade size? For example, suppose that when you do your
equivalent
>units, you find:
>
>Commodity Equivalent Unit
>
>Corn 15
>CRB 3
>Cotton 5
>DM 3
>Dollar Index 6
>Euros 12
>Five Year 6
>Copper 10
>Heat Oil 3
>Unleaded Gas 3
>JPY 3
>Coffee 3
>Lumber 3
>Live Cattle 7
>German Bunds 5
>Muni Bunds 5
>Natural Gas 10
>Swiss Francs 2
>Silver 6
>SP 2
>TYAM 5
>Bonds 4
>Wheat 5
>NYFE 3
>
>
>Now, if you traded just these amounts, you'd use much less [something less
than
>$250K] in margin. IF you were trading a $1 million dollar account, how
would you
>determine the multiple of equivalent units to trade? What if it were 20
>commodities?
>
>I hope this makes some sense.
>
>Best,
>
>Tim Morge
>
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