Monday, May 5, 2008

The Diversification Myth

It is very popular in the world of finance and economics to advise people to diversify. The usual phrase "don't put all your eggs in one basket" is usually cited as a great exemplification of the diversification principle.

In short, diversification implies the investment on not only one, but several financial instruments in order to reduce risk. This may, or may not reduce profit, depending on the level of correlation between said instruments. Generally however, diversification does carry the partial hedging of the different means of profit. If one financial instrument profits the other loses somehow and this effectively reduces the risks produced by having all your "eggs in one basket".

For me, diversification is protection, protection from ignorance. When one is not completely aware and confident of what one is doing, diversification is needed as protection, because the outcome seems blurry and unpredictable. If a person knows exactly what he or she is investing in, I mean, know it a hundred percent, then there is no need for diversification, because this will only negatively affect the profits of the first investment.

Since non of us can predict the future, we all need a certain degree of diversification. To what degree ? To what degree are you ignorant ?

Hedging Expert Advisors, The Double Edge Sword

Throughout my whole experience in the area of automated trading I have encountered a fair amount of expert advisors based on hedging as well as correlation strategies. Expert advisors such as the Five Pairs Hedging Expert Advisor have attracted a lot of attention because of the theory behind them. There are also a lot of other forex systems based on this type of strategies, like the Freedom Rocks Program for example, which tries to exploit swap while hedging positions.

First of all, let me explain to you the concept of hedging. To hedge, in finance, refers to the action of taking opposite or complimentary positions on different instruments to reduce risk. Hedging differs from diversification in that hedging implies a correlation between the two instruments while diversification may target completely unrelated things.

As an example, in forex, buying and selling a currency pair at the same time is the most straightforward way of hedging as the profit or loss of any of the two positions is compensated by the other. However, this does not carry any profit for the trader. In a more general fashion, one could hedge different pairs and profit either from the swap differential or from displacements in the overall correlation of the pairs.

The EUR/USD and the USD/CHF have had a historical correlation of almost -0.9, that means that 90% of the time USD/CHF goes up, EUR/USD goes down, and vice versa. If the pairs deviate from this correlation, say, EUR/USD goes significantly up but USD/CHF still does not go down, one could in theory profit from the reestablishment of the correlation by buying USD/CHF.

However, there is a catch. When correlations deviate between pairs, it is fairly difficult to know which pair deviated from the relationship. If EUR/USD went up and USD/CHF did not follow, who is wrong ? Did the EUR/USD pair go up unnecessarily ? or did USD/CHF didn't go behind it ? This is the question, not always does the first one who deviates is necessarily right.

Hedging is particularly dangerous when it is used as a means of protection, as when one wants to profit from swap. Correlations are a very wavy thing and they may vary and change in the future without ever warning the trader. This is the reason why I advice people not to use the Freedom Rocks system, which seems excessively risky to me and does not offer enough rewards for the excess of capital that is risked. A strategy like this can easily wipe out an account when currencies suddenly deviate a lot from their correlation.

Personally, I don't like hedging strategies, neither when they are used as protection instruments nor when they are the source of the profit. For me, hedging carries the additional charge of spreads paid for additional positions and does not guarantee the effectiveness of either the profit, or the protection. In my opinion, strong forex strategies that rely on hard stop losses and the use of one open position at a time offer the greatest potential for profit with the smallest possible risk.

Friday, May 2, 2008

Viseu Open 001, One Month, Up in Profit !

Many of you may have been following my blog regarding the testing of the Viseu Open 001 expert advisor. As we may have expected from backtesting results, this expert advisor has proven to be profitable for the time being. As I watched the expert trade for the past month, I realized that it trades in a fashion very similar to that of the Shark and Griffin expert advisors. In fact, the experts traded at exactly the same time on a few trades, which means that they have a similar signaling system, although I do consider Shark and Griffin's to be more complex.

I like Viseu's trading style, it has good entries, never has consecutive losses and does accumulate profit in a very sustainable manner. I am now considering a live trading account with this ea's name on it. If I end up a three month trial period with Viseu on the green, I will let it trade live.

I am very happy with this expert advisor, it may prove that we all may share this free alternative as part of our profitable forex portfolios. Just to finish this review I leave you with a picture of Viseu's equity curve for the past month.

New Improved Forex Killer Strategy (long term trading)

Well, as many of you may know, I have developed a new forex killer strategy over the last three weeks with good results. This strategy is much simpler than the older one I had published and focuses mainly on the four major currencies. So we will only be trading EUR/USD, USD/JPY, GBP/USD and USD/CHF. I also recommend forex killer users to take a look at automated trading systems, as they may prove to be more profitable and more hassle free than forex killer.

The strategy uses clever money management to improve our chances of taking profit over trading positions. For this strategy, we will use our forex killer software and the daily data for the major currencies saved from metatrader.

- For this strategy you will trade at the end of each trading day.

- Save the daily data for each one of the major currencies in metatrader 4

- Load the data on forex killer

- Calculate the results for all the currencies

- We want a short and long term signal probability higher than 75%. Yes, Long AND Short term graphs MUST have a probability higher than 75% or we do not enter the trade.

- After you get a positive signal go to your trading platform and open two trades in the direction of your signal. Each trade is opened so that a 200 pip loss is equivalent to 1% of your equity.

- Both trades will have a one hundred pip stoploss, one of the trades will have a one hundred pip take profit while the other will have a 100 pip trailing stop and a 300 pip take profit. This clever management means that after the first take profit hits, the other trade is risk free.

- After the trade is opened, wait until both orders are closed through either one of the market orders.

I have tried this strategy for the past 3 weeks on a demo account with very good results. I have had about 6 positive signals which are equivalent to 12 trades. From all these trades, 9 were profitable and 3 are still opened.

I hope you enjoy this new and easier to use, long term trading strategy for the forex killer software. I also encourage you to get my ebook on automated trading systems if you are new to automated trading systems and would like to find a profitable one !

Forex Autopilot Expert Advisor, Unbiased Review

A few weeks ago, I started to feel curious about this new expert advisor everyone seemed to be talking about. I went to it's cheesy marketing web page filled with marketing tactic ( where they say things like "75% discount, prices will come back to normal in three days!", date which always seems to be the same one after three days) and I took a try for this expert advisor which sells for a mere 89 USD.

At first, let me say the things that attract forex autopilot customers. It is a very cheap expert advisor compared to most of the profitable ones, which usually cost between a 250 one time fee and a 90 dollar monthly subscription. The webpage is also filled with unneeded ways to shove the idea of richness and desire into people's minds, you see champagne, cars, etc.

When it comes to putting their money where their mouth is, they still have a long way to go. I must say, I still don't have enough testing data to ensure whether it is a profitable system or not, what I can tell you is why I would never trade this expert advisor in my live accounts.

First, there is the way this expert trades. It opens roughly two trades per day, which seems normally selective, and trades on the EUR/USD one minute timeframe. It then opens orders based on some indicators and lets them run after they either hit the take profit or some indicator based exit signals. This is where we have a conflict. Indicator based exit signals ? As I have seen in forward testing, this expert advisor is comfortable with a 400 pip draw down, as seen before last week's FOMC meeting. If you put a stoploss on the expert advisor, it fails dramatically.

I am very skeptical about expert advisors which tolerate open draw downs like this, specially this ea. It is reasonable when you have pyramiding expert advisor like Pipforia or Pointbreak that close profits at the end of market cycles, and even these expert advisor have never actually seen an open draw down above 20%. The fact that the autopilot expert advisor doesn't use a stoploss and is quiet conformable with a 400 pip draw down without showing exit signals gives me the creeps.

Well, I have given you the facts I have experienced with this expert advisor. An expert which is tolerable to large open draw downs and that also lacks a consistent money management system. I would have to say, I would never trade it in a live account. Would you ?

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