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I’m sitting in the RV park in Flagstaff. We drove today from Sedona, or just South of Sedona, up to Flagstaff and it was really interesting because Sedona is red desert, pretty barren, and very, very dry and hot. And we’d actually didn’t drive that far, it’s only maybe 100, 200 hundred miles, I don’t know, something like that, but we came up in elevation a few thousand feet, whatever that converts to in meters. I can’t do the math right now. And this environment is totally different. Check it out. We’re sitting in the RV park in the middle of the woods, it looks like, and we’re just five minutes from downtown Flagstaff. Downtown is pretty small, small town but really awesome, amazing place, beautiful scenery, and tomorrow, we are going to go see something amazing and I can’t wait to do my video tomorrow on location for you guys because what we’re going to see is something which was really catastrophic for the environment and I’m going to show you that. I’ll talk to you about that tomorrow.
But today, I had an interesting observation about some of my trading systems I wanted to share and there’s a learning in it, which I think is important. What I’m noticing is that several of my systems, at the moment, don’t have a very high level of exposure. I’ve got a lot of cash on right now … A lot of cash on, that doesn’t really make sense. I have a lot of cash and I don’t have very many positions on and I was reflecting on the nature of my systems and my trading rules and what was causing that and one of the things that I’ve done with my systems is designed my systems to be very picky about the conditions in which they would take a trade. And I did it intentionally because I don’t want to just take any … I want to only take the very best risk reward trades and so I’ve designed my systems to be quite restrictive. They have a very high expectancy, a great equity curve, but they don’t trade that often.
And so, they may not make it as higher return as a system that trades all of the time but the drawdown is dramatically lower and so I wanted to talk about this idea of return verse risk adjusted return and if you use [inaudible] broker, when you do a back test, you get these two performance statistics. You get the CAR, the Compound Annual Return, and you get the RAR, the Risk Adjusted Return. And a lot of people skip over the Risk Adjusted Return because it’s kind of hard to conceptualize but I just want to share it with you and explain.
Let’s imagine you’ve got two systems and they both return 30% per annum on your account and one of them does it with a hundred percent exposure all the time, it’s always fully in the market, and the other system does it with, say, 50% exposure. On average, it’s only half in the market. The Compound Annual Return for both systems is going to be 30% per year but the Risk Adjusted Return for the first system, which is fully invested, that’s going to be 30% per year. The Risk Adjusted Return for the second system, which is only 50% invested, is going to be double the first system, so it’s going to be 60% and that’s really powerful to know and to understand because what it means is the return per unit of time that your money is invested is dramatically better.
And so, when you’re looking at two different trading systems, it’s very tempting just to look at how much money they make but what I want you to do is look at how much money those systems make per unit of time invested and so the Risk Adjusted Return, the RAR, is actually a really powerful performance metric for that. Whenever I’m comparing two systems or even two different versions of the same system, I’m really conscious of the risk adjusted return and what I like to see is any adjustment I make to my system, any optimization, any additional rules I add, should dramatically increase the Risk Adjusted Return because what I want is to get the maximum return per unit of time, my capital is deployed in the market.
Now, that gives you a higher return but there’s a secondary benefit because if your system isn’t fully invested all of the time, your catastrophic risk is actually dramatically lower. For the first system I talked about earlier, which makes 30% per year but it always fully invested, if the market collapses, let’s say by 50% overnight, and that’s an extreme scenario, but let’s just use this scenario. If the market collapses by 50% overnight, then your system is going to be impacted in proportion to the market. But if your system, the second system, is only 50% invested, and the market collapses, then your catastrophic risk is way lower because you don’t have as many positions on. You need to think about risk, not just in terms of how much risk you’re taking on each trade, but what your exposure is, your instantaneous exposure right now, and also your average exposure over the longterm because when your exposure is very high, your catastrophic risk is also high, and when your exposure is low, you catastrophic risk is low. If you’ve got a choice between two different trading systems and they make basically the same amount of money and one has a lower exposure as in it’s invested less, then that’s the better system. It’s the better system because your catastrophic risk is low and your capital is more efficiently deployed.
Now, there’s another benefit, a third benefit, of doing this, of using a system that has a high RAR and a low exposure and that is you can actually layer multiple systems because, let’s say, you’ve got one system, which is on average 50% deployed, and then you start trading that and then you design another system, which is also on average 50% invested, then you can often combine those two systems with very little additional capital or maybe even no additional capital depending on how correlated the exposures are. And so, I do this because I’ve got quite a few different systems that I layer and they’ve all got quite low average exposure and what that means is that I can combine many systems in my portfolio and get that diversification benefit but not have a lot of leverage. A lot of people have systems which are very highly invested and if they want to add another system, they either have to halve that position size to add the second system or take on a lot of extra leverage, which is very, very risky and I don’t want you to do that.
Instead, take this approach. Have a think about designing systems which have a lower exposure and a higher risk adjusted return and then combining multiple systems like that and you’ll find that you can get a smoother equity curve, make more money in the long run and have a much lower drawdown and your catastrophic risk is dramatically less. Just my 2 cents about compounding return versus Risk Adjusted Return, it really warrants thinking about because most people skip over the Risk Adjusted Return and the exposure statistics when they’re doing their back testing but, from my point of view, super, super important. It’s really going to dramatically increase your ability to make strong, smooth turns by layering and combining multiple systems. I hope that helps. My name’s Adrian Reid. This is Enlightened Stock Trading and if you need support to develop your own trading system, to learn how to back test and optimize properly, comment below, ‘Back test’. And I’ll get some details too about how I can help support you on that journey, designing your first system or additional systems to add to your portfolio. I hope that helps. I’ll see you in the next video. Bye for now.