The purpose of this series of posts is to provide a manageable list of fundamental trading rules to help you improve your trading process - regardless of your experience level. I will also explain the rationale behind each rule and highlight its significance. Here are the 6th and 7th in a series of 11 rules that will help you improve your returns and reduce your trading losses.
Rule #6: Trade a Wide Range of Securities
If you want to find more trading opportunities and reduce your risk at the same time, broaden your investment universe by trading a wider range of securities and security types.
The average correlation between sector ETFs and the S&P 500 has recently been between 0.80 and 0.90 (correlations range between -1.0 and +1.0). If you do not like the equity market, you are stuck with cash or bonds and both currently offer negative real returns. Those are not very attractive alternatives.
I can't list all possible investment vehicles in a single article, but futures offer a broad selection of liquid markets, with very low correlations among contracts (See Figure 1). There are always trading opportunities in at least one of the futures markets.
In addition, futures have many advantages over stocks:
- Most futures contracts are very liquid and have very low commissions relative to the notional market value of the contracts.
- Most futures contracts trade overnight, reducing overnight gap risk.
- The specific commitment of trader (COT) data is available for every futures contract.
- The seasonal patterns are different and significant for most futures contracts.
- Each futures contract can be traded long or short with no borrowing costs and very low margin requirements.
- Futures offer roughly 10:1 leverage, which is important when using futures contracts for pair (long/short) trading strategies.
Expanding your universe of securities will create more trading opportunities (which will enhance your returns) and provide greater diversification (which will reduce your risk). It is a win-win situation.
Rule #7: Trade Multiple Strategies
Most investors are familiar with the benefits of diversification from owning a portfolio of uncorrelated assets. However, the benefits of strategy diversification are rarely discussed, but are just as powerful.
The three main types of directional strategies are trend following, breakout, and reversal. The two principal strategy frameworks are signal generation and rotational. Signal generation and rotational ranking can even be used together to create a joint framework.
Each of these strategies/frameworks can be used to trade a wide range of different securities. To earn the optimal risk-adjusted return on capital, multiple systematic strategies (of different types) should be used to trade a wide range of securities, preferably securities with low correlations.
Using multiple strategies/frameworks across a wide range of securities will allow you to generate profits in all trading environments, while reducing your level of risk. Even the best strategies will have losing trades. However, by diversifying across different strategies, those losses should be more than offset by profitable trades in your other strategies. As a result, trading multiple strategies should reduce your risk and your portfolio drawdowns.
If you are knowledgeable about options and proficient with option strategies, you could also add non-directional and volatility-based strategies to your repertoire. Most have low correlations with directional approaches, which could further reduce your risk and allow you to generate income in alternative market environments.
Investing the time to develop several strategies for a wide range of securities will help you generate profits in all market environments and should also reduce your risk. As a full-time proprietary trader, I use as many as 20 different strategies to trade stocks, ETFs, options, and futures. Regardless of the equity market environment, I always have multiple open positions, primarily due to the never-ending succession of long and/or short opportunities in the futures markets
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