Seekin ngbetterriskadjustedretu urnswithdiversification

Manythanksaredueto t ThomasBa artonandChrisStocktonfo orperforming gmuchofthe eresearchonthis hesegentleme enareextrem melyintelligen ntandImhu mbledtohav vereceivedth heirassistanc ce. study.Th Summary y Thelinear rregressioncurve c channel l(LRCChanne el)isprimarily yastatisticaltoolforbroa adbasedinde exes ptoseeifpairingindividualstockswou andverylow l betasecu urities.Recen ntlyIsoughtout o somehelp uld allowbett terresultstha anjusttradin ngasingleind dexalone. Thesis Thetheor ryisthatpairi ingopposingsignalsindiff ferentsecurit ties(onelong gfromthebo ottomofthe channelagainstonesh hortfromthetopofthech hannel)would dbeamorem marketneutra alposition dtotakinglon ng/shortsignalsonthebro oadbasedind dexalone. compared Backtestingoptionstr radesonasin ngleindexisanextremelyt timeconsum mingproject.S So,performin ng optionsbacktestingon naportfolioof o symbolsissuchalarge taskthatitis sjustmorepr racticaltorely yona fewassum mptionsconfirmedwithsp pottesting. Assumptio on#1ATMverticalshave eslightlybett terperforma ncethanund derlyingsignalsbecauseof f definedriskandatime edecaybenef fit.Thishasbeen b fullypro oveninSPXoptionsbacktestingandsp pot checkingindividual i sto ockshasprovi idedevidence eofthesame e.Sohavingu underlyingsig gnaldataisagood startingpointtodeterminethevalidityoftradingastockwith haLRCChannelbias. Assumptio on#2Notenough e oppos singsignalsoccuratthesa ametime,sowemaybebetteroffjust runningaportfolioofseparately s ma anagedsignals/instrumen tsandusedis scretiontoba alancethe numberof o longsandshortsheldtocreatesomemarketneut trality. Study Herearesome s resultsfromourstud dy.Thomaspulled p thefolllowingchartfromalistof fthe275stoc cks withthehighest h volum meoptionsactivityasreportedbytheC CBOE.

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Thisisacombinedperformanceofallstocksonthe t LRCChan nnel:

odoftimeusin ngjusttheSP PXsignals: Hereisthesameperio

y canseeth hatthedrawd downsarede eeperontheS SPXalonevs.theportfolio oofstocks. Visually,you However,byusingcred ditspreadsontheSPXwecanimprove ethesignalsm moothnessbe ecauseofthe reasonspreviously p mentioned(defi inedriskandtimedecay). Thefollowing gP/Lincludescreditsprea ads bothATM Mandatthe.2 25Deltaasco omparedtotheunderlying gSPXindex.

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 Youcanseethatthecr reditspreadP/L P issmooth herthanthes signalchartpr reviouslyinse erted.Thisis wherethe eassumptioncomesinif ftheSPXP/Lissmootheru usingcredits spreadsthent theportfolioof stocksma aybebetterusing u creditsp preadsaswel ll.Thefollow wingisaquick kexampleofc combiningth heSPX andamod deratelyperformingstock kusingcreditspreadsonb oth.

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HereisaP/L P chartofMOS M usingcre editspreadson o theLRCCh hannelsignals s:

MO OSCreditSpread ds
7,000.00 0 6,000.00 0 5,000.00 0 4,000.00 0 3,000.00 0 2,000.00 0 1,000.00 0 1 3 5 7 9 11 13 3 15 17 19 21 23 25 27 7 29 31 33 3 35 37 39 41 43

Hereisthechartofthe esametimeframe f usingSPX S LRCChan nelcreditspr reads

SPXCre editSpre eads

6,000.0 00 5,000.0 00 4,000.0 00 3,000.0 00 2,000.0 00 1,000.0 00 1 (1,000.00) 3 5 7 9 11 1 13 15 17 19 21 23 25 27 29 3 31 33 35 37 7 39 41 43

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HereisthecombinedP/L P (splitwith hequalweigh hting)

SPX XandMOS M Com mbined

6,000.00 0 5,000.00 0 4,000.00 0 3,000.00 0 2,000.00 0 0 1,000.00 1 3 5 7 9 11 13 15 17 19 21 23 2 5 27 29 31 1 33 35 37 39 41 43

s metrics sonperforma ance.Oneme easureIliket toquicklyqua antifysmoot thnessisma ax Herearesome drawdow wninP/Lasarelationshipof o annualreturn. MOS MaxDD AnnualRet R Rate/DD D SPX MaxDD AnnualRet R Rate/DD D Combined d MaxDD AnnualRet R Rate/DD D (1,089.95) 2,4 406.03 2.21 (1,864.00) 2,1 103.30 1.13 90.00) (3,09 2,70 08.75 0.88

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Conclusio on Asyoucansee,theReturncompare edtoMaxDrawdownwas smuchhigher rinthecomb binedsignals eperformanc ceofeitherof ftheindividualinstrument t.Thisprovid desevidencethateventho ough versesthe individual linstrumentsmaynothav vesmoothret turnsusingLR RCChannel acombinedp portfoliousin ng additionalmeasuresof fallocationmay m provideanopportunit yforbetterr riskadjustedr returns. Thisisjustanintroductiontotheco onceptofdive ersificationas sawaytored ducedrawdownandcreat te smoother experiencedinthemarket rreturns.Afterall,drawdo ownisthequ uantifiablean dactualriske t.If youcanlo owerthisnum mber,thenyo oucantakeon nmoresizea andincreaset totalreturns(alsoknowna as Alpha.) StaytunedtoLessThanRandomformoreideas ondiversifica ationstrategi ies...andagain,manythan nksto ThomasBarton B andCh hrisStocktonforhelpingpullthisinform mationtogeth her! Sincerely, AndrewFalde Founder|lessthanrandom.com Managing gDirector|Fa aldeCapitalManagement, M ,LLC Contributor|SMBTraining

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