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I have been testing a trend following strategy. The results shows massive drawdowns which makes the equity curve very unstable. I just wanted to know what are some ways in which I can reduce the volatility (increase smoothness) of the equity curve? Better exits? Better entries?

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  • $\begingroup$ Is this a stat arb strategy? If so, consider using a portfolio optimizer that balances your positions according to a risk model. You can buy models and optimizers from a number of vendors. $\endgroup$ – chrisaycock Feb 13 '11 at 11:25
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Another possibility is to analyze the equity curve itself so as to go live with the system when good performance is expected and to either reduce risk or just paper trade when performance is expected to be negative. Are a series of positive returns followed by negative returns (i.e. is there mean reversion)? Does a trend-following "meta-system" and/or a trailing stop loss (on the total account equity) reduce risk or at least make it more tolerable? A couple other ideas might be to try supervised learning for the drawdown periods or incorporate concepts from control charts.

There is some danger that you might just end up multiplying your model risk by overlaying a meta-strategy on your original system. Statistically significant changes may be very hard to come by and in the end you might just have to trade smaller size. Good luck.

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Be careful when you optimize the exit parameters (and any other parameter) as you could get better results in backtest that will only be due to over fitting. IF you haven't done that yetn use In and Out sample to verify your improvements. After that you can try to build entry filters. In my experience trend following usually have bigger drawdowns than mean reverting.

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