Algorithmic trading systems can be an effective means to diversify your portfolio. Because these systems often trade futures, which are highly-leveraged instruments, and because their approach typically involves short-term trades, you might want to consider the algorithmic portion of your portfolio to constitute the smaller and riskier portion that seeks high growth.
After considering both the opportunities and risks, if you’ve decided that dedicating a part of your portfolio to algorithmic trading might be right for your financial goals, note that there are smarter ways to approach this endeavor, as there are many mistakes to avoid. There are numerous algorithmic systems available on the market, and you may want to do your due diligence when selecting them.
Here are five major pitfalls to avoid:
1. Not knowing when to hold and when to fold
It’s important to carefully analyze a system’s performance statistics, paying close attention to its average and worst drawdown. Note that average and worst drawdowns can always be exceeded. And this might constitute some objective measure as to whether a system is performing within, beyond, or below expectations.
So if a system has an average drawdown of 25% and a worst drawdown of 35%, then any drawdown above 25% might be considered within expectation. Drawdowns exceeding 25% might put you on alert, and a drawdown exceeding 35% might be considered the “uncle” point. Investors who do not set a measurable range of risk targets may risk “folding” when they should be “holding” or holding far too long when they should have folded.
2. Not knowing how to interpret live vs hypothetical results correctly
Every system that is performing well was once a hypothetical system that hadn’t yet traded in a live market. That said, a system that has traded live isn’t necessarily better than a system that hasn’t. But what is important is to pay attention to systems that have both live and hypothetical performance data.
What you are looking out for is this: if a system’s hypothetical performance is very high, but its live performance for the equivalent time period is very low, then that should be a red flag. For instance, if a system’s one-year performance shows a gain of, say, 30%, but its one-year live performance shows a loss, then perhaps the discrepancy is wide enough for you to consider avoiding that system.
3. System jumping
Every trading system undergoes drawdowns. That said, it makes little sense to indiscriminately ditch a system for a better-performing system for the sole reason that it is experiencing a drawdown. If you decided to stop trading a given system, this decision should be based on objective criteria (as discussed in the first pitfall above).
The risk in indiscriminately jumping from one system to another is that you may end up jumping across multiple systems only to catch all of their drawdowns, never allowing any of the systems to recover, instead, converting your drawdowns into realized losses.
4. Over-diversification
Algorithmic systems can be an effective tool for diversification, but you must choose them carefully. If you select too many systems that overlap in certain markets, you may be defeating the purpose of diversification, as you would be over-concentrated in a handful of markets.
Furthermore, you can also over-diversify in strategies. For instance, if you have a handful of systems that do short-term day trades, then no matter how diversified their markets are, you may still be over-concentrating your risk toward a particular approach. Instead, you might want to select a mix of short- to intermediate- to long-term strategies to fully diversify your strategic approach.
5. Overexposure
Last but not least, you do not want to be overexposed to the risks associated with highly-leveraged trading. Remember that because of the risks in leverage and approach, algorithmic systems might be best treated as the smaller and riskier portion of your portfolio.
How much you allocate to this segment of your portfolio is up to you. Because you are using only risk capital–money you can afford to lose–in pursuit of aggressive growth, only you can determine what might be adequate based on your risk tolerance. Allocating anything upwards of 30% of your capital might be considered very risky if not reckless.
Algorithmic trading systems can be an effective means for diversification but only if you approach it correctly. ZY Trade can assist you in determining which systems may be right for your financial goals and risk tolerance. Contact us at info@zytrade.com or call us at 888.240.7099 to learn more. When considering products that seek aggressive growth, professional assistance may be your most favorable approach.
The risk of loss in the trading of stocks, options, futures, foreign exchanges, foreign equities, and bonds can be substantial and is not suitable for all investors. Trading on margin or the use of leverage is not suitable for all investors and losses exceeding your initial deposit is possible. Supporting documentation is available upon request. Trading futures, options on futures, and foreign exchanges involves substantial risk of loss and is not suitable for all investors. Carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources and only risk capital should be used. Opinions, market data, and recommendations are subject to change at any time. The lower the margin used the higher the leverage and therefore increases your risk. Past performance is not necessarily indicative of future results.
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