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.