Diversification is the practice of spreading your account across a broad range of unrelated investments. Just like a football coach strategically places his players across the field-from the keeper at one end to the strikers on the other end-to be prepared to secure the ball wherever it may go, you should be looking to strategically place your money across the Futures market to be prepared to profit from whatever sector of the market that may begin to move.
Diversification can protect your trading portfolio from sudden and disastrous losses. Imagine if you were to take all of your money and buy Futures contracts on crude oil only to see the price of oil turn around and plummet in a single day. It wouldn't take too big of a move to wipe out your entire account. Now imagine if you were to take all of your money and buy a few Futures contracts on crude oil, a few Futures contracts on corn, a few Futures contracts on the S&P 500 and a few Futures contracts on gold. Even if the price of oil fell dramatically-causing you to lose money on that trade-you would still have three other trades that had not been affected by the change in the price of oil.
Of course, you shouldn't invest in random Futures contracts just to diversify your account. You must always believe the trade you are making has the potential to be a profitable trade. But you should look to spread your risk across multiple attractive trades.
Diversification comes in different shapes and sizes. In this section, we will take a look at two ways to profitably diversify your account:
Perhaps the most obvious and straightforward form of diversification is diversifying between various commodities. As mentioned above, chances are low that you will lose money on a crude oil contract, a corn contract, an S&P 500 contract and a gold contract at the same time. These Futures contracts simply aren’t all affected by the same market forces.
Conversely, some Futures contracts are closely related. And if you only invest in closely related Futures contracts, you could lose money on each contract. For instance, crude oil and natural gas are closely related, corn and wheat are closely related, the S&P 500 and the FTSE 100 are closely related and gold and silver are closely related.
Traders who achieve effective commodity diversification look to spread their trades out among the various Futures sectors. Just to review, the following sectors comprise the commodity Futures category:
- Agriculture
- Base Metals
- Energies
- Meats
- Precious Metals
- Softs
The following sectors comprise the financial Futures category:
- Bonds
- Currencies
- Short-term Interest Rates
- Stock Indices
To put it in perspective, you have 10 Futures sectors to choose from when you are a Futures trader. You do not need to limit yourself to just one or two of those sectors. You can trade a contract in the softs sector, the bonds sector, the energies sector and the agriculture sector and diversify your risk.
Naturally, you should conduct a thorough analysis before placing any trade. Remember, you shouldn't diversify among random contracts just for diversity's sake. You should always have a reason to buy or sell a specific contract.
If you are just getting started in your Futures trading, it may take a while before you feel comfortable trading contracts from all 10 Futures sectors, and that is just fine. There is no pressure to invest in everything.
Diversification relates not only to which Futures contracts you choose to buy and sell but also to how you decide to buy or sell those contracts. Strategy diversification can be just as important to your overall success as a Futures trader as commodity diversification.
You have learned many different trading strategies throughout this course. You've learned about trading with price patterns, trading with Fibonacci analysis, trading with technical indicators, trading the news and trading various spread strategies. Now it's time to start using these various strategies.
Imagine you are looking across the different market sectors because you want to maintain a healthy level of commodity diversification, and you notice that the Futures contracts in one of the market sectors (e.g. precious metals) are moving sideways while the Futures contracts in one of the other market sectors (e.g. energies) are moving higher in a strong up trend. Certainly, you could diversify your account and buy some contracts in the precious metals sectors and some contracts in the energies sector and achieve a high level of commodity diversification, but is that really the most effective way to deploy your money into these trades?
Buying the contracts in the energies sector is probably a good idea because those contracts are currently in up trends. However, buying the contracts in the precious metals sectors seems like a waste of time because those contracts are channeling sideways. Perhaps a more effective use of your money would be to implement a spread strategy, like an inter-delivery spread, that takes advantage of Futures contracts that are moving sideways. By doing so, you would not only ensure that you achieve your desired level of commodity diversification but also ensure that you are using the appropriate trading strategy for what the market gives you.
This may seem like a strange comparison, but you should be willing to be more like a little toddler in your Futures trading. If you have ever spent much time with a toddler, you know that toddlers want many different things-like food, toys, and so on-and they are willing to use diverse tactics to get those things-like hugging, crying, yelling, and so on. For instance, if a toddler wants some food, he may start by hugging your leg and asking you for some food. If you don't give him the food he wants, he will most likely switch tactics and start yelling at you. If this tactic doesn't work, he will quickly switch to another tactic, like crying, until you finally give in.
Try taking the same approach with your Futures trading. If you find one strategy isn't working, try another one. If that one doesn't work, try another one. You are only limited by your imagination and your willingness to be flexible.
In the end, if you can diversify your trading across multiple Futures contracts and implement a few different trading strategies to take advantage of whatever circumstances the market is throwing at you, you will find you are well on your way to becoming a successful Futures trader.
Commodity Diversification
