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markets. As a trader examines the additional markets it could be at the expense of the original market, consequently reducing the overall performance. A proper balance is required to reduce the amount of risk that the equity is subject to. A trader must use contracts that have enough liquidity and are not correlated. The cost of not diversifying enough is a high level of avoidable risk. The cost of too much diversification is reduced performance, caused by excessive unavoidable risk. |
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However, if the markets traded are highly correlated and cannot be reduced in number for whatever reason, the trader must reduce the number of contracts traded. For example, if you are trading one contract each of the German mark, British pound, Swiss franc, and Australian dollar, then as far as risk control is concerned you could be trading just four contracts in one market instead of one contract in four markets. This is because currencies are usually positively or negatively correlated. In other words, the amount of leverage used in a highly correlated portfolio should be adjusted down when compared with a portfolio consisting of diversified markets. |
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Trading leverage is more commonly defined as the number of contracts traded in each market, and should be adjusted upward or downward so the amount of equity risked is not more than 3 percent. More on this later. |
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Time Frame Diversification |
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Overall risk can be reduced by developing a methodology that examines the price action of the same market while utilizing different time frames and different entry and exit times. In other words, a trader could have one multiple contract entry, and then have multiple exits based upon applying the trading methodology to different time frames. Alternatively a trader could have multiple entries in the same contract, and use one common exit. For example, a trader could go long ten corn contracts, and then exit two contracts based upon the price action of a 5-minute chart. The trader could then exit another two contracts based upon the price action of an hourly chart, eventually exiting the other six contracts based upon the price action of the daily, weekly, and monthly chart. By doing this, the trader is able to catch the very short move and the longer-term movein other words, to stay with the trend. Likewise, a trader could scale into a large position using multiple time frames. |
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The only variable is the time frame used; the trader's methodology and the underlying contract remain the same. |
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Methodology Diversification |
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A trader utilizing different methodologies is diversifying risk. For example, a methodology that works well in a trending market could underperform in a nontrending market. By allocating |
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