The usefulness of diversification is most felt when the market is sideways or falling. A concentrated portfolio ends up taking a big hit during such times.
This is one of the reasons why passive index-based investing is picking up. An index offers the benefit of diversification, plus it has the best companies in each sector.
Thus, in case of a recovery, the better-managed companies are normally first off the block. However, diversification is not so common when it comes to trading.
In trading, most traders, especially the ones who are struggling continue to trade the same way irrespective of the market condition.
It is difficult for most traders to understand that no 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 ground for price action traders and option sellers.
As in cricket, where one can not play the same stroke irrespective of the ball that is coming at him, trading also requires one to change tact based on the market condition.
Unfortunately, not every trader has the acumen to understand the market condition and make changes to their strategy on short notice.
This is especially true in the present scenario where increasingly traders, including retail traders, are using algorithm trading. They keep on taking the same trade without bothering about the market condition.
In order to prevent oneself from a series of losses taken during such times, professional traders have been diversifying their trading strategy.
While some adapt to the market condition and trade accordingly, others prefer to run multiple strategies at the same time.
The inability to predict market direction gives rise to building strategies that have an edge. Each strategy will have a different edge that will work under different market conditions and times.
The strategies used are those that give smaller losses when the trader is wrong and generous profits when their trades are winning.
Diversification of strategies should not be for the sake of it. There is a scientific way of doing it. Proprietary trading houses trade non-correlated trading strategies.
They would be taking trades in strategies that make money in a highly volatile market, while simultaneously taking option selling strategies that work best in a non-trending market.
In selecting more than one strategy, the trader needs to backtest and see if these are non-correlating. When one strategy is generating superior returns, the others may give smaller returns or a small loss.
Diversification can also be in terms of markets, stocks, or in terms of time.
One common strategy that best explains diversification is the long-short strategy. Here the trader goes long in a stock that is the strongest and is short on the weakest stock of his universe. These stocks can be from the same sector or different ones.
Another form of diversification is taken in terms of time. Here the trader takes position either by looking at various timeframes or initiating a trade at different times.
As an example, the 09:20 short straddle trade is a very common trade that is adopted by retail traders. Off late these trades have not been giving steady returns.
Many traders now take the same short straddle trade at various time intervals, like after every hour. This helps in preventing from a big drawdown and also distributes capital into smaller trades spread throughout the day.
Trading houses are known to take 7-8 trading strategies simultaneously which helps them in smoothening their profit curve. Though there might not be a scenario where all their strategies will be profitable, diversification helps during drawdowns.
There will always be some strategy that will be cushioning the fall and preventing the portfolio from being severely hit. Since the primary aim of a trader is to protect their capital, diversification helps in softening the body blows.
(The author is Chairman, TradeSmart)
(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)