The Ultimate Trading Risk Management Guide by Burns Steve & Burns Holly

Author:Burns, Steve & Burns, Holly [Burns, Steve]
Language: eng
Format: epub
Publisher: Stolly Media, LLC
Published: 2019-02-14T16:00:00+00:00

8

Dangers of Correlation & Benefits of Diversification

“If you diversify, control your risk, and go with the trend, it just has to work.” – Larry Hite.

M any traders and investors trade in only one asset class, and some only trade one sector or type of stock. The stock market is a popular place for retail traders, and it’s the place to be long in a bull market when there are expectations of increased corporate earnings and the economy is growing. You can do well only trading stocks if you follow the trend or stay out of them when price action doesn’t favor your signals and system.

Stocks have traditionally risen over ten-year periods, beating most other asset classes in the long term. But it’s important to note that just because it’s been that way in the past, doesn’t mean it will stay that way. And stocks aren’t the place to be in 20% bear market corrections, flat price periods, or when the market is volatile.

Success comes from capturing trends inside your trading or investing time frame. The better the entry and the longer the time frame, the better chance you will make money. Stocks don’t always trend, but you can usually find trends if you expand your watch list, systems, and backtests.

In addition to equities, there are forex, futures, bonds, and option contract markets. Trend followers increase their odds of catching outsized trends and increasing profits by trading multiple markets. If you only trade one market or one type of system and price action isn’t lining up with your signals, you’re limiting your possibilities and decreasing your chance of success. Trading markets that are not correlated gives you a wider range of opportunities with different types of price action.

People that trade only stocks have more correlation risk than they realize, especially if they are long only traders. This is great during bull markets, but it can lead to large losses during bear markets. If someone who is employing this strategy is holding ten volatile stocks at the same time and the stock market gaps down, they can be in big trouble. If their stop loss is risking 1% of their capital per stop, and all ten are triggered at the same time, their account is down 10% in one day. If they are risking more of their capital than 1% or have more than ten positions on at one time with the help of leverage or margin, they can lose a substantial amount in a market drawdown. If they are holding six equity positions but also have gold, oil, bonds, or a currency, there is less chance of a significant loss because these assets are not as correlated, and it would be rare for all of them to go against the trader at once. Holding both long and short positions in short selling strategies can help diversify a portfolio and lower correlation risk, because it would be unusual for a short and a long position to go against you at the same time.

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