Risk Control Method №2: Diversification Among Trading Time Frames and Methods 

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Risk Control Method №2: Diversification Among Trading Time Frames and Methods



We've discussed the importance of determining the type of trading style (trend-following, counter-trend, etc.) and trading time frame (day trading, short-term trading, long-term trading, etc.) that are best for you. Generally, when starting out it is best to settle on one type of trading approach and to focus your efforts there. As traders progress and as their account equity grows, it makes a great deal of sense to consider trading using more than one method. Be aware that you need to have a certain level of experience and expertise in order to apply this approach, since the complexity level rises also.

The primary purpose of using multiple trading methods is to attempt to smooth out the equity fluctuations in your account. What you hope to accomplish is to apply a second method which will, in highly technical terms, "zig" while your other method "zags." Ideally, while one method is experiencing a drawdown, the other method will be generating profits to offset all or at least part of those losses.

The first step is to develop a second trading method that has a realistic probability of making money in the long run in its own right. There is no point in diversifying into a method that is going to be a drain on your trading capital simply for the sake of diversification.

To understand the potential benefits of trading in different time frames, consider the following example of a trader using both a short-term trend-following method and a long-term trend-following method to trade two contracts of each market in a diversified portfolio. Each system uses some method to identify the current market "trend." However, one system is looking at the short-term trend while the other is looking at the long-term trend. For example, one system might use a 10-day moving average of prices to identify the trend and the other system may use a 100-day moving average. At times the two systems will be "in sync." However, because the two systems are looking at the same market in two different ways, at other times one method will say the trend is "up" and the other system will say the trend is "down," or perhaps "neutral." So if the trader trades one contract of a given market based on each system, the possibilities are as follows:

Short-Term Trend

Long-Term Trend

Net Position

UP UP Long 2
UP Neutral Long 1
UP Down Flat
Neutral UP Long 1
Neutral Neutral Flat
Neutral Down Short 1
Down UP Flat
Down Neutral Short 1
Down Down Short 2

Note the effect of various market conditions on the positions held by this trader. The best situation for a trend-follower is for a strong trend to develop—no surprise there. If the short-term and long-term trends are both up or both down, the trader will have his maximum long or short position of long two or short two contracts. Under any other circumstance this trader will have either a reduced position, long*one or short one, or no position at all. If the two trends are not "in sync," or if they are both neutral, the trader will have no position, i.e. no exposure in the market place. This makes perfect intuitive sense. If the trends are not in sync or if both are neutral, why would a trend-follower want a large exposure in the market place anyway?

This is only one example of how trading time frames and methods can be combined. Other examples might be to combine a trend-following approach with a counter-trend approach, or a technical approach with a fundamental approach, etc. Assuming both approaches have positive expectations, the combined equity curve may be far less volatile than either one would be if traded separately.





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