Currency Pair Diversification

Suppose you've backtested a system for 5 currency pairs and you've come up with the following results (hypothetical):

<TABLE style="WIDTH: 255pt; BORDER-COLLAPSE: collapse" cellSpacing=0 cellPadding=0 width=341 border=0 x:str><COLGROUP><COL style="WIDTH: 71pt; mso-width-source: userset; mso-width-alt: 3474" width=95><COL style="WIDTH: 92pt; mso-width-source: userset; mso-width-alt: 4498" span=2 width=123><TBODY><TR style="HEIGHT: 12.75pt" height=17><TD class=xl22 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext 0.5pt solid; BORDER-LEFT: windowtext 0.5pt solid; WIDTH: 71pt; BORDER-BOTTOM: windowtext 0.5pt solid; HEIGHT: 12.75pt; BACKGROUND-COLOR: transparent" width=95 height=17>Currency Pair</TD><TD class=xl22 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext 0.5pt solid; BORDER-LEFT: windowtext; WIDTH: 92pt; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" width=123>Growth at VAR 1%</TD><TD class=xl22 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext 0.5pt solid; BORDER-LEFT: windowtext; WIDTH: 92pt; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" width=123>Growth at VAR 5%</TD></TR><TR style="HEIGHT: 12.75pt" height=17><TD class=xl23 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext 0.5pt solid; BORDER-BOTTOM: windowtext 0.5pt solid; HEIGHT: 12.75pt; BACKGROUND-COLOR: transparent" height=17>GBPUSD</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="0.3">30%</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="1.4">140%</TD></TR><TR style="HEIGHT: 12.75pt" height=17><TD class=xl23 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext 0.5pt solid; BORDER-BOTTOM: windowtext 0.5pt solid; HEIGHT: 12.75pt; BACKGROUND-COLOR: transparent" height=17>USDJPY</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="0.24">24%</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="0.95">95%</TD></TR><TR style="HEIGHT: 12.75pt" height=17><TD class=xl23 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext 0.5pt solid; BORDER-BOTTOM: windowtext 0.5pt solid; HEIGHT: 12.75pt; BACKGROUND-COLOR: transparent" height=17>EURCHF</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="0.2">20%</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="0.38">38%</TD></TR><TR style="HEIGHT: 12.75pt" height=17><TD class=xl23 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext 0.5pt solid; BORDER-BOTTOM: windowtext 0.5pt solid; HEIGHT: 12.75pt; BACKGROUND-COLOR: transparent" height=17>EURCAD</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="0.19">19%</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="0.73">73%</TD></TR><TR style="HEIGHT: 12.75pt" height=17><TD class=xl23 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext 0.5pt solid; BORDER-BOTTOM: windowtext 0.5pt solid; HEIGHT: 12.75pt; BACKGROUND-COLOR: transparent" height=17>AUDUSD</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="0.28">28%</TD><TD class=xl24 style="BORDER-RIGHT: windowtext 0.5pt solid; BORDER-TOP: windowtext; BORDER-LEFT: windowtext; BORDER-BOTTOM: windowtext 0.5pt solid; BACKGROUND-COLOR: transparent" align=right x:num="1">100%</TD></TR></TBODY></TABLE>

The firs column shows the currency pair. The second column shows the growth of the account if you risk 1% of your account everytime you trade that currency assuming that you trade that specific currency pair only and didn't withdraw funds from your account. The third column shows the growth if you risk 5% of your account.

Suppose that the success rate for every pair is roughly between 60% to 70% and all of them can go down for several weeks before showing a significant growth.

Apparently you have different approaches to trade this system:

 

1. Stick with GBPUSD as it shows the highest growth and set VAR (Value At Risk) to 5% for the best growth possible.
2. Trade all 5 currency pairs with this system but set VAR at 1%.
3. Trade all 5 currncy pairs but set the VAR for every currency pair based on their past behaviour. For example it doesn't worth it to increase VAR for EURCHF as it doesn't show a significant growth when you increase the risk.
4. Other approaches.

What do you suggest? What would be the best approach? Does trading diversification with such system help us to enhance the growth yet mitigate drawdowns?

Is there anybody out there to help me with this issue? Thanks.

I am not so sure what you are trying to achieve but to me the most important factors are market share of the currency pair, spread between bid and ask, violativity and volume. The obvious choice of the currency pairs are still GBPUSD, EURUSD and USDJPY. But some traders base on their locality choose their prefer currency pairs for trading.

Of course the funamental needs is to choose the most profitable pairs that you are familiar with.

I think drawdown is equally important, if not more important, than growth. Show us what the flip side is, then well pick a side.

Thanks for your response. Let me explain what I have in mind. Suppose you are using a trading system that is successful over a relatively long period of time on a single currency pair. To make your profit a considerable amount you increase the risk factor (or rather Value At Risk) but this approach could result in substantial loss of capital in short term.

To avoid such short term losses you spread risk among several pairs and trade them at the same time (assuming that the system is profitable on all those pairs). Now the likelihood that all your trades end up in losses at the same time is less (the worst case sinario would be what happens if you trade one pair). Theoretacally this approach (currency pair diversification) could result in a smooth growth of capital. However, I'm looking for a practical approach to this practice.

It might be difficult to follow this approach with manual trading but a mechanical trading system can handle it easily.

In this hypothetical model I assume that you may face an average of 10% drawdown when you risk 1% of your account to trade each pair and a 30% drawdown when you risk 5%.

Well I would say option 1, but I really dont have all the drawdown information. I assume different pairs will drawdown differently. If you can get over the emotional aspect of a 30% DD, I believe this is the way to go. What I would do is pick your maximum drawdown you are willing to cope with. From there, determine which version of your system will grow the quickest without exceeded your drawdown tolerance. Its different for everyone.

Thanks very much. I hope to hear from other folks to see how they plan their trades ahead.

Hi,
To add to twinchell, I would also confirm that in my backtesting different pairs can drawdown differently but can sometimes drawdown at the same time!

I would set trading strategy/position sizing to a maximum of 15%DD based on past figures and anticipate doubling historical drawdown to 30%DD as a rule of thumb

Best regards
Alan

Thanks Alan. These figures sound reasonable to me.

My perception is that if you trade say five pairs at the same time and risk 1% of your account on each trade the chances that you face a 5% drawdawn is less than trading one pair with 5% VAR (assuming that the behaviour of all those pairs are very similar to each other).

I'm trying to find a solution that mitigates drawdowns and creates a smoother growth curve. However, I'm not quite sure what will happen in reality. I'm working on an MT4 EA nowadays and try to enhance it's behaviour for different pairs. I'll let you know if this approach is practical or not.

It would be great if I hear from others as well.

Hi there,
The discussion of diversification is interesting. Whilts in theory trading neutral pairs may reduce drawdowns, believe short term trading into apparent trends for say top 10 pairs and simultaneous close of all trades at predermined profit level may be more effectove. Your thoughts on this would appreciated.

Thanks,

Tom