How many times have we heard the advice that we need to diversify our investments? What does that really mean? In past Newsletter articles I have written about the importance of proper money management in stock and options trading. In that context, I have written about making equal dollar trades, or, better yet in my view, making equal percentage trades of our risk money. Obviously, there is some diversification there, but the diversification is among equities or equity options. As a stock or options trader, I normally am diversifying among various companies and various strategies. What about diversifying into various categories of risk? Some investments may literally be risk free as I describe in "Trade Your Way to Wealth" (now available at both Amazon.com and Wiley.com on pre-release) while others may be extremely risky. Diversification among those investments is probably desirable as well. The high risk investments, for example, may also have extremely high reward possibilities while a zero risk trade may have relatively limited potential rewards (though surprisingly high at times). Each of us needs to know the relative risks of strategies and must decide how to apportion those risks within our own investment and trading plans.

One thing, therefore, that I think is worth exploring is diversification of strategies. We may choose to have the bulk of our investments in low or no risk investments, a portion in moderate risk, and some in very high risk positions or strategies. Surprisingly, the high risk strategies may provide the most money, but they also have the greatest potential losses. Preservation of capital is extremely important in my view for unless we do preserve our capital we will have nothing with which to trade. Keeping those ideas in mind, then, we can begin to create a balance among strategies that work for our own personal goals and risk tolerance. This analysis should become a building block for our personal business plan.

Beyond single stock and option strategies, the trader may well decide to trade whole markets or sectors or to diversify into other areas such as futures, real estate, or even gas and oil exploration. In recent years, the expansion of ETFs (Exchange Traded Funds) has enabled many retail traders to trade whole markets such as the SP-500 (SPY) or the Nasdaq 100 (QQQQ) or the Dow 30 Industrials (DIA) using a single ETF rather than having to buy each equity in the index. Similarly, one can now trade whole sectors with one ETF. For example, the financial sector can be traded with XLF and the tech sector with XLK. Trading whole markets or whole sectors have certain advantages over trading single stocks for they are not subject to the same risks as an individual stock and may also be less volatile.

Other ETFs may enable us to trade a commodity index (DBC) and REITS (real estate investment trusts) may enable us to hold positions in various categories of real estate. Often the movement of something like commodities does not correlate with stock market movement so ownership may provide true diversification as well as a possible hedge against a directional movement in the market.

Good Trading!
Bill Kraft

September 22, 2007

Copyright 2007, Makin' Hay, Inc., All Rights Reserved

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