Investing Mantra: Why More Than One Trading Strategy Should Be Implemented

Diversification is a common strategy in investing. It helps reduce portfolio risk while allowing the investor to participate in more than one stock.

The utility of diversification is most felt when the market is sideways or falling. A concentrated portfolio ends up having a big hit at those times.

This is one of the reasons why passive index investing is making a comeback. An index offers the benefit of diversification, plus it features the best companies in each sector.

Therefore, in the event of a recovery, the best managed companies are usually the first to come out of the block. However, diversification is not that common when it comes to trading.

In trading, most traders, especially struggling ones, continue to trade the same way regardless of market conditions.

It is difficult for most traders to understand that no one strategy will work all the time. A trending market will be good for any trend following trading strategy, while a flat market will be a good playing field for price action traders and option sellers.

As in cricket, where one cannot play the same stroke regardless of the ball that comes to him, trading also requires one to change one’s feel depending on market conditions.

Unfortunately, not all traders have the acumen to understand the condition of the market and make changes to their strategy at short notice.

This is especially true in the current scenario where more and more traders including retail traders are using algorithm trading. They keep doing the same trade without worrying about market conditions.

To avoid a series of losses during such times, professional traders have diversified their trading strategy.

While some adapt to market conditions and trade accordingly, others prefer to run multiple strategies at the same time.

The inability to predict the direction of the market results in the construction of strategies that have an advantage. Each strategy will have a different edge that will work in different market conditions and times.

The strategies used are those that give minor losses when the trader is wrong and generous profits when his trades are winning.

Strategies diversification should not be just for the sake of it. There is a scientific way to do it. Proprietary trading houses trade uncorrelated trading strategies.

They would be trading strategies that make money in a highly volatile market, while at the same time taking option selling strategies that work better in a non-trending market.

When selecting more than one strategy, the trader should backtest and see if they do not correlate. When one strategy generates superior returns, the others may give lower returns or a small loss.

Diversification can also be in terms of markets, stocks, or in terms of time.

A common strategy that best explains diversification is the long-short strategy. Here the trader goes long on a stock that is the strongest and short on the weakest stock in his universe. These actions can be from the same sector or from different ones.

Another form of diversification is taken in terms of time. Here, the trader takes position either by looking at various time frames or by starting a trade at different times.

As an example, the short straddle trade at 09:20 is a very common trade that is taken by retail traders. Until late, these exchanges have not been giving consistent returns.

Many traders now take the same short straddle trade at various time intervals, such as after every hour. This helps prevent a large drawdown and also spreads the capital into smaller trades spread out throughout the day.

Trading houses are known to take 7-8 trading strategies simultaneously which helps them to flatten their profit curve. Although there may not be one scenario where all of your strategies are profitable, diversification helps during drawdowns.

There will always be some strategy that will cushion the fall and prevent the portfolio from being hit hard. Since a trader’s primary goal is to protect capital from him, diversification helps smooth out body blows.

(The author is president of TradeSmart)

(Disclaimer: The recommendations, suggestions, points of view and opinions given by the experts are their own. These do not represent the views of the Economic Times)

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