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Multi-Dimensional Diversification

February 21, 2005

 

How Diversified are You? Many of the investors reading this have already wisely diversify their assets into different asset categories such as managed futures or a technical based trading system. Our congratulations go out to you, but how diversified are you, really? Several investors fail to diversify within such an investment, allocating all of their funds towards one market, trading strategy, or time frame. Are you one of them?

Investing in only one trading system or CTA(Commodity Trading Advisor) is similar to investing in just one stock or mutual fund. We have all seen how devastating that can be with the fraud related bankruptcies of Enron, et al. and the numerous Internet stocks now trading under $1. It is simply too hard, and too risky, to invest all of your hard earned money in one particular stock, mutual fund, trading system, or market. What if you pick the wrong one?

Attain Capital recommends diversifying across three different dimensions within alternative investments to lessen the risk of "picking the wrong one". A properly diversified investor would be diversified amongst different:

  1.  

    1. Markets

    2. Time Frames

    3. Strategies

    4. Developers

Markets - Too many investors concentrate on just one market or commodity group. The most common offender is the index trader, who concentrates solely on S&P futures or e-mini SP and Nasdaq e-minis. The danger of such an approach is in the amazing volatility which appears in these index markets from time to time. A surprise Fed rate cut, 9/11 type disaster, or other unforeseen event can wipe out an investor with too much exposure to stock index futures. Diversifying you alternative investment to other groups, such as Energies, Metals, Agriculturals, and Currencies allows the potential for profits from the "moving" group to make up for losses in other groups. In the course of a year, one or more commodities in each group can make a big move, such as the energy and currency groups have done the past twelve months. A diversified portfolio of strategies will pinpoint these moves, and the profits from those trades can more than offset the losses from the other groups, creating a much smoother equity curve.

Time Frames - Diversification across different time frames allows an investor to realize the benefits inherent in both short term and long term strategies. Long term strategies' ability to let profits run is mixed with short term strategies risk averse stance on getting out at the end of the day to reduce overnight risk. Confirmation of signals across different time frames also allows for multiple contract entry on a higher probability, confirmed trade. Lastly, there is the opportunity for profits on both the long and short side of the same market, as different exit timing can equal different end results.

Strategies - Every trading system has a different strategy, by definition, making diversification across strategy types the toughest diversification tool to implement. The different strategies can be broken down into general categories, however, such as trend following, option writing, breakout signaling, oscillator based, and pattern recognition.

Each of these categories has its strengths and weaknesses. For example, a trend following system such as Aberration will do poorly in markets which are oscillating back and forth with no clear cut trend, but an oscillator based system would do quite well in such market conditions, selling overbought conditions and buying oversold areas.

Diversification across several strategy types will also expose investors to several different money management strategies at once, creating extra protection from downside risk.

Developers:

One area often overlooked in portfolio creation and diversification strategies is diversification among system developers. Developers are trying to make a living just like the rest of us, and the smart ones have many different offerings across different markets and time frames so they may sell more systems.

However, loading up on many systems of a single developer may not be in the investor's best interest. The first worry is that the developer (whether consciously or not) uses some of the same logic in the different systems. It is not too hard to imagine a developer hitting a tough spot in the development of a second, third, or fourth system offering - and "running home to mamma" by inserting the logic he knows works well (because it works in his other system(s). The danger in this, of course, is that if there is a flaw in that logic or an environment not conducive to that logic; the investor is exposed twice (or more depending on how may of that developers systems you trade).

IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Feature   |   Week In Review   |   Chart of the Week   |  

Chart of the Week : Diversification Checklist

Feature   |   Week In Review   |   Chart of the Week   |  

It was a slow week on Wall Street as investors waited patiently on Allan Greenspan's bi-annual testimony to congress. Combine Greenspan with the long holiday weekend and you get a dead week for the US stock markets.

Bond traders didn't care for Greenspan's comments regarding the future policy on raising the Fed Funds rate and quickly sold off their 2005 highs, closing -1.62% lower. Foreign currencies reacted in the opposite fashion as both Eurocurrency (+1.57%) and the Swiss Franc (+2.26%) rallied against the US Dollar which fell -1.28%.

Finally, in the commodities, soybeans were the most active market rising 5.09% because of a drought in Brazil. Meanwhile, high grade copper continues to be in high demand with prices rising 4.89% this week.

**Day Trading**

S&P futures traded in a tighter range for the entire week than they did last Friday when futures traded in a 16.1 point range. Needless to say, daytrading activity was very light and hopefully next week will provide more profitable opportunities. .

AG Xtreme continues its hot streak in '05 and profited a modest +$325 after trading four out of the five days this week. BWT Zones SP has consistently been able to lock in profits early in the trading session and tacked on another $1500 for investors. Helix SP averaged two trades per day for the week and came out down -$250 in the end. Day Breaker traded once this week, on Thursday, for a loss of -$812.50. R-Mesa was slightly more active for the week and gave back -$2203.25.

Emini S&P systems performed much more favorably than Emini Russell systems for the week, quite the opposite from the past few weeks. RC Miracles was very active this week and profited +$677.50 per emini contract. Its sister system, RC Success followed through on last week's performance with another gain of +$410 per contract. Helix ES had several profitable trades but gave back -$163 per contract after trading ten times last week. Cipher and Magnitude also gave back -$100 and -$407.50 per contract. Clipper lost -$230 per contract-both were short trades that looked like promising set-ups but showed no follow-through on either trade. BWT Zones eRL came down a bit from last week's stellar performance and lost -$1189 per contract. BWT Rock'n Russell suffered similar fate, losing -$978 per contract using the position manager.

**Swing Trading**

The swing trading systems performance was mixed due to the market conditions. Once again Axiom shrugged off the choppiness and was able to grab profits of +$1045.00 per contract in the e-mini SP. The system also upped it's winning streak in the e-mini Nasdaq to four in a row after posting profits of +$50.00 on one trade this week.

Tzar held short the entire week in the ES, NQ, and eRL due to the lack of movement in the markets. Eclipse reversed short on Thursday and lost -$180.00 per contract on the trade. I-Master bounced back with profits of +$307.50 in the ES, although the system lost -$270.00 per contract in the e-RL and -$245.00 in the e-MD.

In bond swing trading Mesa Bonds & Notes took the worst of the sell-off as both systems continue to hold long in the 30 year bonds and the 10 year notes. Mesa Bonds is making +$1356.25 per contract in open profits, while Mesa Notes is losing -$628.13 per contract.

**Long Term**

If asked, most trend following strategists will tell you that 2004 may have been the toughest year on record for their type of trading. Well, 2005 isn't shaping up to be much better. In general most of the financial and commodity markets are in a consolidation phase that refuses to allow any trends to develop. The recent rally in the bonds, which may have been the best trend this year, came to an end this week, stopping out most systems. One can only hope that the systems and the markets show the same resiliency they did in '04, which saw most trend followers post profits despite tough trading conditions for three quarters of the year.

As I noted above soybeans and high grade were the two big movers this past week. Brix and Andromeda were the only two systems effected by the bean rally as both were stopped out for losses of -$635.00 per contract and -$1450 per contract respectively. Andromeda was able to recoup some of the bean losses in high grade as the system is holding long for open trade profits of +$1050.00 per contract. LaJolla is the only other system holding long and making +$500.00 per contract.

Foreign currencies rebounded from their slump as Greenspan's comments weighed on the US Dollar. The only two systems affected by the move include Checkmate which lost -$2217.50 in the Swiss Franc after getting stopped out of a short trade, and Brix which is holding short in the Swiss Francs. Aberration Plus were happy to see the Mexican Peso on the rise as the system is holding long for open trade profits of +$950.00 per contract.

Other commodity markets in the news include crude oil which rose +2.53% and heating oil which was up +2.99%.

IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Feature   |   Week In Review   |   Chart of the Week   |