Diversification for Day Traders

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Diversification in finance describes the process where a portfolio of correlated assets is built in such a way that produces a better risk/return profile than would be achievable with only one asset or with a basket of unrelated assets.

Diversification in Contemporary Finance

The concept of diversification is based on modern portfolio theory, which is the statistical analysis of the relationships between the risk and return rates of two or more assets.

Using complex mathematical formulas, investors can use diversification to build a portfolio of assets that complement each other’s expected performance.

With the enormous range of assets available for trading and the complex interrelationships among many of them, it is possible for investors to construct highly sophisticated portfolios that offer extremely exact risk/return profiles using the principle of diversification.

Diversification Example

Suppose that asset A has a high rate of return and a high variance (risk rate), while asset B has a low rate of return and a low variance. Furthermore, these two assets are inversely related, so when the value of asset A goes up, the value of asset B goes down.

By combining a weighting of asset A and asset B into one portfolio, the investor can diversity away some of the risk involved in a range of rates of return.

Instead of a portfolio with a high rate of return and high risk rate or a low rate of return and low risk rate, the investor can use diversification to create a mixed portfolio with a medium rate of return and a medium risk rate.

Furthermore, the investor is able to create a better risk/return profile (the rate of risk for any given rate of return) using a mix of assets than he would be able to find from any one single asset in the market.

Practical Diversification

The most common example of diversification is that between stocks and bonds. Most investors desire the higher returns offered by equities, but they fear the long and pronounced downturns that the equity market regularly experiences.

Therefore, they invest the majority of their portfolio in equities, but save a significant proportion for investing in bonds as well.

This diversification may reduce the overall rate of return compared to a portfolio of pure equities, but it helps to smooth out the periodic downturns, as the price of bonds tends to rise as the price of equities falls.

Another common example of diversification is having a proportion of a portfolio invested in gold and other precious metals. While these assets have their own relationships with the business cycle, they tend to rise in value during times of risk and uncertainty and fall in value during times of higher inflation.

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Therefore, gold and other precious metals are a useful tool in diversification, particularly when preparing for periods of extreme uncertainty in the markets.

A more recent addition to portfolio diversification is cryptocurrency. Cryptocurrencies tend to offer extremely high returns, but with a correspondingly high rate of variance.

Therefore, an allocation of 10% to 20% of a portfolio to cryptocurrencies is a common way to gain exposure to the potentially high returns of cryptocurrencies while protecting against their higher risk.

Cryptocurrencies also tend to have little or no correlation with the overall market, so they are a useful tool for weathering general market downturns.

Diversification and Trading

Diversification is an investment tool that does not apply to most day trading. However, it is important to understand how the drive for diversification affects the behavior of most other market participants, who are investors and not traders.

Investors who diversify will tend to buy and sell the same assets and asset classes in response to the same market events.

This means that market events that affect the portfolios of major market participants, such as pensions funds and investment firms, will be exaggerated by the repositioning of these large institutional investors.

Day traders who understand how these institutional investors respond to market events are well-positioned to predict short term price changes in the assets that are affected by the diversification efforts of these market participants.

Final Thoughts

Diversification is a central concept in contemporary finance that drives much of the behavior of market participants. Through diversification, investors are able to achieve favorable risk/reward profiles that would be impossible using just one asset.

Day traders who understand the nature of diversification are well-positioned to predict resulting price changes, as institutional investors rebalance their portfolios in response to market events.

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Available research data suggests that most day traders are NOT profitable.

In a research paper published in 2020 titled “Do Day Traders Rationally Learn About Their Ability?”, professors from the University of California studied 3.7 billion trades from the Taiwan Stock Exchange between 1992-2006 and found that only 9.81% of day trading volume was generated by predictably profitable traders and that these predictably profitable traders constitute less than 3% of all day traders on an average day.

In a 2005 article published in the Journal of Applied Finance titled “The Profitability of Active Stock Traders” professors at the University of Oxford and the University College Dublin found that out of 1,146 brokerage accounts day trading the U.S. markets between March 8, 2000 and June 13, 2000, only 50% were profitable with an average net profit of $16,619.

In a 2003 article published in the Financial Analysts Journal titled “The Profitability of Day Traders”, professors at the University of Texas found that out of 334 brokerage accounts day trading the U.S. markets between February 1998 and October 1999, only 35% were profitable and only 14% generated profits in excess of than $10,000.

The range of results in these three studies exemplify the challenge of determining a definitive success rate for day traders. At a minimum, these studies indicate at least 50% of aspiring day traders will not be profitable. This reiterates that consistently making money trading stocks is not easy. Day Trading is a high risk activity and can result in the loss of your entire investment. Any trade or investment is at your own risk.

Any and all information discussed is for educational and informational purposes only and should not be considered tax, legal or investment advice. A referral to a stock or commodity is not an indication to buy or sell that stock or commodity.

This does not represent our full Disclaimer. Please read our complete disclaimer.

Citations for Disclaimer

Barber, Brad & Lee, Yong-Ill & Liu, Yu-Jane & Odean, Terrance. (2020). Do Day Traders Rationally Learn About Their Ability?. SSRN Electronic Journal. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2535636

Garvey, Ryan and Murphy, Anthony, The Profitability of Active Stock Traders. Journal of Applied Finance , Vol. 15, No. 2, Fall/Winter 2005. Available at SSRN: https://ssrn.com/abstract=908615

Douglas J. Jordan & J. David Diltz (2003) The Profitability of Day Traders, Financial Analysts Journal, 59:6, 85-94, DOI: https://www.tandfonline.com/doi/abs/10.2469/faj.v59.n6.2578

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Diversification for Day Traders?

It may seem a little strange but there are three types of diversification I commonly use when I day trade or swing trade. This is not a complex process, by diversification I am simply taking about having multiple trades on at the same time, and for different reasons. I will use the forex market for these examples, as it is a seamless 24-hour market, and margin requirements aren’t increased for holding positions overnight (as with futures and stocks which may make applying these methods more difficult).

Forex Pair Diversification

Instead of always just trading one pair I will look for trade setups in whatever pair I can find them in. Whether day trading or swing trading this often means having multiple positions going on at the same time. And there is an advantage to this. Say my average win rate on my strategy is 65%, meaning for every 100 trades I’ll win 65 of them, on average.

By just taking one trade, really anything can happen. I do have a slight edge and I am expected to win that trade about 65% of the time, but with just one trade really anything can happen. I could easily lose on it.

But the more trades I take the more I see my 65% win-rate advantage. Think of a casino, they could easily lose 1 hand of a blackjack, but over the course of a week and thousands of hand they rarely lose.

I am not advocating over-trading, which is when you just trade to trade, with no strategy in mind. I am talking about taking more opportunities utilizing a well-defined strategy. This typically means looking at multiple forex pairs for opportunities.

While some forex pairs are highly correlated, most are not. You can take multiple positions in different forex pairs and they are all doing to move slightly differently (see current Forex Correlations Stats). This creates a type of diversification. If you take 5 positions, you may lose on 1 or 2, but you’ll make money on the other 3 or 4 positions, assuming you have a decent strategy. If your strategy does win more than it loses, it would be very rare to lose all 5 trades. And even if you did, it would be more common to win on all 5 trades.

Strategy Diversification

Since most pairs are going to move differently than one another, the price action in them will be different based on volatility and where the price is relative to support & resistance, etc. Different price action means different trade set-ups, and different strategies.

Using the same strategy all the time is fine. Yet having two or three strategies you employ helps with stabilizing your profits over time.

Over the years I have developed many strategies, yet most have at least one weakness, which means in certain market conditions it will not perform as well as other strategies. By utilizing three strategies all the time, the strengths of certain strategies helps offset the weaknesses in others.

Assume I put out three trades using the same strategy. The strategy does not do well in volatile conditions, and on this day an unexpected event rocks the markets and I lose on my three trades.

Now assume I had used three different strategies, the one above, one which does very well in volatility and other which fairs ok. Now instead of losing three trades I potentially make money on one or two.

Timeframe Diversification

This one takes more work, as it combines strategy and forex pair diversification and then adds another element. Look for trade set-ups on different time frames. You may typically trade off a 1-minute chart, but there are also trades based on a 5-minute, hourly and daily charts, etc.

By putting out trades on different time frames you’ll be getting in more trades each day and you will have more and more trades finishing, posting a profit or loss to your account.

As discussed above, assuming you have a winning a strategy, all these trades help give you an edge each day. One day you may be having a losing day day trading, but a couple of your swing trades come in resulting in a profit for the day. It may work out that the swing trades lose as well, resulting in a bad day, but the odds of winning are greater than they are for losing. Assuming a greater than 50% win-rate on your trades, any high quality that you add is likely to produce more winning days.

Final Word

After hearing this the main mistake traders make it to start trading as much as possible. That isn’t the point. We still only want to take high probability trades based on a solid winning strategy. We are just going to look for more of those trades in different places, such as different pairs and time frames. We can also utilize different strategies to increase the number of set-ups we trade. Think of yourself like a casino. The more hands that are played with a slight edge the better the probability that you will finish the day with a profit. Only take 1 trade a day, and basically anything can happen.

You don’t have to utilize these method to be successful. Many day and swing traders make a living trading one strategy, in one forex pair on one time frame. These methods are just alternatives to consider.

There is a positive side effect to doing this. You will realize that you can’t predict which trades are going to win and which ones are going lose. Therefore you won’t get attached to any single trade….because you have lots! You start see the market as simply numbers, and not about being right or wrong. This type of understanding is crucial to trading longevity.

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July 3, 2020
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Diversification – the Key to Opportunity and Trading Success

“Of the six tools needed for successful day trading, Diversification is the most important.”

Diversification in Traditional Investing

Diversification in the world of investing is synonymous with “safe,” “secure” and “smart”; yet in spite of the advantages diversification brings to trading, it is a relatively foreign concept to day traders.

Money managers and investment professionals know the benefit of diversification which is why diversification is an essential component of any retirement savings plan. No one questions the logic of diversifying investments when it comes to a retirement plan. Everyone knows that diversification lowers risk, and if done right, the sound investments will outweigh the bad ones.

Diversification for Day Trading

The good news is that the advantages that diversification brings to your 401k are the same benefits that diversification offers your day-to-day trading. The key to successful diversification is “doing it right.” Diversification at the day trading level is more than just trading a variety of markets; instead, diversification for the day trader has to do with diversifying how you see the markets. When done right, diversification offers you more opportunities to trade as well as lowering your overall risk – and for a day trader what could be better than that?

There are three components to proper trade diversification: entry, exit strategy, and money management. Do these three right, and you will have a complete, robust, diversified trading system.

Three is Better Than 1

What kind of trader are you? Ask any trader this question, and they will inevitably put themselves into one of three categories: Scalper, Swing Trader or Trend Trader; but why? Most traders already know there are three prevailing market conditions: scalping, swing trading and trend trading; but why would you limit yourself to only one of the three? Why not diversify and do all three at once?

Don’t put all your Trading eggs in ONE Basket!

As obvious as this may appear on the surface, traders never seem to consider scalping, swing trading and trend trading at the same time, yet this is the height of diversification. When you are on the alert for scalp, swing and trend trades, you will be able to capture the best trade for the current market condition. And by focusing on the trade that the market conditions are best set up for, you increase your chances of success dramatically.

Compare this method of diversified trading with what the average trader does. The average trader keeps plugging away at the markets with their same routine day after day after day. They think that if they implement their signal, faithfully they will be successful. They have a good trades and bad trades, but the bad usually outweigh the good. They analyze their system but can never seem to figure out why they make money sometimes and lose money at other times?

They chalk it up to “bad luck,” “a fluke” or “crazy markets” never realizing that the underlying market conditions are changing and causing the problem. When the trader’s system is in sync with the markets, they make money, but when the system and market are out of sync, they lose money. This situation is the trading equivalent of trying to put a square peg in a round hole. When the hole is square, the peg fits fine, but when the hole is round, you have serious problems.

“After a while, most traders scrap their system and look for a new one. This act starts the whole cycle over again, usually with the same result. The average trader will be doomed to repeat this process many times, never realizing that until they learn to diversify their system to take advantage of the dominant market condition they will always be limiting their chances of success.”

So how do you diversify your system? You begin by recognizing there are three market conditions: scalp, swing, and trend; and develop signals to capture those particular scenarios. Of course this is easier said than done; however, it must be done if you are going to lower your risk and increase your chance of success.

An easy way to achieve this goal is to alter the time frames on your charts. Generally speaking, scalp trades will be more evident on shorter-term time frames and trend trades on the longer time frames. For instance, you could use a 3 or 5-minute chart to watch for scalp trades, a 15-minute chart to spot swing trades and an hourly or daily chart to look for trend trades. This approach is a little more primitive than developing a separate system for each market style, but it is a start.

An important consideration when developing your signal generators is clarity. If you are going to be looking for three types of trading signals you need absolute clarity to be able to make a decision. You need to be able to look at a chart and instantly recognize if you have a scalp, swing or trend trade developing. In the real world, there isn’t a lot of time for difficult decisions. The more straightforward and more clear your signals are the better your results will be.

Clarity is the Key

In fact, signal clarity is paramount; even over signal accuracy. Most traders believe that they are not making money because their signal is not accurate enough, but this is not the case. Most traders fail not because of their signal; instead, they fail because they are focusing solely on their signal and ignoring the other two components necessary to diversify their trading: exit strategies and money management. They do not know that with a good exit strategy and money management you can still make money even if you only have a 50/50 signal! Money management is indeed the secret sauce to day trading. If you don’t believe me, click here and test it for yourself.

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