Trading Educators Blog
Diversification is one of the crucial factors in the success of some, but not all trading plans, and may in fact make the difference between success and failure of the plan. Putting all your eggs in one basket is not a good idea for some traders. This approach takes the position that rather than trading ten contracts in one market, look to trade smaller amounts in several different markets. The aim of diversifying is to substantially lower the draw down, minimize the equity swings and hopefully increase the overall profit. This can represent a more efficient use of equity capital. Diversification means usually avoiding highly correlated markets to increase your chance of success. It is said that trading soybeans, soybean oil and soybean meal does not represent three different trades, but one trade. Traders generalizing in this way, display a great deal of immaturity. There are many times that soybeans are following a path entirely different from Soybean Oil. Trade each market based on its individual characteristics and price action. However, when markets are correlated, a trader who puts on highly correlated trades may have a bigger draw down and increase their chances of ruin.
Different markets trend or swing well at different times. Traders who trade only one market may become so frustrated with the losses, the time lost, or the trading strategy that they will give up before the market becomes tradable again. So for diversification, pick a good handful of unrelated, diversified markets to build a portfolio, which can lead to a lower maximum draw down, and generally more consistency.