By Sergei Belov, Ernest Chan, Nahid Jetha, and Akshay Nautiyal ABSTRACT We applied Corrective AI (Chan, 2022) to a trading model that takes advantage of the intraday seasonality of forex returns. Breedon and Ranaldo (2012) observed that foreign currencies depreciate vs. the US dollar during their local working hours and appreciate during the local working hours of the US dollar. We first backtested the results of Breedon and Ranaldo on recent EURUSD data from September 2021 to January 2023 and then applied Corrective AI to this trading strategy to achieve a significant increase in performance. Breedon and Ranaldo (2012) described a trading strategy that shorted EURUSD during European working hours (3 AM ET to 9 AM ET, where ET denotes the local time in New York, accounting for daylight savings) and bought EURUSD during US working hours (11 AM ET to 3 PM ET). The rationale is that large-scale institutional buying of the US dollar takes place during European working hours to pa
As many of you know, I am a fan of Kelly formula because it allows us to maximize long-term growth of equity while minimizing the probability of ruin. However, what Kelly formula wont' prevent is a deep drawdown, though we are assured that the drawdown won't be as much as 100%! This is unsatisfactory to many traders and especially fund managers, since a deep drawdown is psychologically painful and may cause you to panic and shut down a strategy prematurely.
There is an easy way, though, that you can use Kelly formula to limit your drawdown to be much less than 100%. Suppose the optimal Kelly leverage of your strategy is determined to be K. And suppose you only allow a maximum drawdown (measured from the high watermark, as usual) to be D%. Then you can simply set aside D% of your initial total account equity for trading, and apply a leverage of K to this sub-account to determine your portfolio market value. The other 1-D% of the account will be sitting in cash. You can then be assured that you won't lose all of the equity of this sub-account, or equivalently, you won't suffer a drawdown of more than D% in your total account. If your trading strategy is profitable and the total account equity reaches a new high watermark, then you can reset your sub-account equity so that it is again D% of the total equity, moving some cash back to the "cash" account. Otherwise, you continue to keep the equity in the cash account separate from the equity of the trading sub-account.
Notice that because of this separation of accounts, this scheme is not equivalent to just using a leverage of L=K*D% on your total account equity. Indeed, some of you may be too nervous to use the full K as leverage, and prefer to use a leverage L smaller than K. (In fact, the common wisdom is that, due to estimation errors, it is never advisable to set L to be more than K/2, i.e. half-Kelly.) The problem with using a L that is too small is that, besides not achieving maximum growth, the portfolio market value will be unresponsive to gains or losses and will remain relatively constant. Using the scheme I suggested above will cure this problem as well, because you can apply a higher leverage L_sub to the sub-account (e.g. use L_sub = L/D%) as long as L_sub < K, so that the portfolio market value is much more sensitive to your P&L while still ensuring the drawdown will not exceed D%.
Has anyone tried this scheme in their actual trading? If so, I would be interested in hearing your experience and see if practice is as good as theory.
There is an easy way, though, that you can use Kelly formula to limit your drawdown to be much less than 100%. Suppose the optimal Kelly leverage of your strategy is determined to be K. And suppose you only allow a maximum drawdown (measured from the high watermark, as usual) to be D%. Then you can simply set aside D% of your initial total account equity for trading, and apply a leverage of K to this sub-account to determine your portfolio market value. The other 1-D% of the account will be sitting in cash. You can then be assured that you won't lose all of the equity of this sub-account, or equivalently, you won't suffer a drawdown of more than D% in your total account. If your trading strategy is profitable and the total account equity reaches a new high watermark, then you can reset your sub-account equity so that it is again D% of the total equity, moving some cash back to the "cash" account. Otherwise, you continue to keep the equity in the cash account separate from the equity of the trading sub-account.
Notice that because of this separation of accounts, this scheme is not equivalent to just using a leverage of L=K*D% on your total account equity. Indeed, some of you may be too nervous to use the full K as leverage, and prefer to use a leverage L smaller than K. (In fact, the common wisdom is that, due to estimation errors, it is never advisable to set L to be more than K/2, i.e. half-Kelly.) The problem with using a L that is too small is that, besides not achieving maximum growth, the portfolio market value will be unresponsive to gains or losses and will remain relatively constant. Using the scheme I suggested above will cure this problem as well, because you can apply a higher leverage L_sub to the sub-account (e.g. use L_sub = L/D%) as long as L_sub < K, so that the portfolio market value is much more sensitive to your P&L while still ensuring the drawdown will not exceed D%.
Has anyone tried this scheme in their actual trading? If so, I would be interested in hearing your experience and see if practice is as good as theory.
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