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What role does portfolio optimization play in a trading strategy?

Imagine a world with a multitude of financial institutions and instruments (such as securities markets and insurance contracts) where people can choose exactly the types of risks they want to accept and get rid of. In such a world, we could all run the risk of losing our jobs or depreciating the market value of our home. Such a world would be the ultimate theoretical case for describing the capabilities of the financial system to effectively redistribute risk in society.

Over the centuries, people have created various economic institutions, developing such types of contracts that would facilitate an efficient risk-sharing as much as possible by Expansion of the optimization spectrum and from increasing specialization in risk management. Insurance companies and futures markets are examples of institutions whose primary function is to facilitate the redistribution of risk within the economic system.

Modern economics treats an investment portfolio as the sum of assets (stocks, real estate, currencies, etc.) owned by a person (investor). These assets are the subject of management. The investor is faced with the task of optimizing the investment portfolio. That is, the essence of management is to increase the liquidity of the investment portfolio while maintaining the level of profitability and risk.

Hedging allows you to manage a portfolio and protect assets from adverse market events called systematic risk. It is important to understand that hedging is not a way of generating additional speculative profits, but a tool used to protect assets. Both retail investors and large funds use hedging. Hedge funds get their name from this term, although in essence they are not always anti-risk organizations as, on the contrary, they use an expanded list of instruments and aggressive tactics.

Creation of an optimal securities portfolio

The basis of modern portfolio theory was founded by Harry Markowitz in the 1950s ideas for managing a securities portfolio. His approach is to analyze the expected average values ​​and fluctuations in returns of financial assets and, on this basis, to select the optimal weightings with which the investor should include each security under consideration in his portfolio.

A qualitative analysis of your holdings and your level of risk can get you pretty far, but you may want to go further to more accurately hedge your portfolio by calculating some numbers. This is where portfolio optimization comes into play.

Portfolio optimization

Portfolio optimization is a mathematical process that seeks to maximize portfolio return and minimize risk, no matter what level of risk you choose. The measure of risk can be beta, or the correlation of a security with the market below the Pricing model for capital investments, or it can be value-at-risk, the maximum dollar loss that is expected over a period of time with a given level of confidence – say 95 percent.

In most cases, you will need to purchase the software required for optimization or access it through a broker or financial advisor. It is difficult, but not impossible, to do a good optimization on your own.

If you want to give it a try, go to http://www.excelmodeling.com/EMI_Preface.htm to view a portfolio optimization table created by Craig Holden, author of Excel Modeling (Prentice Hall), a portfolio optimization textbook. You (and hedge fund managers) measure risk and return historically. Regardless of the quality of the optimization software you have purchased and the data it contains, the results will not be perfect because the future will never be exactly the same as the past.

The software

To preserve risk while maximizing returns, a fund manager may run a program that provides optimal portfolio weighting. MetaTrader 5 is popular end-to-end software for managing a hedge fund. The software is directly linked to global financial exchanges and popular liquidity providers. A single investor or fund manager can control and restructure their business, manage risk, generate reports, receive offers and withdraw funds – all within a single program.

MT5 also has various tools for algorithmic trading. Every fund trader has access to efficient algorithmic trading tools. The use of ready-made Expert Advisors enables custom modules and the creation of new ones via the specialized ones MQL5 IDE Support for Python, R and other languages.

Bottom line

You can only invest wisely if you do not know what you are investing in. If you don’t understand what a hedge fund manager is talking about when talking about potential asset classes or strategies, you are more likely to make mistakes with your hard-earned money. Follow hedge fund manager practice and never forget to think about the risks beforehand.

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