After establishing our client’s risk profile, we face an important issue, namely: How to set a reliable and meaningful objective for the investment and how to draw out a strategy that can achieve those objectives.

How to set a reliable and meaningful objective for the investment and how to draw out a strategy that can achieve those objectives.

Not totally surprising, we are often not able to come up with some fast and simple answers that we can simply execute over time.

Drawing on my long experience, I have developed some thoughts on this:

We are trying to project what would be the most likely scenario of the future outcome resulting from the trading of our models.

The variables are numerous:

1-            Return or profit.

2-            Drawdown or loss

3-            Time frame

4-            Observation points e.g. Daily, weekly, monthly, yearly.

5-            Volatility.

6-            Predictability or conformity with historical model performance.

7-            Validity of any future projection.

We have many parameters to deal with here. As one would expect, we will not be able to put rigid expectations on all them. As an example, if we have a profit target to meet then we need to leave drawdowns and volatility somewhat undefined (or loosely defined). This may be required during the investment process as we may need to assume higher risks in order to meet the agreed upon target.

On the other hand, if we put limits on the drawdowns then we may not be able to achieve the profit targets.

A good strategy in our opinion is to aim at the risk level that we can tolerate, rather than a simple profit target. In essence, we opt for a certain market exposure at the lowest cost possible.

Therefore we need to come up with what we believe is an optimal risk profile to aim for. Furthermore, any objectives that we agree upon should be reviewed every 3 or 6 months to adjust and adapt to market’s most recent behavior.

 

Executing the investment plan

Two elements affect our patience to stick with an investment

  • Drawdown amount %
  • Time spent in negative performance or around breakeven.

Automated trading strategies will go through drawdowns that may exceed historical performance.

By definition, a trend following strategic model has to be positioned in the market at almost all times in order to benefit from market moves. We try to do this at the least cost possible.

Thus short term steady profits month after month may happen but are not the objective. Typically profits occur in very short periods in any given year.

Therefore, we believe that the ideal investment objective to aim for should focus on risk exposure. This implies that we maintain a level of market exposure in a diversified portfolio of forex, commodities and financial futures at the lowest cost possible. We expect such strategies to achieve profits whenever the markets move decisively in a given direction. The expected profit will depend on the level of risk exposure that was taken in the first place.

Such positioning in the market will serve two objectives: return generation and hedging against major events.