Smart Trader

Q: 1. What is the best way to investigate what the correlation between two trading systems is? By comparing both equity lines? Or by comparing the day by day trading results of both systems? Or by comparing the algorithms? Or maybe something else?

2. What do you think is the best way to investigate what the correlation between two instruments is (for example DJIA and SP500)? The historical quotes? Or by comparing the day by day price changes? Or maybe something else?

3. And finally, what do you think is the best choice: Diversification by using ONE trading system for TWO uncorrelated markets or using TWO uncorrelated trading systems for ONE market?

A: All your questions are based upon some assumption of what best means? And I have no idea what it means to you… only to me. The following comments should indicate why.

When I suggest that people use non-correlated trading systems, it really means that there is very little relationship between the concepts behind it. Thus, a trend following systems that looks for a well established pattern before it entered, should have very little correlation with a bottom picking trading system that looks for extreme down moves and then attempts to catch sharp 1-3 day reversals.

Now both of those systems could make money every week and would appear correlated, but I would say that they are not because the concept you are trading is so different. That’s really my definition of non-correlated systems and my criterion. But it might be quite different from yours. As far as equity curves are concerned, I’d like all my systems to be highly correlated in that they ALL have a LARGE PROFIT every month.

Why would you want to measure the correlation between the S*P 500 and the DOW. The S*P 500 contains generally contains the DOW, does it not?

Again, for question 3, I have no idea what you mean by best. What are you trying to accomplish through diversification? That might define what’s best. And why would you want to diversify when some of the best investors (like Buffett) say that diversification is a substitute for ignorance.

Q: I am half way through the fifth volume of the Peak Performance Course.

My question is about tampering with a trading system. The course content seems to suggest that the top traders follow their trading system verbatim and through superior money management and risk control, they are able to achieve consistent profits. But, my trading system supplier is telling me to use discretion when using their trading system. For example, to stand aside during the FOMC meeting week, to avoid trading during large range days. To me, this sounds like tampering with the trading system, which a top trader would never do.

But I am thinking, maybe tampering is acceptable if you use additional filters ONLY TO OVERRIDE trade signals and NEVER TO GENERATE them. That is, only accept signals that are generated by the trading system, but override them if the additional filters suggest that you do so.

How does that sound?

A: No trading system works in all market types and most are discretionary. You should know what the market type is (see the latest update in Tharp’s Thoughts) and how your system performs under those condition. And not trade it if the conditions are poor.

I usually recommend in the Peak Performance Course, for example, that you not be discretionary until you know what you are doing.

Q: The formula for the 'Average Directional Movement Index' (ADX) on page 268 (second edition of Trade Your Way), is this correct? I have been unable to reconcile my own calculations with those found at various financial websites. The majority of ADX calculations I have found involve exponential moving averages but 'Trade your way...' states that only a simple moving average is required?

A: The simple moving average is fine. If you want to go to the source on ADX, go to Wells Wilder's book, New Concepts in Technical Trading. Actually when you think of it, if you really want the average true range (meaning a measurement of volatility over say the last 14 days), why would you do an exponential moving average? That would not give you an accurate measurement of what's happening in terms of volatility.