Motion to Dismiss System Development?

I now have the subjective function from http://www.optionfanatic.com/2012/10/12/the-subjective-function-part-6/.  Before I move on and apply this to the SPY VIX trading system, I want to briefly discuss one other point that threatens to derail system development.

In my last post (see above), I mentioned the following with regard to high-profit, infrequently-trading (i.e. “surgical”) systems:

> Ideally, I would like to take advantage of the time one such system is not in the market
> by trading with another surgical system that is in the market. I am therefore in the
> market more frequently with systems that deliver concentrated profits.

When trading with surgical systems, the only way to achieve a reasonable percent return on the entire portfolio in a risk-controlled manner is to combine them.

Statistically speaking, this is the employment of non-correlated systems (i.e. low R-squared values).  With two non-correlated systems, one system may be making money while the other is flat (i.e. out of the market) or one system may be losing money while the other is making a bit more.  The catch is that R-squared is calculated based on historical data.  During explosive market conditions, one system may make money when the other system suddenly loses much more.  Even worse, both systems may become correlated and lose money together.

While these are threatening possibilities, without more details I can’t say it’s reason to dismiss system development altogether.  You could look at a long historical backtesting period to determine how often these conditions occur.  When they occur may be generalizable to a particular type of market condition.  You could explore the possibility of including a failsafe filter–for example, suspending trade of a mean-reverting system in case of powerful breakout or breakdown.  Whether the markets traded by these systems are the same or different could also affect the severity of this threat.

I will continue analysis of the SPY VIX trading system in my next post.