Most new traders enter the trading arena with dollar signs in their eyes. They are looking for the one “Holy Grail” strategy that will turn their pipe dreams into reality. This dream is heavily promoted by unscrupulous trading vendors; those who show only the upside and profitability to trading. Isn’t it amazing how many strategies for sale out there seem to be drawdown free?
Of course, the reality for most traders is just the opposite. Traders try one method or strategy, put all their capital in it and trade it. When the new system inevitably hits a downturn, those lucky enough to escape with some of their capital simply move on to the next “Holy Grail” they find. And the story repeats, again and again, until the trader goes broke. This phenomenon is one of the many reasons why most traders lose money.
This begs the question: “Is there a better approach to trading? An alternative to searching for some ‘Holy Grail’ technique?” Thankfully, there is, although most people don’t talk about it very much because it’s rather boring, somewhat academic and not nearly as sexy as some slick new indicator. It’s summed up in one word: Diversification.
In simple terms, diversification means that the trader does not rely on one approach to the markets. In stock trading, for example, many traders diversify by trading stocks in different industries or with different degrees of correlation (beta values) to the overall stock market. This is what most people think of when they hear the word diversification. It’s the traditional definition. The benefits of this type of diversification have been well documented in academic research for decades, so most people know about it.
In futures trading, or as part of a more active speculative stock trading program, diversification can be achieved in numerous ways. A trader could incorporate various “macro” styles into the same market.
For example, a trader could:
- Trade soybeans with a calendar spread trading approach, taking advantage of price changes between old crop year and new crop year pricing differentials,
- Employ an option-selling strategy, taking advantage of flat periods to collect premium, and
- Trade soybean futures directionally, hoping to hop on a trend.
Each one of these techniques could be employed simultaneously. Even though all strategies trade soybeans or their derivatives, the results of each strategy may be completely uncorrelated to the other strategies. That provides diversification.
Another way to diversify in futures is to trade the same strategy with different time frames, or different markets. A discretionary price action trader could, for example, use that approach to trade uncorrelated markets. An algorithmic trader may employ the same approach, trading the same strategy with different markets. Or, he could trade different strategies with different markets. Each of these approaches also could provide the desired diversification.
The key to diversification, no matter what the market or the type of trader, simply becomes trading multiple different ways.
Why diversification works
The reason diversification works so well can be summed up simply: Profits add; drawdowns do not. A simple example illustrates this fact. Consider two good, but not great, futures trading strategies, as shown in “Two are better than one” (below). One strategy trades lean hogs; a different strategy trades the E-mini S&P 500. Each strategy on its own is profitable, with, of course, its own inevitable drawdown. Clearly, neither strategy is a Holy Grail by itself!
The real power in trading both of these strategies is in trading them simultaneously. The maximum drawdown for the combined portfolio of lean hogs and the E-mini S&P 500 is less than trading each system by itself, as shown in “Combined results” (below). While one strategy is in drawdown, the other is reaching new equity highs, and vice versa. Thus, over time the drawdowns are smoothed, and you get more profits. This is the benefit of diversification.
While actual results certainly can vary, in most cases, this drawdown-smoothing effect can be improved even more by adding additional trading strategies (or applying one strategy to multiple non-correlated markets). As long as the strategies are uncorrelated, or only slightly correlated, the overall account drawdown in percentage terms possibly can be lessened by adding more strategies.
The key with achieving diversification is to simultaneously trade uncorrelated strategies, or markets. But how do you do that exactly? There are a number of ways to compare the performance of trading systems, but one way to uncover likely diversification is to measure the correlation coefficient (R^2) between two strategies, as shown in “Getting results” (below). This can be done in a spreadsheet program such as Microsoft Excel or with nearly any mathematical software. The lower the correlation coefficient, the more diversification the strategies will provide.
This method becomes cumbersome, though, when checking the correlation of many strategies. Each strategy has to be checked with every other strategy, and that can take a long time to complete the analysis. Thankfully, a relatively easy alternative exists.
Because the end goal of diversification is to improve the equity curve characteristics, one could simply measure the profit to maximum drawdown ratio of the resulting equity curve. A strategy that improves the overall profit to drawdown performance will be adding diversification to the portfolio – resulting in less drawdown for an equivalent amount of profit.
Knowing how to evaluate diversification is important, but it is after the fact. How can you know beforehand that a new strategy will be uncorrelated to other strategies? Experience has shown that simply doing things differently usually leads to diversification.
For example, a trader can incorporate at least one, and ideally many, of the following differences to result in a diversified strategy:
- Different strategy parameters
- Different strategies within the same category of technique (for example, different approaches to trend-following)
- Different strategy approach (countertrend or mean-reversion vs. trend-following)
- Different bar length strategies (X-minute bars along with daily bars)
- Different markets (trade some grains, some energies, some currencies, etc.)
Any one of these by itself can provide an uncorrelated strategy that supplements an existing strategy. Create a strategy with two or more of these differences, and the diversification can become even more pronounced.
Drawbacks to diversification
As good as diversification is, it is not without its drawbacks. For example, trading multiple strategies requires more capital. A trader with a $5,000 account just does not have enough capital to be well diversified.
Second, during times of crisis, all markets may become temporarily highly correlated. This occurred during the 2008-09 financial crisis. It also could occur if something dramatic happens, such as the U.S. dollar being devalued. In such a situation, everything could go against the trader all at once.
A final drawback to diversification is that the possible upside performance is limited. A trader concentrating on trading only one strategy has a much better chance at a blockbuster year than a diversified trader if the concentrated trader’s specific strategy has a tremendous year. The diversified trader, on the other hand, will likely have some weak-performing systems in any given year, which will limit his total account upside. But, this also means that the concentrated trader also has a higher risk of getting blown out, if his strategy has a really bad year. If the downside protection is not required, though, a trader might be better served by remaining non-diversified, and aiming for huge gains. Clearly, personal preference, trading style, bankroll and risk tolerance play a role in this decision.
Many longtime traders will tell you that being diversified is the best way to go. The opposite philosophy-- putting all your eggs in one basket--is not a good choice, especially if the basket could be dropped at any time. Putting your eggs in multiple baskets--in other words, being diversified--lessens the possibility of a catastrophic loss. If a trader is trading 20 strategies, one or two can stop working without it destroying the overall account. A single-strategy trader, unfortunately, cannot say the same thing. Being diversified can lead to smoother returns, and less risk of ruin. Many traders find this preferable to swinging for the fences.