Diversification: A Valuable Tool in the Day Trader’s Trading Toolbox

In the world of investing, “diversification” 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 trading professionals know the advantage of diversification which is why diversification is a key 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 good investments will outweigh the bad ones.

The good news is that the advantages that diversification brings to your 401k are the same advantages that diversification offers your day-to-day trading. The key to successful diversification is “doing it right”. Diversification on the day trading level is more than just trading a variety of markets; rather, 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 actually 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.

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? Obviously traders already know that there are three dominant 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?

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 method 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 is the trading equivalent of trying to put a square peg in a hole. When the hole is square, the peg fits fine, but when the hole is round…

After a while most traders scrap their system and look for a new one which starts the whole cycle over again, usually with the same end 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 that 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.

A simple 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 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 individual signal generators is clarity. If you are going to be looking for three types of trading signals you need absolute clarity in order 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 complex decisions. The simpler and more straightforward your signals are the better your results will be.

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; rather 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!

For more from Erich, visit the Indicator Warehouse for additional futures resources and NinjaTrader Indicators.