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Gimme a D, Gimme an I…
By Darren Merwitz | July 19, 2007
DIVERSIFICATION. I predict myself posting a lot on this topic. Diversification is undeniably one of the most important areas of any and all investment and trading strategies. And I’m not limiting this to my standard argument that any typical stocks and bonds portfolio needs a forex element for diversification (though it does!). I’m talking about diversification in any and every possible way.
I’ll give a basic example. So lets say you have a basic trending system that buys when the 12 and 26 period moving averages cross. Trading that way may not be a bad idea, but that’s a pretty small basket to put all your eggs in! And who said that 12 and 26 were magical numbers that would predict starts and ends of trends? Why not 20 and 50? Or 50 and 200?
Actually, the mechanics of a trend say that the shorter term moving average has to move faster than the longer term moving average - so all the above stated numbers should work in trending environments. Some better in some situations, and some better in others. So rather than rest the entire success of your account on the shoulders of your strategy using the supposedly magical numbers of 12 and 26, why not spread it out? Say, execute a third of the amount on each of three moving average strategies. And so DIVERSIFYING yourself.
As a trend starts, the 12 and 26 period moving average will trigger the first trade. If the trend picks up steam and continues, eventually the 20 and 50 period moving average strategy will enter into position. And if the trend is strong enough, eventually the 50 and 200 period strategy will enter. This way, the extent that you’re in the move depends on the strength of the move. You’re diversifying yourself between different strengths of the trend and not fully relying on the trend to be the strength and length of one that will have to do well with a 12 and 26 period moving average.
This logic can be extended to every aspect of your strategy. Diversifying between various inputs, different time-frames, different strategies, currencies and so on. You can remove the reliance of your performance on the ups and downs of one over-burdened strategy.
This is obviously a very extensive area and I have barely scratched the surface but my intention is to shed a little light of how diversification can come in any form, as long as it is different to what you’re doing, it has the possibility to add value. Obviously, the strategies you’re adding need to make sense in their own right, but you clearly don’t have to start investing in US Treasuries right away to diversify your forex strategy!
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Topics: Systems Trading Blog |