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A Guide to Creating A Successful Algorithmic Trading Strategy by Perry J. Kaufman

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CHAPTER 9 Equal Opportunity Trading

All things being equal, the individual investor can do a better job getting diversification and controlling risk than the big players because it’s easier to manage a small amount of capital. Risk needs to be controlled. Losing sight of it can be fatal to your investments.

Hedge funds with enormous amounts of assets under management, such as ED&F Man, will find it very difficult to diversify. They are limited by market liquidity and will seek out the cash markets to spread their risk more effectively. For these firms, diversification is limited.

For the rest of us, to control risk properly, you must start by taking positions with equal risk. That’s equal risk, not equal expectations of reward, or some risk-reward combination. It’s only the risk that matters. The purpose is to give each trade an equal chance to participate in the returns. If you have twice as much exposure on one stock that you believe has a better chance of a profit, then it had better return twice the average, or you’ve only increased your risk.

With all due respect, picking stocks in order of expected return is a pretty tricky process, even if you use a well-known ranking service, such as Starmine. Among the top 5 or 10 highest-ranked stocks, can you tell which will have the highest return in the next week or the next trade? It’s very unlikely. So staying with equal risk is going to be safer and easier.

CALCULATING POSITION SIZE

It’s not complicated to calculate the position ...

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