# Algorithmic Trading Diversification

## Is Diversification A Holy Grail?

Updated, September 2022

Most new traders enter the trading arena with dollar signs in their eyes. They are looking for the one “Holy Grail” strategy that will turn their pipe dreams into reality. This dream is heavily promoted by unscrupulous trading vendors, ones who show only the upside and profitability to trading. Isn’t it amazing how many strategies for sale out there seem to be drawdown free?

Of course, the reality for most traders is just the opposite. Traders try one method or strategy, put all their capital in it, and trade it. When the new system inevitably hits a downturn, those lucky enough to escape with some of their capital simply move on to the next “Holy Grail” they find. And the story repeats, again and again. This phenomenon is one of the many reasons why most traders lose money.

So, this begs the question: “is there a better approach to trading, an alternative to searching for the Holy Grail?” Thankfully, there is, although most people don’t talk about it very much. The better way is summed up with one word – “diversification.” In other words, diversified trading systems. This article explains what diversification is, why it is so valuable, and most importantly, how to achieve it.

Most new traders enter the trading arena with dollar signs in their eyes. They are looking for the one “Holy Grail” strategy that will turn their pipe dreams into reality. This dream is heavily promoted by unscrupulous trading vendors, ones who show only the upside and profitability to trading. Isn’t it amazing how many strategies for sale out there seem to be drawdown free?

Of course, the reality for most traders is just the opposite. Traders try one method or strategy, put all their capital in it, and trade it. When the new system inevitably hits a downturn, those lucky enough to escape with some of their capital simply move on to the next “Holy Grail” they find. And the story repeats, again and again. This phenomenon is one of the many reasons why most traders lose money.

So, this begs the question: “is there a better approach to trading, an alternative to searching for the Holy Grail?” Thankfully, there is, although most people don’t talk about it very much. The better way is summed up with one word – “diversification.” In other words, diversified trading systems. This article explains what diversification is, why it is so valuable, and most importantly, how to achieve it.

## What Is Trading Diversification?

In simple terms, in creating a diversified trading system means that the trader does not rely on one approach to the markets. In stock trading, for example, many traders diversify by trading stocks in different industries or with different degrees of correlation (beta values) to the overall stock market. The benefits of this type of diversification have been well documented in academic research for decades, so most people know about it.

In futures trading, diversification can be achieved in numerous ways. A trader could incorporate various “macro” styles to the same market. For example, a trader could trade Soybeans with a calendar spread trading approach, taking advantage of price changes between old crop year and new crop year pricing differentials. He could also employ an option selling strategy, taking advantage of flat periods in order to collect premium. The trader could also trade Soybean futures directionally, hoping to hop on a trend. Each one of these techniques could be employed simultaneously. Even though all strategies trade Soybeans or its derivatives, the results of each strategy may be completely uncorrelated to the other strategies. That provides diversification.

Another way to diversify in futures is to trade the same strategy with different timeframes (bar sizes), or different markets. A discretionary price action trader could, for example, use that approach to trade uncorrelated markets. An algorithmic trader may employ the same approach, trading the same strategy with different markets. Or, he could trade different strategies with different markets. Each of these approaches could also provide the desired diversification.

The key to diversification, no matter what the market or the type of trader, simply becomes trading multiple different ways.

The reason diversification works so well can be summed up in a simple phrase “profits add, drawdowns do not.” A simple example illustrates this fact. Consider two good, but not great, futures trading strategies, as shown in the figure below. One strategy trades Lean Hogs a different strategy trades the mini S&P. Each strategy on its own is profitable, with of course its own inevitable drawdown. Clearly, neither strategy is a Holy Grail by itself!

In futures trading, diversification can be achieved in numerous ways. A trader could incorporate various “macro” styles to the same market. For example, a trader could trade Soybeans with a calendar spread trading approach, taking advantage of price changes between old crop year and new crop year pricing differentials. He could also employ an option selling strategy, taking advantage of flat periods in order to collect premium. The trader could also trade Soybean futures directionally, hoping to hop on a trend. Each one of these techniques could be employed simultaneously. Even though all strategies trade Soybeans or its derivatives, the results of each strategy may be completely uncorrelated to the other strategies. That provides diversification.

Another way to diversify in futures is to trade the same strategy with different timeframes (bar sizes), or different markets. A discretionary price action trader could, for example, use that approach to trade uncorrelated markets. An algorithmic trader may employ the same approach, trading the same strategy with different markets. Or, he could trade different strategies with different markets. Each of these approaches could also provide the desired diversification.

The key to diversification, no matter what the market or the type of trader, simply becomes trading multiple different ways.

**Why Diversification Is So Powerful**The reason diversification works so well can be summed up in a simple phrase “profits add, drawdowns do not.” A simple example illustrates this fact. Consider two good, but not great, futures trading strategies, as shown in the figure below. One strategy trades Lean Hogs a different strategy trades the mini S&P. Each strategy on its own is profitable, with of course its own inevitable drawdown. Clearly, neither strategy is a Holy Grail by itself!

The real power is trading both of these strategies is in trading them together. The maximum drawdown for the combined portfolio of Hogs and mini S&P is actually less than trading each system by itself, as shown in the table below. While one strategy is in drawdown, the other strategy is reaching new equity highs, and vice versa. Thus, over time the drawdowns are smoothed, while the profits for each simply add together. This is the benefit of diversification.

### Why Diversify?

This drawdown smoothing effect can be improved even more by adding additional trading strategies. As long as the strategies are uncorrelated, or only slightly correlated, the overall account drawdown in percentage terms can be lessened by adding more strategies.

### How To Diversify

The key with achieving diversification is to simultaneously trade uncorrelated strategies. But how does one do that? One way to ensure diversification is to measure the correlation coefficient (R^2) between 2 strategies, as shown in the figure below. This can be done in Excel or with any mathematical software. The lower the correlation coefficient, the more diversification the strategies will provide.

This drawdown smoothing effect can be improved even more by adding additional trading strategies. As long as the strategies are uncorrelated, or only slightly correlated, the overall account drawdown in percentage terms can be lessened by adding more strategies.

The key with achieving diversification is to simultaneously trade uncorrelated strategies. But how does one do that? One way to ensure diversification is to measure the correlation coefficient (R^2) between 2 strategies, as shown in the figure below. This can be done in Excel or with any mathematical software. The lower the correlation coefficient, the more diversification the strategies will provide.

The key with achieving diversification is to simultaneously trade uncorrelated strategies. But how does one do that? One way to ensure diversification is to measure the correlation coefficient (R^2) between 2 strategies, as shown in the figure below. This can be done in Excel or with any mathematical software. The lower the correlation coefficient, the more diversification the strategies will provide.

This method becomes cumbersome, though, when checking the correlation of many strategies. Each strategy has to be checked with every other strategy, and that can take a long time to complete the analysis. Thankfully, a relatively easy alternative exists.

Since the end goal of diversification is to improve the equity curve characteristics, one could simply measure the profit to maximum drawdown ratio of the resulting equity curve. A strategy that improves the overall profit to drawdown performance will be adding diversification to the portfolio – resulting in less drawdown for an equivalent amount of profit.

Since the end goal of diversification is to improve the equity curve characteristics, one could simply measure the profit to maximum drawdown ratio of the resulting equity curve. A strategy that improves the overall profit to drawdown performance will be adding diversification to the portfolio – resulting in less drawdown for an equivalent amount of profit.

## A Great New Way To See Algo Trading Diversification

Two of the biggest questions that come up with diversification are:

**1. How do I know if a new algo strategy is adding to, or subtracting from, my portfolio diversification?**

2. How do I know when I have enough algo strategies to be fully diversified?

2. How do I know when I have enough algo strategies to be fully diversified?

Since these are questions my Strategy Factory students frequently ask, I decided to put together a great new tool. I call it the

**Diversificator™**.

This Excel tool - included at no cost in the Strategy Factory workshop - gives the trader the ability to:

**A. Quickly grab performance data from multiple Tradestation reports, and visualize portfolio equity and drawdown curves**

**B. Check and see if a strategy is adding to diversification, or subtracting from diversification.**

C. Determine how many strategies are needed to achieve diversification.

C. Determine how many strategies are needed to achieve diversification.

This tool does a lot for you with diversification. With it, you can easily see how to achieve and improve your portfolio's diversification.

## Diversified Trading System

Knowing how to evaluate diversification is important, but it is after the fact. How can you know beforehand that a new strategy will be uncorrelated to other strategies? Experience has shown that simply doing things differently usually leads to diversification. For example, a trader can incorporate at least one, and ideally many, of the following differences in order to get a diversified strategy:

- Different strategy parameters
- Different Strategy entirely (different approaches to trend following) - As an example my trading books provide many different example strategies
- Different strategy approach (counter trend or mean reversion versus trend following)
- Different bar length (X minute bars instead of daily bars)
- Different markets (trade some grains, some energies, some currencies, etc)

Any one of these by itself can provide an uncorrelated strategy to an existing strategy. Create a strategy with two or more of these differences, and the diversification can become even more pronounced.

**Drawbacks to Diversification**

As good as diversification is, it is not without its drawbacks. For example, trading multiple strategies requires more capital. A trader with a $5,000 account just does not have enough capital to be well diversified. Second, during times of crisis, all markets may become temporarily highly correlated. This occurred during the 2008-9 Financial Crisis. It could also occur if something dramatic happened, such as the US dollar being devalued. In such a situation, everything could go against the trader all at once.

A final drawback to diversification is that the possible upside performance is limited. A trader concentrated on trading only one strategy has a much better chance at a blockbuster year than a diversified trader, if the concentrated trader’s strategy has a tremendous year. The diversified trader, on the other hand, will likely have some weak performing systems in any given year, which will limit his total account upside. But, this also means that the concentrated trader also has a higher risk of getting blown out, if his strategy has a really bad year. If the downside protection is not required, though, a trader might be better served by remaining non-diversified, and aiming for huge gains.

**Summary**

Many longtime traders will tell you that being diversified is the best way to go. The opposite philosophy, “putting all your eggs in one basket,” is not necessarily the best way to go, especially if the basket could be dropped at any time. Putting your eggs in multiple baskets – in other words, being diversified – lessens the possibility of a catastrophic loss. If a trader is trading 20 strategies, one or two can stop working without it destroying the overall account. A single strategy trader, unfortunately, cannot say the same thing. Being diversified can lead to smoother returns, and less risk of ruin. Many traders find this is an ideal situation.

**About The Author:**Kevin Davey is an award winning private futures, forex and commodities trader. He has been trading for over 25 years.Three consecutive years, Kevin achieved over 100% annual returns in a real time, real money, year long trading contest, finishing in first or second place each of those years.

Kevin is the author of the highly acclaimed book "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: https://kjtradingsystems.com

Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.