Last Updated on December 17, 2024
“Diversification is the holy grail of investing” – these aren’t our words, but a principle that Ray Dalio, the founder of the world’s biggest hedge fund, follows strictly. The trick, he says, is diversifying in a way that reduces risk without impacting returns. This sounds easier said than done, especially for funded traders who must comply with different account requirements. Drawdown limits, maximum position sizes, and other program-specific rules can make diversification feel like a tightrope walk.
However, it shouldn’t, and in this article, we explore a set of diversification ideas that you can apply within your funded trader account to optimize your returns and minimize risks without breaking the rules.
6 Types of Diversification Strategies For Funded Traders
The principle of diversification is always explained through the mantra, “Don’t put all your eggs in one basket.” However, it doesn’t exactly tell the whole picture.
Let’s think of diversification in the context of dinner preparation. If you only serve steak, it might taste great and be okay for a one-off meal, but, long-term, it can deprive you of essential nutrients and lead to health problems. Instead, you should create a balanced meal where you add vegetables, grains, and nuts. The reason is that each food group serves a different purpose – protein for strength, veggies for vitamins, carbs for energy, and so on.
Similarly, in trading, putting all your capital into one strategy, asset class, or trade setup might work in the short term, but it exposes you to significant risks. Diversifying across different strategies, timeframes, and instruments adds variety, ensuring better long-term resilience, lower risk, and better return prospects – if one asset performs badly, the others in your portfolio can compensate.
So far so good. But what about diversification in the context of funded trading accounts?
The constraints of a funded trading account require you to be creative, disciplined, and adaptable in spreading your risk across instruments, strategies, position sizes, and timeframes in a way that won’t breach different account requirements, such as:
- End-of-the-day drawdown limits: the amount of money by which your current account can go below your highest account balance;
- Daily loss limit: the amount of money you can lose in a single trading day;
- Progression ladder: the maximum number of contracts you can have open at any time.
Now, let’s explore six top diversification strategies and how funded traders can apply them in line with their account requirements.
1. Diversification Across Asset Classes
According to a Morningstar study, an increase in the number of assets in your portfolio from one to four leads to a 50% reduction in portfolio volatility.
Funded trading accounts allow for great freedom when it comes to access to instruments. For example, you can trade futures contracts on equities, forex, commodities, indices, and more. Each asset class has different characteristics and reacts differently to economic events, market news, seasonal trends, and geopolitical developments, offering traders a natural hedge. In that sense, diversifying across these asset classes reduces your exposure to a single market’s volatility. In fact, trading across multiple asset classes is one of the simplest ways to diversify risk.
However, to make the most of these opportunities, your number one priority should be learning how different assets correlate. For this purpose, you can use the so-called correlation matrices – tables that indicate whether two assets have a positive or a negative correlation. You can use free tools such as those from JP Morgan or Guggenheim Investments.
The general rule of thumb is to avoid having too many assets with strong positive correlations since this will reduce your portfolio’s diversification. If you fail to do so and the market goes against you, you will see the positively correlated assets in the red. Ray Dalio explains it best in the following video:
Also, make sure to keep track of relevant news and economic event calendars so that you remain ahead of market developments and react timely.
If you stick with these principles, then you will have a good foundation to build upon.
2. Diversification Across Different Commodities and Assets in Futures Contracts
Even if you are trading only commodity futures contracts, it doesn’t mean you won’t be able to properly diversify. Just the opposite – there are so many different types of commodities that it might be challenging to choose what to go for. From energy and metals to agriculture and more – diversifying can help you capitalize on global economic trends while mitigating sector-specific risks.
For example, energy commodities like crude oil usually follow geopolitical trends.
Metals like gold serve as “safe havens” that can preserve your capital during turbulent times.
Agricultural commodities like wheat or soybeans, for example, can open up seasonal and weather-dependent trading opportunities.
Holding positions across these and other categories spreads risk and ensures profitability isn’t tied to one sector.
However, to make the most out of your commodity trades, keep track of the supply-demand drivers for each asset (e.g., OPEC decisions for oil, inflation for gold, crop reports for agricultural commodities, etc.).
The case is the same when it comes to FX futures contracts, where you can specialize in trading the currencies of developing and developed nations to expand your universe of opportunities.
To improve your performance, it is crucial to get familiar with the specifics of the different currency pairs and how they respond to different economic factors. For example, the major pairs, such as EUR/USD and USD/JPY, have high liquidity and lower spreads. The minor pairs, such as AUD/CAD or GBP/NZD, have less liquidity, but there are more opportunities for larger moves. Most exotic currency pairs, such as USD/ZAR or EUR/TRY, for example, have higher volatility and spreads. Also, make sure to focus on pairs with lower correlation since they react differently to macroeconomic events.
A Tip For Funded Traders
One thing you should remember when diversifying across contracts is following the “Progression Ladder” – the restriction that funded trader programs have on the number of contracts you can open at any point based on your account size. Breaching it can lead to your account being locked.
3. Diversification Across Trading Strategies
No single strategy works in all markets, and relying solely on one trading approach can leave you vulnerable to changing market conditions. Think of strategies as tools in a workshop – a hammer is excellent for nails but useless for screws. The more tools you have, the better equipped you are to handle different tasks.
In that sense, diversifying strategies – such as scalping, swing trading, and trend-following -can help you remain flexible and capable of adapting to different environments. For example:
- Trend-following usually thrives in directional/trending markets where you aim to capitalize on sustained price movements but might not be a wise choice in sideways price movements;
- Scalping can be a good strategy for exploiting short-term volatility but is also not as effective when the trading volumes are low;
- Mean-reversion strategies profit from price corrections (e.g., in choppy markets) mainly when there are overbought or oversold market conditions but are tricky to apply during strong trends.
Try to combine strategies that work in different market conditions. However, note that while having multiple strategies up your sleeves ensures you will be prepared for most or even all market conditions, you shouldn’t trust such setups blindly. Instead, focus on rigorous backtesting – before implementing a new strategy in your funded trading account, backtest it with historical data.
Another thing to note is to allocate capital based on the performance of each strategy. That way, you will be able to dedicate higher capital to strategies that are performing well in current market conditions.
4. Diversification Across Timeframes
There is nothing wrong with specializing in quick-fire, short-term trading or longer timeframes. However, combining both can open up more trading opportunities, reduce risk, and elevate your profit potential. Furthermore, market conditions vary throughout the day, week, and month, and focusing on one timeframe limits your ability to adapt.
So, if you want to experiment with diversification across different timeframes, a good thing to keep in mind is their differences. Here are some pointers to get you started:
- Short timeframes (e.g., 1-minute or 5-minute charts) are suitable for scalping or day trading strategies aiming to capture intraday moves. These timeframes can provide more opportunities to register small but high-frequency gains. However, they also require constant attention and can be energy-draining.
- Medium timeframes (e.g., 4-hour or daily charts) are suitable for swing trading, where you try capturing weekly trends by balancing frequency with predictability. Traders that prefer medium timeframes can sometimes limit themselves to just one or two trades per day.
- Long timeframes (e.g., weekly or monthly charts) are less stressful and allow for strategic trades but require patience and might not always be suitable for your funded trading account rules.
The ability to trade across different timeframes can also help you build more robust trading strategies by allowing you to combine perspectives (e.g., using a longer timeframe for trend confirmation and a lower timeframe for entry/exit points).
However, bear in mind that while a layered approach where you trade on multiple timeframes allows you to capture opportunities across different market cycles, it can be tricky and risky if you aren’t disciplined and capable of following everything going on.
A Tip For Funded Traders
As a funded trader, it is essential to remember that if you decide to trade shorter timeframes, adjusting your risk per trade is important. For example, you can consider allocating less capital to shorter timeframes since they carry higher volatility, and even a single trade can breach your drawdown and daily loss limits.
This type of diversification strategy will also help you comply with the “Maintain Consistency” rule in E2T’s programs. The rule states that throughout your examination, no trading day can account for 30% or more of your total PnL. In other words, it is intended to ensure that your results aren’t due to being lucky on a particular day or market trend but that you know your game and can successfully navigate different market scenarios and timeframes.
5. Diversification Within Position Sizes
Position sizing is the cornerstone of risk management and a top priority for funded trading account holders since it allows them to optimize performance without breaching drawdown limits.
The trick here is to find the optimal balance between small and large positions since both have pros and cons. For example, large positions amplify profits but also magnify losses. Small positions, on the other hand, reduce risk but may not generate meaningful returns.
So, how to find the right balance? While there are no right and wrong answers, a general rule of thumb is to strive to allocate fixed percentages per trade (e.g., 2% of your account equity). The goal is to prioritize making a series of small wins instead of a couple of big ones. That way, the chance that you will breach the maximum drawdown is minimized, while you will still have prospects for good returns over time (profiting from the number of successful trades, not a couple of one-off wins).
Not all traders follow that rule, though. If you feel confident that a particular opportunity can make you good money and want to allocate a bigger percentage to it, go ahead. However, make sure to do so only within stable markets. When there is more volatility, allocate smaller percentages since a single swing can quickly get you below the maximum drawdown limit for your account.
Think of diversifying position sizes in the context of a game of poker – you can’t go all-in on every hand. However, there will be cases where the odds might be in your favor, and it would not be wise to fold.
Instead of percentages, you can also look at position sizing through the lens of the number of contracts. For example, instead of placing a single trade with five contracts on one asset, you can consider buying three contracts on S&P 500 futures (ES), one on crude oil (CL), and one on EUR/USD. This approach spreads risk across different markets while adhering to position size limits.
6. Diversification In Risk Management Tools
As the great Paul Tudor Jones famously said,
The most important rule of trading is to play great defense, not great offense.
So, we couldn’t miss the opportunity to say a few words on how diversifying your risk management toolbox can improve your performance as a funded trader.
Relying only on a single risk management tool (e.g., fixed stop-losses) won’t be optimal for all your trades and different market conditions. However, if you build a bigger arsenal and apply more risk management tools, you will be better positioned to lock in that great defense.
But enough with the theory. Let’s look at the most common practical setup – combining static and dynamic stops. You can use fixed stop-losses when the markets are more turbulent or if there are prospects for more volatility (e.g., news coming overnight) and trailing stops for trending markets.
The idea of dynamic position sizing (e.g., how much you risk per trade) is also relevant here – for opportunities you are more confident about, you can go above the 1-2% rule, and vice-versa.
Time to Roll Up Your Sleeves and Diversify
Remember Warren Buffett’s words:
Risk comes from not knowing what you’re doing.
Diversification is one way (probably the best) to ensure that you know what you are doing. The concept is so essential that it is literally everywhere, and there is a high chance that you might have gotten bored of hearing about it over the years. However, the six strategies that we discussed above show that there are creative ways to think about diversification. Importantly, they will help you better spread the risk and maximize profitability while at the same time being mindful of your program’s rules.
Interested in seeing how these work in practice without risking your capital? What about doing so by making the first steps toward a professional funded trading career? Earn2Trade’s funded trading programs have you covered.
