Systematic Trading research and development, with a flavour of Trend Following
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Futures Trading and Small Account

July 12th, 2011 · 17 Comments · Futures, Money Management, Strategies

I recently spent more time doing “reading research” rather than “testing research”. As result, this post resembles a collection of links on ideas seen on the web of how to trade futures with a small account – one of the topics I have been interested in.

The Issue: Diversification with Small Account

A small account size – or starting equity – can make it difficult to achieve diversification (a “free lunch” with a high “cover charge” as described in this post – you can read more on diversification and correlation from this blog here and here).

Diversification can be achieved by trading a large number of components in a portfolio, whether “components” represent:

  • Instruments
  • Systems
  • Timeframes

Instruments Diversification

“Instruments” is usually the first aspect that comes to mind when thinking about diversification.
Including more assets/markets/instruments in a portfolio is often described as the “free lunch” – and this is one of the main reasons why large CTAs often include upwards of 100 markets in their portfolio selection.

A small account most likely cannot trade a portfolio of 100+ instrument. This is an issue that Dean Hoffman tries to address in this article: The Conundrum of Small Managed Futures Accounts.

Noting that most diversified trend follower CTAs have a minimum account size of at least $1M, Hoffman describes the advantages of trading larger accounts (able to trade many instruments including those with high margin requirements, more granular position sizing with contract scaling).

Hoffman then describes Dynamic Portfolio Selection as a potential solution for small accounts to achieve increased results from a “virtual high diversification”. The system monitors a large set of instruments but instead of taking all signals (as a diversified trend follower would most likely do), it evaluates and ranks each instrument relatively (based on each market’s potential on a risk-adjusted basis), resulting in about 90% of trading signals being filtered out. This naturally cuts down the number of positions held at the same time, and consequently the required account size.

As this is mostly a “marketing” article for Hoffman’s CTA offering (implementing this concept), there is not much more information on what sort of filtering is applied to select the “best” signals but the general idea is worth investigating (and you can check for yourself whether their performance seems to hold up against the theory).

The subject of dynamic portfolio selection has also been covered in the inevitable Trading Blox forums in this “Dynamic Portfolio Selection” post started by Dean Hoffman himself.

A couple of posts on this blog also describe potential filtering ideas based on relative market volatility and higher-level trend direction.

This idea of filtering trades is not new: the Turtles used to use the concept decades ago, as mentioned by TB forum user sluggo in this post (which contains a link to Trading Blox code implementing similar “heat limitation” mechanism).

Systems (and Timeframes) Diversification: Swarm Behaviour

Combining several systems is also a possibility to achieve diversification. With the extra advantage that it is possible – to some extent – to design systems and control their correlations to the rest of the suite of systems (as opposed to markets, which can have a furious tendency to correlate to +1 or -1 during crisis times).

And as we all know, correlation is a key element of the “diversification benefits” equation (check this thread from user sluggo on TB forums for a good presentation/discussion on the topic).

Adding a profitable mean reversion/counter-trend system to a trend following system will, in all likelihood, reduce the volatility of the combined portfolio, thanks to the negative correlation that it brings. Adding many uncorrelated systems is likely to increase this positive effect.

However, trading a diversified suite of systems has a similar constraint to trading a large portfolio: it increases the required account equity.

A comment from Pumpernickel on a recent post from Quantum Financier (who is starting a series of posts on “signal aggregation: how we form and use an ensemble of signals isolating different pieces of information to build a profitable strategy” ) pointed to a couple of documents from Fall River Capital.

The (pdf) document (part 1 and part 2 of their white paper) describe how they tackle this issue on a large scale, by trading hundreds to thousands systems simultaneously, using the concept of swarm behaviour (which can be seen throughout the natural world, such as in the mesmerising starling flights in the English Somerset Winter, pictured above).

From the white paper (other Fall River white papers and general website are also interesting to read):

An […] approach is to assign each trading system a vote. Each model is polled for its position (long, short, or out) daily, and the total is aggregated into a tally that may be thought of as a “Vox Populi,” or crowd opinion poll. Research showed that aggregating the systems by this simple tally method was a quite workable approach, allowing us to “cheat” by holding a single position per market rather than hundreds or thousands. Regardless of the number of component models, the master strategy holds a position in accordance with the majority of the crowd.

How they choose the models/systems to be included in the portfolio is mostly driven by each system’s correlation to other systems:

The portfolio of individual candidate systems consists of between several hundred and a few thou‐ sand members that share both low correlations to one another and robust returns over many years of market history. The result is a “swarm” of trading models, each attacking the market from a different direction. This process of system development, evaluation, and selection does not prioritize superior standalone system performance, but rather seeks to uncover profitable trading rules that complement one another when implemented together.

Their testing results seem to show that this approach tracks fairly well an “equal allocation” approach with hundreds/thousands of systems, which itself benefits greatly from low correlated system diversification (reduced volatility, or increased vol-adjusted returns).

This “systems voting” strategy has also been discussed on the TB forums there (again started by user sluggo…).

Other Alternatives

These are ideas to stimulate research on how to alleviate the “futures trading diversification with a small account” issue. Other ideas can also be found on other threads from the TB forum (examples 1, 2 and 3 – search the forum for more discussions), showing that the topic is a “popular” one.

Another alternative would be to move away from trading actual futures but instead focus on “proxy” instruments such as ETFs (see this post for a quantification of how ETFs can track futures) or spread betting (they usually offer lower minimum trading lots, allowing for lower required trading equity, but can have other disadvantages, such as counterparty risk, less instruments available or cost of funding/leverage). Another trade-off to make in system/strategy design..

Picture credits: midlander1231 via flickr (CC)


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17 Comments so far ↓

  • Nick Radge

    Another alternative, although not available to US citizens, is trading CFD contracts that mimic the futures. These are usually available in 50% tick sizes of the underlying futures, although one or two brokers provide ‘user defined’ tick sizes with a minimum of $1.

  • Jez Liberty

    Thanks for the suggestion Nick – One of the spread betting firms I have been looking at actually offers CFDs as well (and it seems to be much more interesting from a funding point of view) which is why I did not make the distinction…

  • RiskCog

    I have always assumed that Medallion uses an approach of thousands of systems voting on positions to take in the smaller number of trade-able markets. Hard to prove of course.

    There is one other way to diversify and that is by time-slicing; as in trading a different system every day or every week. For example if your trend following system really likes a short Yen trade, and your short-term reversion system likes the S&P contracts then you could just switch back and forth systematically and not have to hold both at once.

    Don’t know if you agree but I think it is completely ridiculous when folks seem to accept that trading the same system in 100 instruments is more diversified than trading that system in 99 instruments. The extra “diversity” is probably not much more than trading that system in just a handful of markets.

  • Jez Liberty

    @RiskCog: interesting theory on Medallion.

    With regards to your “switching” suggestion, I would be wary about trade frictions if switching between strategies every day for example.

    For your last comment – you could take a look at the chart I built on that TB forum thread I referenced in the post (link: ).
    It shows how the positive effects of diversification diminishes with the number of instruments (but is also function of the correlation between instruments), so indeed going from 99 to 100 instruments would only give a small “diversity” gain.

  • Mirec

    Nice article. It is comming the right time. I started to trade my own strategy on small futures accout just few weeks ago. I am planning to publish my portfolio, results and also all the trades on my website. I would just like to hear if it would be interesting to people and if it would add something to the trendfollowing community?

    Thanks. M.

  • Fred

    You may want to consider I am a trend trader and publish trades for my system on that site. By having your trades published on a third party site you establish credibility. The problem with publishing trades on your own site is that your viewers don’t know if you are showing the good trades only.

    If you ever want to demonstrate the effectiveness of your trading strategy to a hedge fund in the future, you will need five years of trading history. Sites such as Collective2 provide this type of performance history.

    Just a thought.

  • Fred

    Oops. That previous post is from Fred not Mirec.

  • Doug A. G.

    I started trading futures for a thousand capital as starting and got wiped out and added a thousand more and I’m on the way to recovery. I am focusing on the process right now as compared before when I am trading equities where it requires big amount of capital (to diversify). I am just an ordinary undercapitalized individual wannabe’ trader trying to conquer the world of the highly educated elite/capitalized/wealthy investors/traders. But I am here taking that challenge. As a “poor” individual trader, I am doing my best to be a good trader, my main contention is this, “I don’t have (money) capital right now but I am building my capital in the process of trading that will take years (maybe), and when I have a capital, I already have the knowledge in trading (by then). I don’t have the capitat yet, but I have the idea, which I think is better than have a capital and have no idea. As they say…broke is just temporary, but (being) poor is eternal…

  • Jez Liberty

    corrected it Fred…

  • Fred

    As Jez notes, the problem with insufficient capital is a lack of diversification. I trade between 30 and 40 ETF’s and, as is common knowledge, it is easy to see the equity curve become smoother as more instruments are added. Most investors believe they can tolerate drawdowns as long as the CAGR remains sufficiently high. However, many investors experience anxiety with a drawdown over 10% for example. From my experience, a smoother equity curve brings the benefit of less anxiety.

  • Mirec

    Fred how can i find your results on this site?

    I decidef to trade futures instead of ETFs myself. Starting portfolio of 10 futures.


  • Nick Radge

    @Doug – a $1000 is a losing prop0sition regardless of how good your system or strategy is. The cost of commission alone will keep you from moving forward. You’d be better off papertrading using some kind of simulator and saving extra capital. Less than $10,000 is a losing prooposition unless you get ‘lucky’.

  • Mirec

    Fred thanks, is etf2x your homepage? I would like to conract you privat. M.

  • Fred

    Yes is my site.

  • Nick Radge

    @Fred – what does your historical testing show as your max drawdown?

  • Fred

    A number of the ETF’s that I use are relatively new so backtesting results are of somewhat limited significance.

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