Portfolio Diversification is perfect to reduce risk, even in day trading
Broadly, there are two types of traders. One, there are value traders who identify companies that are solid and invest in them for the long term. Warren Buffet is a good example of this group of investors. He has owned companies such as Coca-Cola and Geico for the past 30 years.
The second category are traders who don’t have the long term patience to own companies. Traders spend most of their time identifying trends and swings in the assets that they target.
The key to success for any value investor is diversification.
This is simply because companies will go through cycles of wins and losses.
For instance, a company such as Coca-Cola can have a perfect year because of the World cup before returning to the previous normal area. During that year, the shares will rise and as it comes to settle down, the shares will go down.
Traders on the other hand are not known to be great in stock diversification. This is because they aim to enter a position and exit within a very short duration (learn how).
In fact, traders are able to trade in companies they have never heard before just because of a news story that has just come up. It is however important to note that traders can successfully diversify their risks no matter the short timeframes of their investments.
Power of correlation
As traders, correlation is a very important concept that you can use to diversify your trades. Assets such as currencies, commodities, indexes, and equities are all interrelated.
As such, a movement in one currency can have an impact on the movement of a particular commodity.
For instance, for a long time, the price of gold and that of the dollar has had a negative correlation. This means that when the price of gold moves up, the price of the dollar replicates it by moving down.
This has some underlying reasons: Investors view gold has a safe haven because the United States policy on dollars. Therefore, when the dollar becomes very strong, there is usually a gold selloff as investors accumulate dollars and vice versa.
→ Gold Trading: Strategies to Trade it Profitably
Another correlation that traders can use is on the prices of crude oil. Western Texas Intermediate (WTI), and Brent Crude have a near perfect correlation. This means that when the price of Brent goes up, the price of WTI will also reciprocate by going up.
You can also add natural gas and gasoline to this equation. In this case, a trader who buys Brent and WTI is actually risking losing money.
The one that buys one and sells the other is protecting his portfolio because if WTI goes up and Brent breaks the correlation, he will still make money from one.
A trader can perform the correlation himself using excel and the data that is available in his trading platforms. For MT4 traders, this data can be found in the tools section. There are also websites which provide up to date correlation data automatically.
Need for research
Research is very essential for any trader who wants to diversify. This is because a trader who is diversifying needs to understand the two assets that they are buying or selling.
For instance, if you want to go short gold and long EUR/USD, you need to understand the fundamentals in gold, Eurozone, and United States. It is also important to understand cycles involved in the ‘assets’ that you are trading.
A lot of research materials is available online:
- The economic calendar can help you identify the times to make entries and the times to exit
- The earnings calendar can give you a clear picture of what to expect in a certain company
- Various speeches and interviews (like podcast) from influential people can help you gain insights on the assets you want to trade on.
It is important to note that the power of diversification is not for everyone.
There are people who have attained a lot of success without taking this route. These are people who make money by buying or selling individual assets.
Therefore, if you find success in diversification, you can go ahead and use it. As we have explained in our previous articles, the key to success in day trading is finding a simple strategy that you understand!
So, you should not try something you find complicated.
Always remember there are traders who have become very successful by following a very simple strategy, and you can do it too.