Draw down and risk management

Both the backtesting results and live performance have demonstrated that our index pairs trading strategy works well in different market conditions. Some readers are wondering the downside risk of the strategy and how to handle this risk.

First of all, we list the maximum unrealized loss of each trade since January 2015, and calculate the maximum drawdown in different leverage scenarios, as shown in following figure:

In the first scenario, we trade 1 contract in the long/short positions for each $20,000 cash in the account. The effective leverage is about 2. 8 trades have maximum drawdown of less than 3%, and the biggest drawdown is 9.7%.

In the second scenario, we open 1 pairs of future for each $10,000 cash in the account. In this case, the effective leverage increases to about 4. As we can see from the above table, the maximum drawdown in each trade also increases. The biggest potential loss is about 20%.

This scenario analysis suggests that controlling the leverage level is one of the key steps to a successfull risk management. Less leverage leads to more stable wealth cure while limiting the growth. We would need to balance the risk and the return, and choose the appropriate leverage based on own risk budget.

Aternatively, we can change the strategy so that it can response to the market faster and hence reduce the holding period. Recall that the model has strong market timing ability. We design a second version of pairs trading strategy that bases on the initial model and the performance of the timing market portfolio. We calculate the momentum of the market portfolio and use it to turn on or off, and even reverse the pairs trading. The number of trades since January 2015 increases from 11 to 47, and the wealth curve is smoother than the original one's. See following graph for demonstration. It's worth pointing out  that the higher-frequency trading is not neccessary always better than the original trading.