They say that there is no holy grail in trading but if there is anything that resembles it, that is diversification. During the past few decades portfolio theory has evolved into a very important part of finance and a “must learn” for anyone wishing to manage large amounts of capital or succeed in the investment world. However it is true that for the majority of retail forex traders the notion of diversification is primitive and there is no real sense of what “needs to be done” in order to effectively diversify investments within the forex market. On today’s post I will give you five important tips that will help you better diversify your forex trading and achieve potentially better results in the longer term.
What is diversification and why is it important ? When you invest your money within a certain system or trading tactic in the forex market there is a certainty that you will reach draw down periods that may either be temporary – the system is merely facing its market exposure under unfavorable market conditions – or catastrophic, the system has become too risky to be traded. In order to increase the like hood of survival in the long term we need to come up with several trading tactics so that the importance of draw down scenarios is diminished and the failure of a system only brings minimal consequences – at least not catastrophic – to our overall trading profits.
Diversification is exactly this, using different trading strategies and instruments in order to have a higher chance of survival. However diversification must be done correctly because when it is not done adequately it can have an opposite effect and compound instead of diminish risk. The following six tips will help you increase the effectiveness of your diversification efforts.
1. Draw down periods should not overlap. When you analyze the long term reliable simulations of your trading tactics you should ensure that the overlap between draw down periods is as small as possible. The idea here is that when a system goes into draw down, the others will go into profit and vice versa. A good diversification effort has systems which have very different draw down and profit period distributions so that the overall draw down risk is greatly reduced. Having a monthly distribution analysis and locating the worst periods of draw down of each system to compare them is very important when building a portfolio as systems that have draw downs located in very different dates will have a much better hedging effect while those that have overlapping draw downs can dangerously compound risk.
2. It is not so much about having different trading “tactics”. Many people believe that the key to diversification is to have a system that is “trend following” another that is a “range trader” and a scalper or something that trades very short term movements. This idea doesn’t have any ground since the actual “strategy used” by the different systems you trade makes no difference provided that their draw down periods are hedged correctly. A good example of this is seen in Asirikuy where you have many portfolios that use different trend following systems which hedge each other extremely well while other portfolios made of “counter-trending” and “trending” tactics do not hedge each other that well. When you build your portfolio don’t focus on the strategies used but on the distribution of draw down periods, that is the most important aspect you need to cover in order to have good diversification.
3. Systems more important than instruments. Through my experience during the past few years I have noted that diversification in systems is much more important than diversification in instruments. Having many systems trading one same instrument is better than having a single system trading many instruments because different trading tactics provide more robustness than adding other instruments. This can perhaps be explained by the fact that all forex instruments are correlated to a certain extent while different trading tactics can be almost fully uncorrelated. Of course, the best diversification comes from using many systems on many instruments but if you only have one option trading one instrument with many systems seems to provide a better long term approach.
4. Diversify brokers. Perhaps one of the most overlooked aspects of forex trading and diversification on this market is the fact that you should NOT use a single forex broker. Since there is no central exchange in forex trading and brokers can have different liquidity and execution issues it becomes important to always diversify brokers in order to achieve good longer term results. I personally use about 7 different forex brokers with similar trading setups on all of them and I always advice Asirikuy members to diversify their trading through at least a few brokers to obtain better long term results. Broker diversification in forex is a must.
5. Keep tabs on individual performance. A very important part of portfolio trading and diversification is to keep a record of the performance of individual systems so that you can tell if any particular system is behaving statistically very different compared to how it behaved during your previous live testing and simulations. For this reason it is always important to keep a separate record of each system’s performance characteristics so that they can be evaluated individually as a “bad system” loaded within a profitable portfolio may camouflage itself and lower portfolio returns for a long time before you actually notice its influence. Always keep an individual system record and evaluate draw down depths and lengths compared to the historically expected values.
6. Keep an eye on open draw down when designing portfolios. A very important issue that is generally overlooked when designing trading portfolios is the potential open draw down that is created by the different strategies. Since account statements do not include record of open draw down and largest equity losses it becomes easy to underestimate maximum equity draw downs by ignoring potential open draw downs. This becomes even more important when a large number of systems are used. In order to do this make SURE that all the systems have set stop loss values and make sure that each system is traded on a risk that will put its individual maximum loss below 2% (this is especially important when using more than 3-4 systems). Ideally you would want to build an equity curve of each system so that you can calculate true maximum equity draw downs when building the portfolios.
As you see diversification is a very important aspect of forex trading that has the ability to increase our chances of long term survival by an important amount. By using several different trading systems with draw down periods that tend to remain separated, trading several systems on different instruments, diversifying your broker and keeping a record of each individual system’s performance you certainly will gain a higher probability of surviving in the long term.
If you would like to learn more about portfolio design and how you too can build your own trading systems and use them to have a robust and well diversified approach to forex trading please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach to automated trading in general . I hope you enjoyed this article ! :o)