Allocating Capital Across Strategies with Overlapping Trades
Summary
The document considers how to combine several trading strategies with similar returns and volatility when their trades rarely or sometimes overlap. Equal cash allocations produce a weighted average return, while allocating the full capital to whichever strategies are active could increase capital use when signals do not coincide. The central practical proposal is to share risk capital among active strategies, splitting it equally when their performance estimates are the same.
The discussion also raises whether strategy weights should reflect performance, whether complementary signals should be selected by their hypotheses or by how often they trade together, and whether trading different assets adds value. A response suggests using a Black–Litterman framework to combine return and covariance estimates, with confidence in views informing the uncertainty matrix. These are starting points rather than a demonstrated optimal rule: the document provides no empirical comparison, and it does not account for differing risk, correlations, transaction costs, or constraints on moving capital between simultaneous positions.
Key ideas
- Equal allocations across strategies yield their weighted average return.
- When strategies are not trading simultaneously, allocating capital to active signals may use capital more efficiently.
- One response proposes splitting capital equally among active strategies when their expected performance is equal.
- A Black–Litterman framework is suggested for combining strategy return views and covariance risk.
- The document poses, but does not resolve, how to select complementary strategies or weight them by performance.
Tags
Full text
# How to combine trading signals to achieve higher capital efficiency? # How to combine trading signals to achieve higher capital efficiency? I trade use a completely automated approach where all signals are generated by proprietary trading strategies. However, recently I encountered an challenging problem: Imagine we have 3 Strategies that all make 5% return annually with the same volatility and they rarely trade together. The question is how to make the best use of capital to maximize the portfolio returns. A. The naive approach is to allocate 1/3 of cash to each strategy, and we will end up with $ 1/3 * 5 + 1/3 * 5 + 1/3 * 5 = 5\% $. This is effectively the weighted average approach. It does have the merit of diversification, but the cash is undoubtedly utilized inefficiently. This is in fact the lower bond of portfolio returns. B. Another approach is to try to share the risk capital among the 3 strategies in some efficient way. Ideally, if they never trade together and we are allocating the full capital to each strategy should any signal sets up, then we will end up the upper bond of return, which is $ 5\% * 3 = 15\%$ for the entire portfolio. In reality, 3 strategies tend to have trades that set up together. So, what do you think is the optimal solution for achieving maximum capital utilization? Svisstack has provided a good starting point for discussion. Now, I will refine my questions based on his reply: - How to combine signals efficiently when there are N strategies, shall we keep capital fully invested while weighting each strategy by their performance? - What type of strategies, if combined together, can yield maximum benefits? For example, shall we combine two strategies that are both based on similar hypothesis, similar holding period, or two strategies that rarely traded together regardless of other characteristics? - Is it wise to combine 2 strategies that traded on different assets? ## Answer by Svisstack (score 1) https://quant.stackexchange.com/a/12796 Your problem going into maximize trading capital using 3 strategies. Optimal scenario should use all available capital for 3 strategies, in way that when only 1 strategy trading then using all available capital, when second trying to create trade while first taken all capital, then half of capital can be moved from 1 strategy to cover 2 strategy trades or 2strategy wait for release capital from 1 strategy. When third strategy try to get in then same, should wait for capital release or capital allocation from 1 and 2 strategy should be moved to cover third strategy trades in proper ratio. In your scenario when 3 strategies have same performance estimation, capital should be spitted equally between active (trading) strategies at every moment. ## Answer by experquisite (score -1) https://quant.stackexchange.com/a/12795 Can't you combine them with a Black-Litterman model of their covariant risk/return? http://www.researchgate.net/profile/Petter_Kolm/publication/230329526_Incorporating_Trading_Strategies_in_the_BlackLitterman_Framework/file/3deec519f9ee0c45cd.pdf This should work well enough, though I would recommend also implementing Idzorek's extension for numerically calculating the appropriate omega matrix based on view confidence as a percentile: http://datalab.morningstar.com/knowledgebase/aspx/files/Step_by_Step_Guide_to_the_Black_Litterman_Model.pdf I have also been meaning to get around to reading Meucci's book, which apparently covers this sort of thing: http://www.amazon.com/Asset-Allocation-Springer-Finance-Textbooks/dp/3642009646
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