The usefulness of diversification is most felt when the market is sideways or falling. A concentrated portfolio ends up taking a big hit during these times.
This is one of the reasons why passive index investing is growing. An index offers the benefit of diversification, plus it has the best companies in each industry.
So in the event of a takeover, the best-run companies are normally the first to exit the bloc. However, diversification is not that common when it comes to trading.
In trading, most traders, especially those who are struggling, continue to trade the same way regardless of market conditions.
It is difficult for most traders to understand that no strategy will work all the time. A trending market will be good for any trading strategy that follows the trend, while a flat market will be a good playground for price action traders and option sellers.
Like in cricket, where one cannot play the same shot regardless of the ball that comes his way, trading also requires changing tact depending on the state of the market.
Unfortunately, not all traders have the insight to understand the state of the market and make changes to their strategy on short notice.
This is especially true in the current scenario where more and more traders including retail traders are using algorithm trading. They keep taking the same trade regardless of the state of the market.
In order to avoid a series of losses suffered during these periods, professional traders have diversified their trading strategy.
While some adapt to market conditions and trade accordingly, others prefer to run multiple strategies at the same time.
The inability to predict the direction of the market gives rise to the development of strategies that have an edge. Each strategy will have a different edge that will work in different market conditions and times.
The strategies used are those that give lower losses when the trader is wrong and generous profits when his trades are winners.
Diversifying strategies should not be done for fun. There is a scientific way to do it. Proprietary trading houses trade uncorrelated trading strategies.
They would take trades on strategies that make money in a highly volatile market, while simultaneously taking options put strategies that work best in a trendless market.
By selecting more than one strategy, the trader should perform a backtest and see if these are not correlated. When one strategy generates higher returns, the others may yield lower returns or a small loss.
Diversification can also be in terms of markets, stocks or in terms of time.
A common strategy that best explains diversification is the long-short strategy. Here, the trader is long on the strongest stock and short on the weakest stock in his universe. These actions can come from the same sector or from different sectors.
Another form of diversification is taken in terms of time. Here, the trader takes a position either by looking at different timeframes or by initiating a trade at different times.
As an example, the short straddle trade at 09:20 is a very common trade that is embraced by retail traders. Off late these trades have not yielded consistent returns.
Many traders now take the same short straddle trade at different time intervals, such as after every hour. This helps prevent a large drawdown and also distributes the capital in smaller trades spread throughout the day.
Trading houses are known to adopt 7-8 trading strategies simultaneously, which helps them smooth their profit curve. Although there is no scenario where all of their strategies will be profitable, diversification helps during drawdowns.
There will always be a strategy that will cushion the fall and prevent the portfolio from being seriously affected. Since a trader’s main objective is to protect their capital, diversification helps to mitigate body blows.
(The author is President, TradeSmart)
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