I have been asked several times if and how diversification can help us trade better;
I believe diversification is one of the crucial factors in the success of a trading plan besides having a good trading system and sound money management.
It may in fact make the difference between success and failure of a trading plan.
1. Be aware that most of the trading systems available are trend following in nature.
2. Be aware that commodities trend for a fraction (say 30%) of the time. The rest of the time they are in a sideways market or a small trading range.
3. It stands to reason that most of the good systems will do well in a trending market and get choppy in a sideways market, unless they have devised a way to keep out of a sideways market.
4. What the system hopes to do is to make enough money in a trending market to offset the losses made in a sideways market.
5. What the trader hopes to do is to have enough confidence and money left to make a trade when the market is trending and be profitable.
6. However, a lot of traders being undercapitalized dump their system after a series of confidence shaking losses.
7. By diversifying, a trader can hope to avoid or minimize some of the above problems.
8. The aim of diversifying is to substantially lower the drawdown, minimize the equity swing and hopefully increase the profit.
9. Thus a $10,000 trading acc, trading one commodity having a drawdown of $4,000 and profit of $4,800 may be diversified to have a lower maximum drawdown of say $2,500 and better net profit say of $5,700. This represents a more efficient use of equity capital.
!!!Avoid Highly Correlated Markets!!! Avoid Highly Correlated Markets to Increase your chance of success.
10. Let me first define a trade – to me trading Soybeans, Soybean Oil and Soybean Meal does not represent three different trades, but one trade so does Swiss Franc and Deutsche Mark.
A trader who puts on such highly correlated trades will have a bigger drawdown and increases his chances of ruin.
11. Different markets trend well at different times. Some markets may be going nowhere for an extended period of time. Gold may be in the doldrums for say a couple of years at a stretch before it becomes tradable, soybeans may do the same.
A trader who is trading only Gold or Soybeans may become so frustrated with the losses, the time lost, the trading system, he will give up before the market becomes tradable again.
12. So a good diversified trading plan implies lower maximum drawdown, better profit, more winning weeks and months, generally more consistency. It means trading non-correlated commodities. It means sleeping better at night.
Just some food for thought.