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Finding Success By Diversifying Your Trading | livemarkets.com
Education Trading Psychology

Finding Success By Diversifying Your Trading

 
A lot of trading wisdom repeated by traders is surprisingly unintelligent.  A good example is the mantra that it is important to “have a process” for your trading and follow that process religiously.  Sounds great–until markets change and the process that worked in one kind of market no longer works.  If a business repeated a process endlessly, it would never adapt to changes in consumer tastes, new opportunities, etc.  Similarly, a singular focus on “discipline” is shorthand for a failure to innovate.

Which brings us to yet another piece of common wisdom that masquerades as wisdom:  Be patient and only put on your very best trade ideas.  Sounds great!  Don’t overtrade and wait for the really good “A+” opportunities.

Not so.

In the most recent post, I outlined my approach to trading, highlighting finding opportunities in which detecting market cycles allows for good risk/reward entries in established trends.  What is interesting about this approach is that it applies across a very wide range of time frames.  Thus, one could look at long-term data and trade dominant cycles within broad trends, or one could implement the approach intraday.  As a rule, variability of price action increases as time frames increase, so it’s unlikely that one would obtain the same risk-adjusted returns trading long-term vs. intraday.  By the logic of the idea of “be patient and only put on your very best trade ideas”, we should only trade the time frame that yields the best results.

The problem with that view is that opportunities differ across time frames, as well as across instruments.  While it could make sense to trade a short-term pattern from the long side, this might be a mere blip for a good longer-term short trade.  When we trade multiple patterns that are relatively uncorrelated (or perhaps even negatively correlated), we as traders achieve the diversification normally associated with investing.

We can think of it this way:  an investor diversifies holdings at a given point in time.  The investor might hold in a portfolio relatively uncorrelated positions in currencies, rates, stocks, etc.  That diversification allows trades with a decent Sharpe ration to create a portfolio with a truly superior Sharpe.  If you put enough different edges together in a portfolio, the portfolio will show relatively smooth positive returns, because some ideas are always working when others aren’t.  That’s the beauty of diversification.

The active trader tends to participate in fewer opportunities at any given point in time, but over time will trade multiple cycles and trends, some shorter-term, some longer-term, some in one instrument, some in another.  Note:  A flexible trader might put on multiple long and short trades during the day, achieving over time what the investor structures all at once:  diversification!  

The successful active trader will have multiple, promising patterns (“setups”) to trade, creating multiple, independent edges.  That is the beauty of Mike Bellafiore’s idea of “playbooking”.  Like a football or basketball team, the trader practices many different “plays” and thus can adapt to any environment.  Can you imagine a basketball team consisting of players that won’t take shots because they don’t have the wide-open look at the basket?  Any team–and any trader–is competitive only if they can find multiple ways to win.

Sitting passively and not trading until the perfect trade presents itself is not discipline; it’s the essence of being a one-trick pony.  And when the market changes, the one-trick pony becomes a lame horse.  Many different edges of different quality and different instruments and different time frames creates what we might call a “trader’s portfolio”.  It’s a lot harder to lose when we have many ways to win.  

Good traders have an edge.  Great ones constantly find new ones.

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Further Resources:

The Daily Trading Coach – Trading psychology self-help methods

The Three Minute Trading Coach – Short videos on trading psychology
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