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Mitigating Automated System Risk Through System Diversification

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Investors new to the automated trading system space often carry with them certain ideas--principles, assumptions, and habits--that might have served them well in the equities world. Many of these carry-over ideas apply, given a few tweaks, but there are also a few new concepts to learn that might further benefit their pursuits.

One idea is that of diversification--or spreading risk across multiple assets (or asset classes) to help reduce the volatility inherent to idiosyncratic risk (e.g. company-risk, industry-risk, or sector-risk). This works well when youre holding a basket of equities.

But what if you are interested in subscribing to an automated futures trading system? Will investing in different systems that trade, say, the S&P 500, wheat, and natural gas establish adequate diversification? In some cases, yes; in other cases, now. Why or why not? When youre diversified, your investments respond to different factors and drivers. Despite holding a basket of market-diversified systems, your systems may be exposed to a common set of risk factors that may affect all of them at once.

In other words, you can be diversified in terms of markets but system diversification is just as important. Lets examine this further.

Diversification and Trading Style

Lets suppose youre subscribing to two automated trading systems. One trades crude oil while the other trades the e-Mini Russell 2000. Chances are good that you might see different results, as the markets dont necessarily have a high level of correlation (most of the time).

But what if both systems were implementing a mean-reversion strategy based on, say, Bollinger Bands? And what if certain economic or geopolitical factors create more noise-based volatility in both markets, leading to difficult technical mean reversion readings (of relative oversold or overbought conditions)? Youre in trouble.

If you were to diversify on the level of trading style, you might want to pair a mean reversion strategy (using Bollinger Bands) with a trend-based breakout strategy using a different indicator or technical price action measure. But why subscribe to two day trading systems? Might you not want to diversify in terms of time frame, which extends your possible selections to a wider set of trading styles?

Diversification and Time Frame

If you are subscribing to a day trading system, might you not want to mix it up a bit and add a swing trading system to your list? This way, if any volatility (or lack of) affects markets on a systemic level and on a given day, your market opportunities with regard to a time-differentiated strategy might be wider--the risks, sometimes lessened (not always the case, but you cant always control that).

Lets say you intended on subscribing to three automated trading systems. In terms of time frame diversification, you might be better off combining a day trading system with a swing trading and position trading system, than just combining three systems operating within the same time frame.

And if you can diversify your markets across each system, the more diversified you might be.

Diversification and Developer Risk

Lets suppose you are subscribing to three systems that are diversified in terms of markets, trading styles, and time frames. This alone might count for well-diversified basket of automated systems.

But what if each system was created by the same developer? A number of things can go wrong.

  • The macroeconomic conditions change, requiring a system tweak--and the developer is unable to make the right adjustments to one or more systems.

  • System adjustments have been handed over to a new developer who may be less capable or who may just have a different approach to trading.

  • The developers serves or source computer goes down, affecting all of the systems at once.

Bottom Line

As you can see, automated trading systems are subject to another kind of idiosyncratic risk, one specific to systems themselves. If your aim is to fully diversify your systems, be sure to pay attention to system-related aspects that exist beyond the more common diversification concerns that you encounter when investing in equities.

The risk of loss in the trading of stocks, options, futures, forex, 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 FX 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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About the author

Karl Montevirgen is an independent content writer. Having been involved in the commodities and FX markets for the last 9 years, Karl writes for several companies and publications in the finance space. 

You can view his extended profile, list of publications, and theoretical content work on his LinkedIn page. 

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