In developing scientific theories it is all about framing the narrative of the hypothesis correctly.
To Aggressively Compound or to not Aggressively Compound? That is the Question….. A Tongue Twister from a Womble
So you have a nice backtest result that you feel demonstrates an edge….so it is onto the next question. How do I leverage this edge. Do I aggressively compound or not?
Now the central fact that you need to keep in your head with this decision is that compounding accentuates volatility inherent in the return streams. Too much compounding introduces speed wobbles into your system where you are trying to extract too much from the limited alpha the system generates.
There is always the inevitable debate between those who think backtesting is a waste of time and those who treat the process like gold. This argument typically splits us into our two major trading philosophies we have discussed before…….. that of prediction, where the emphasis is placed on recent market conditions (hence backtesting long data sets is meaningless) and that of price following (where future conditions are unpredictable and we like to test our systems over a broad set of market conditions in the past to see how well our systems manage risk).
When attempting to navigate market uncertainty and noise wouldn’t it be great to apply the scientific method to find those elusive signals in the noise? What’s that you say….”this trading is an art requiring the skill of the human participant rather than a conventional science”…..well perhaps this is the choice in the philosophical approach you use to tackle them.
One of the major reasons why diversification is so important is that when hunting for outliers, the wider you diversify across markets, timeframes and systems….the better chance you have of catching more outliers. The non-linear impact of outliers to your overall performance metrics is what makes the alpha in this style of trading.
Readers of this Blog would be quite aware now of the underlying philosophy of the systematic divergent trader. They would be aware of the concern placed by divergent traders in using statistical techniques as a measure of predictive certainty; They would be aware of many possible future paths called risk and not attracted to the…