In previous posts we’ve spoken about what to look for when selecting forex signals: sound risk management, returns which exceed max drawdowns, and solid win rates and reward profiles. The thing is though, no matter how good the signal you’re following is, there are going to be drawdown periods and losing months. Running a diversified forex signal portfolio is a way to reduce risk from a single system and produce more consistent results.
Diversification effects of running different forex signals simultaneously
If you are running a single forex signal, if that signal provider has a down month, you will have a down month. Simple right? What would happen if you were running two, or even three signals simultaneously on the same account though? If we assume Signal A loses 3% in a given month, but Signal B makes 5% in the same month, you finish with a net profit of 2%. If you’d just followed Signal A, you would have lost 5% and if you’d just followed Signal B, you would have made 5%.
By running multiple forex trading signals simultaneously, it is possible to smooth out your performance and achieve consistently profitable results. After all, if you are trying to make a living of forex trading, this is what you need right? Not making any money for a month simply does not work for most people.
Selecting forex signals that aren’t highly correlated
In order for your forex signal portfolio to be diversified, the forex signals you select for the portfolio can not be too highly correlated. If the signals you select are highly correlated, there will be no diversification effects, because both strategies will win and lose at the same time. It is impossible to escape correlation all together, though with so many different traders and signals available, finding two profitable signals that don’t match each other too closely shouldn’t be too difficult.
A profitable forex signal will overwhelmingly feature more profitable months than down months, so if you find two profitable systems which aren’t highly correlated, the chance of them both experiencing a bad month simultaneously is relatively small.
How do you work out if two forex signals are highly correlated?
Working out whether two signals are highly correlated or not is actually pretty easy. The simplest option is looking at the two system’s equity charts side by side and seeing how close they match. This may not tell you a lot though as a profitable signal’s equity chart will always trend up and it might be difficult to spot the small performance differences that set the two signals apart. A better option is simply looking at each system’s monthly performance and recording the down months for each system, if the two systems aren’t correlated, there won’t be much crossover between the two systems.
For example, System A might lose money in Feb, May, July and September, whereas System B might lose money in March, June, August and October. If both systems are employing sound risk management practices, these losing months will be substantially smaller than the winning months and your portfolio could quite plausibly not have a single losing month over the year.
Calculating actual correlation strength
Comparing a range of signals and want to know exactly how correlated each one is in mathematical terms? This is much easier than it sounds and can really help you decide between one signal or another. In order to calculate correlations between different strategies, simply paste the the monthly performance figures of each signal into a spreadsheet. All you need to do then is divide one signal’s monthly performance by another. If the result is between .67 and 1, or -.67 and -1, the signals are highly correlated. If however the result is between 0 and .67, or 0 and -.67, then the signals aren’t highly correlated (the closer to 0, the weaker the correlation).
Using this approach you could quickly analyze 5, 10, even 20 signals you’ve short listed and select the ones with the weakest correlations.
Managing risk with a diversified signal portfolio
It’s important to remember that if you are running multiple signals, your account will be taking more trades and some of these trades will overlap. As such, you would likely run each signal with slightly less risk than you otherwise would. Diversification effects to reduce risk significantly though, so you will likely find you can run both strategies on more than 50% of the standard risk. Generally speaking, the more diversified two strategies are, the less you will have to reduce the risk for each strategy.
Source: Vantage FX Blog