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Correlation Portfolio Diversification

A Macro-Economic Study of Correlation between Tradeable Assets

It can be challenging to visualise the correlation between assets when you have a whole portfolio full of them. You can create a heatmap that shows all the assets in your portfolio and the correlation between them.

And in true Darwinex fashion, we’ve created a heatmap for 40 of the Darwinex platform assets. This heatmap gives us a high-level view of the correlation between this universe of tradeable assets at Darwinex.

It might look like some random NFT, but what this heatmap does is display the correlation between every asset in an easy to see manner. Using a heatmap in this way can help speed up asset selection when deciding on what to put in your portfolio.

Correlation is the enemy of Diversification.

It gives you a clear view of what combinations of assets are likely to provide good diversification benefit and which ones are likely to not. This extra clarity is essential because trading correlated assets can increase the risk on the portfolio.

What is Delta?

Delta is a mathematical term that simply means a change in value. In a previous post, we showed you how to calculate (r) and (R²), but we highlighted a flaw in this approach and showed you how to calculate (R²) using the Delta (the price change) instead, which is a much more robust way to calculate the correlation.

Using the heatmap, we can see the correlation between an FX major like GBPUSD and the FTSE index. Looking at the heatmap, we can quickly see that these have a correlation of 0.00036. This correlation would indicate that trading these two assets at the same time could provide us with diversification benefit.

Take a look at Martyn’s heap map. If you had to pick 2 FX pairs, a stock index and a commodity, what would you choose and why?

As always, answers on a postcard @darwinexchange

This post covers the correlation between assets. But there are three other techniques we’ve used previously. In the next episode, we take a look at the correlation between timeframes.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer


Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Benefits of Portfolio Diversification

How to Measure Correlation Between Assets

In the previous episode, we showed you two ways to measure correlation. These were; coefficient of correlation (r) and coefficient of determination (R²). These are two widely used techniques for measuring correlation.

However, they do have their limitations.

When the quote currency in two fx pairs is the same, there will always be a correlation. However, due to the fundamental differences in base currency, they will also display uncorrelated behaviours.

This gives us an incorrect view whereby the (R²) number indicated a high level of correlation but the outlying data points highlighted the uncorrelated nature too. Talk about confusing.

A small change can have a big effect.

Today we’re going to make a subtle change that can provide a more robust view of the correlation between assets.

Instead of using price, we’re going to use the price difference. As an example, if we subtract an assets close price from the previous days’ close price, we can see the price change. It is this change in price that we will use for our new calculation.

Already you should be able to see the benefit of using this way. It allows us to compare price movements between the two assets.

We’ve given you a few examples of how correlation differs between assets and a few examples of different ways to measure correlation.

You can take this one step further by creating a correlation matrix in Excel for an indefinite number of assets.

Try doing the above to measure correlation between all the assets you have in your portfolio and see how diversified your asset selection is.

Darwinex helps you measure correlation of Darwins.

Darwinex has already done the hard work for you on the Darwinex platform by calculating the correlation between Darwins.

Remember a Darwin is an asset that tracks the performance of a traders underlying trading account, in real-time. Darwinex then manages the risk of the Darwin independently from the trader to target a max VaR (95%) of 6.5%.

To view the correlation between Darwins go to the correlation tab. It will show the correlation between the asset you have selected and a range of other Darwins. To check a particular darwin enter its ticker into the search box under the table to see the correlation between them.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer


Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Benefits of Portfolio Diversification

Measuring Correlation to inform your Portfolio Diversification Strategy

Measuring correlation is as important as portfolio diversification itself. We can’t diversify our portfolio without first measuring correlation between the assets and strategies in our portfolio.

In fact, not measuring correlation will potentially lead to the risk we are exposed to increasing. By having exposure in two correlated positions, we are effectively doubling our exposure to this risk.

So how do we measure correlation?

The method for measuring correlation will differ depending on what technique we are using to diversify our portfolio. Remember the four techniques we covered previously in this series. These were:

  • Across asset classes
  • Within the same asset class
  • Across different timeframes
  • Across trading strategies

Throughout this mini-series, we’re going to look at different methods of measuring correlation.

To kick things off; we are going to start with the Coefficient of correlation (r) or Pearson’s r, as it’s also known. Karl Pearson developed the idea. He also founded the world’s first university statistics department at the University College, London.

Pearson’s r measures the strength of a linear relationship between two variables. It does this by creating a line of best fit between variables and measures the distance of each variable to the line of best fit.

This results in a range of results between -1 and +1. -1 would be a negative correlation, 0 would be no correlation and you guessed it +1 would be a positive correlation.

What do we mean by positive and negative correlation?

An example of a positive correlation would be two separate trades in the same direction, on the same asset. When the asset price rises; both the trades will gain, due to the positive correlation between the two trades.

A negative correlation would be simply the opposite. Two separate trades in different directions on the same asset. When the asset price rises one trade will gain whilst the other loses and vice versa if the asset price falls.

Positive and negative correlation can both negatively affect our portfolio.

So why measure them individually?

We don’t have to. There is another way to measure correlation. The coefficient of determination (R²).

This takes Pearson’s r and squares it. Doing so removes the negative part of the range leaving a range of 0 to 1. 0 would equal uncorrelated and 1 would equal either positively or negatively correlated. As both positive and negative correlation will negatively impact the portfolio this way would seem to make sense.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer


Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Balance Risk Diversified Portfolio

How to Balance Risk across your Diversified Portfolio

Why do we want a Diversified Portfolio when it reduces our absolute returns?

If we think back to our previous video, remember that we’re trying to increase our risk-reward ratio, not absolute returns. We want to balance the risk of our portfolio.

We believe that risking 1 to get 1 is better than risking 10 to get 5.

Now, this objective is clear, let’s take a look at how we’re going to balance risk across our diversified portfolio.

Last time we covered 4 techniques to implement portfolio diversification into our portfolio.

These were across:

  • Asset Classes
  • Uncorrelated assets within an Asset Class
  • Timeframes
  • Trading Strategies

But how do we assign capital or risk to each of these?

We’ve identified 4 ways to balance risk across a diversified portfolio and we’ll go over each of these now. 

  1. Fixed position size per trade. This is by far the easiest to implement but by no means an effective way of weighting your portfolio strategies. This method affects our risk by: 
    • The size of the stop-loss.
    • The volatility of the underlying asset
    • It will change based on the account equity
  2. Equivalent position size per trade. This is similar to the 1st way, albeit a little more dynamic. All the above will apply with the added consequence of varied position sizes depending on open positions. 
  3. Equivalent risk per trade. Probably the most well-known and widely used. Here we balance the risk for each trade. We adjust the position size factoring in the stop loss size. This means that each trade will have the same risk expressed as a percentage of account equity, one thing this approach doesn’t take into account is the correlation of each position. So 2 positions in correlated assets will effectively increase the risk to the portfolio.
  4. Reward/risk ratio portfolio optimization. This takes into account the following 3 factors: 
    • The relative correlation between each diversification technique.
    • Alpha of each portfolio component.
    • The volatility of each underlying component.

This way is the most complicated but as you can see, provides us with the most comprehensive approach to a Diversified Portfolio. As it’s the most complicated we’re only able to scratch the surface in this post and will need to cover this in more depth in future episodes. 

As always Darwinex has you covered when providing you tools and metrics to help keep track of the inner workings of your portfolio.

We’re going to look at 2 Investible Attributes that can provide valuable insight into the risk exposure of your portfolio.

The first is the Risk Stability (Rs) investible attribute.

This measures the consistency of the risk. A nice flat line means the risk is fairly predictable over time and can be considered a positive.

Large peaks and troughs mean the behaviour of the trading strategy may be unstable and can lead to unpredictable levels of risk. 

Next up is the Risk Adjustment (Ra) investible attribute.

The Darwinex platform is unique in that, Darwinex manages the risk of investments in DARWIN assets independently of providers, ensuring that they carry a monthly maximum target VaR (95%) of 6.5%.

This shows up on the Ra investible attribute as outliers on the chart and is coloured differently. 

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer


Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

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What does Enough Portfolio Diversification look like?

How much is enough portfolio diversification? Reminds me of a song.

Cue Michael Jackson music. Don’t stop ’til you get enough. Was Michael talking about portfolio diversification when he wrote that song? As much as I’d love it to be true, I don’t think it can be.

So, what might a diversified portfolio look like?

Can we have too much portfolio diversification?

What does enough portfolio diversification really look like?

So many questions. Let’s break it down into each technique we’ve looked at so far.

Diversification across asset classes

We could look to trade Forex and stocks. By trading these two different asset classes we would expect that if there were a stock market decline it wouldn’t also lead to a decline in the FX market. We could take it a step further and trade commodities as well.

Diversification within the same asset class.

We could then break down each asset class and look to trade more than one asset within each asset class. Maybe a USD denominated FX pair and a JPY cross. We could trade stocks from different sectors or industries. Then we could trade a metal like copper and a soft commodity like coffee.

Remember though, due to the random nature of price action even two uncorrelated assets will exhibit similar behaviour some of the time. This means the max diversification benefit can only be achieved a maximum of 50% of the time when diversifying across 2 assets. This does increase with the more assets you trade.

Remember these assets need to be uncorrelated.

It’s also important at this point to look at how much the volume of trades has increased. In the above example, we have 2 FX trades, 2 stock trades and 2 commodity trades. Each of those will eat into our available margin.

Diversification across timeframes.

If one of the FX trades, trades the daily timeframe we could look to run a strategy on the 15min as well. Or we could trade one of the stocks, maybe a value stock, long-term and look to hold for a period of months. Then trade a tech stock short term, perhaps some form of intraday strategy.

Diversification across trading strategies.

We’ve already partially covered this in the above example. There may have been some overlap in using the same strategy in different asset classes.

But we could also look to harness different alphas within the same asset class. This could take the form of a momentum strategy and a mean reversion strategy within the same asset class.

The above is just a hypothetical to illustrate just how flexible diversification can be and the potential power it holds. But with great power comes great responsibility. Just because we have these tools at our disposal doesn’t mean we need to use them all.

It’s going to take a vast amount of time to backtest and implement the above. It’s also going to take a sizeable chunk of capital compared to just running two or three strategies. You’ll need to decide which applications are best suited to your portfolio.

To sum up

You can’t have too much diversification from a portfolio point of view. You can however have too little time and money to implement them all successfully. We need enough portfolio diversification that we get the benefit but not so much that it requires too much effort. To reiterate.

You’ll need to decide what’s best for you.

You need to find a balance between effort and value. Only you will know what that is as we all have different circumstances.

What’s your preferred method of diversification?

Tag us on Twitter (@Darwinexchange) with your thoughts.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer


Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

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Portfolio Diversification | Using Multiple Trading Strategies to Diversify your Portfolio

In the last few videos, we’ve covered a range of ways to help diversify your portfolio.

Namely

  • Diversification between asset classes
  • Diversification within the same asset class
  • Diversification across timeframes

Today we want to look at Diversification across trading strategies.

But first, let’s take a step back and think about why we want diversification in our portfolio? As traders, we need to decide how best to get to the desired outcome.

We want to maximise our returns, but also minimise our risk. If we take zero risk, it’s fair to assume we can expect zero return. We need to decide what we’re willing to risk to get the returns we want.

By using some of the techniques above we can look to fine-tune our strategy to do just that. You may have noticed in the examples in the videos, that the returns of some of the individual strategies before diversification are higher than the diversified return.

We’re not looking to chase absolute returns. That’s not the point here. In all the examples the risk-return ratio has been higher on the diversified portfolio. We’re sacrificing a little return, for less risk.

I like to think of an old gambling saying I used to hear ‘you need to bet to win money, but you need money to bet.’ If you lose 50%, you must gain 100% to break even. By fine-tuning the risk-return ratio you are better equipped to speed up recovery in the event of a large drawdown.

As traders, we must decide if the trade-off, of lower returns but a higher risk-return ratio is more appealing to us than absolute returns.

Do you think that diversification is a good idea?

 

Can you diversify your portfolio too much?

Two things can mitigate some of our diversification strategies. Black Swan events and market randomness. That’s why it’s so important to diversify your portfolio properly, to fill in the gaps and reduce the effect of these.

The Darwinex platform has a tonne of trading metrics that both the trader and the investor can benefit from. Even just the description from the trader can provide some good information about the strategy.

You can even import your trading history from another broker and then use our trading metrics to analyse your strategy and compare it to some of our Darwin’s.

If you aren’t yet familiar with DARWIN assets, think of them like ETFs or Mid-Cap Stocks.

Just like an ETF could track the performance of the S&P500, a DARWIN is a financial asset that tracks the performance of a trader’s underlying trading strategy, in real-time.

Darwinex manages the risk of investments in DARWIN assets independently of providers, ensuring that they carry a monthly maximum target VaR (95%) of 6.5%.

Our FCA Regulated Asset Manager charges performance fees on investor profits (20%) on a high-water mark basis, paying 75% of them to Providers.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer


Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.