The Edge vs Risk Relationship

System Trading

Apr 07

In my last post, I shared the importance of a balance among market focus, strategy focus, and tactical focus. In this post, I consider the relationship between risk and alpha because profit is the result of the risk taken and the trading edge.

One source of trading profit is the alpha or the edge. In a way, this can be thought of as one’s consistency, the R (reward/risk), and the outsize profits that a strategy can produce. It is relevant to note that strategies that are tightly tuned to produce consistent results may be more likely to be fragile. In such cases, taking on more risk may reduce the fragility and lead to more robust results.

And, that leads me to the other source of profit which is taking on risk. Some methods can be thought of as producing their gains by primarily converting drawdown or risk into profit. An example, might be “scale scalping” which is a type of strategy that is a combination of averaging down and scalping. Another example, might be selling naked options. Such strategies are more likely to generate a majority of their profits through risk.

The important is that strategies that are too alpha dominant may be difficult to make work or overly fragile. On the other hand, strategies that are risk dominant may be too difficult to trade in practice or simply not worth trading.

The real challenge for the strategy developer is to create strategies that are both consistent and robust and that balance the risk and alpha components.

About the Author

The author is passionate about markets. He has developed top ranked futures strategies. His core focus is (1) applying machine learning and developing systematic strategies, and (2) solving the toughest problems of discretionary trading by applying quantitative tools, machine learning, and performance discipline. You can contact the author at curtis@beyondbacktesting.com.

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