The recent wave of volatility might serve as a reminder of the importance of using a diversified investment trading approach. Here are some tips to avoid possible traps in these choppy markets.
During times of heightened volatility, an investment or trading strategy can be a bit like a golf ball after an errant tee shot. One minute you're flying high, and the next you're plunking into the sand, or worse, a lake. There may be a silver lining, however, because these are exactly the moments that remind us why pursuing diversified investments can be important.
In a year like 2017, when sectors were basically all hitting the green in regulation and the market rally rolled along almost without a break, it's conceivable some investors forgot for a while about the importance of a diversified portfolio. After all, how much attention do you pay to diversification when all your investments are doing well?
However, times like that don't tend to last, as 2018 has showed us, so let's embark on a quick refresher course about some trading mistakes people make and how diversification can help investments weather volatility in the markets. Just remember that diversification and asset allocation do not guarantee against investment loss.
First of all: what's portfolio diversification? We all hear it a lot, but few realize it's more complex than it might seem. You've probably heard the adage, "Don't keep all your eggs in one basket." Many people think they have the diversification game won if they simply make sure their investments are spread among various stock sectors. But for true diversification and potential protection from volatility, it also helps to:
Although the tips above may seem aimed at active traders, long-term investors can also apply them. Let's check several potential obstacles to trading success, and explore how diversified investments might help you chip out of them.
When it comes to trading, many clients feel it's important to keep money flowing in a brokerage account to make new trades or meet expenses. To buy a stock, call, or put, for example, you’ll need to cover requirements. If you use up all your funds on one or two trades, that can mean two things. One, you won’t be able to take advantage of new trading opportunities. And two, you’re potentially putting your entire account value at risk.
For example, if you have $5,000 in a brokerage account and you buy 50 call options for $1 each, plus transaction costs, you’ve used up all available funds. If the stock or index moves lower by the options’ expiration, they might expire worthless. Your account is now worth zero.
If you invest all on any one trade, you put your entire account at risk.
Approach the Green. A smarter approach might be diversifying—trader style—by spreading a percentage of your trading capital over a variety of trades across sectors. That way no single trade can potentially wipe you out. And even if all your trades lose, you’ll still have money left over.
Break it down like this. If you don’t want to risk more than 20% of a $10,000 trading account, then the total risk of all current trades shouldn’t exceed $2,000. Now, diversify that risk over many trades on stocks in different sectors, and possibly even different asset classes. If you expect to be managing 10 trades, each trade should carry less than $200 maximum risk. That way, if all 10 trades lose the maximum, you’re only potentially losing $2,000 plus transaction costs. So you’ll still have approximately $8,000 left over to trade with. Keeping the ball in the fairway, and laying up in front of a hazard, may not make the highlight reel, but it can help keep you in the game.
Some golfers swing hard from the tee trying to reach the green in one shot, but end up slicing into the woods. The trading equivalent can take a few forms, including trading too big or sticking with a bad strategy.
Trading too big can happen even to veterans. You wake up one day and decide a trade is unusually attractive. You say to yourself, “This stock’s so low it can’t go lower.” Or, “The market keeps going up, it’s never gonna drop.” And countless other fantasies.
So you risk two or three times a typical trade allocation because you’re so confident. But, well, you know how this one ends. The stock does go lower, or the market does crash, and turns your big trade into a big loser that that leaves you with empty pockets and perhaps a tree between you and the flag. Reminder: There are no mulligans in trading.
Approach the Green. In addition to rule number one—keeping trades smaller—at a certain point, you may have to cut off a trading strategy altogether. If you’re using a certain logic to identify good spots that turn out not so good, put simply, reevaluate. You may be using a set of technical studies or fundamental indicators predicated on the market moving higher. No matter how well-researched or planned, if your research is yielding nothing but losses when the market stops rallying, it might be time to walk away.
Every strategy can have losing trades. But how many are you willing to take before you find a new strategy? That answer can depend on:
As a rule of thumb, if you’ve lost more than the max loss you identified in rule 1, say more than 20% of your account size, and haven’t had any winning trades in a while, it might be time to drop that strategy and go with something more cautious. Caution can be a good friend during times of increased volatility. Pursuing a diversified investment portfolio can help you avoid losing too much due to any one trade not working out. (For more, see "Portfolio Margin Made Clear" below.)
No matter how fantastic a given market extravaganza, there’s always tomorrow. So don’t try to cram a year’s worth of fun into just 18 holes. You need patience, a daily dose of responding sensibly to fast-changing market conditions, and a fully powered cart that will get you to the next hole.
Approach the Green. If the market doesn’t rise, you’ll need to adjust for the long term, because the market will naturally fluctuate. Volatile times remind us that the market doesn’t always go up, so what works today might not work tomorrow. What works in one set of conditions doesn’t always work in the next. If you only know how to trade a bullish market, but your bullish strategies aren’t working, it might be time to admit you’re in a bear market—or a trading funk. To handle that, you’ll want to stay small in your trades, be active, and stay engaged.
A trading career isn’t built in one expiration or in one earnings cycle. Successful traders look at longer horizons and rely on fundamental rules like these to help make sure the end of a trading funk is a measured, cautious swing away.
If your margin account is worth $125K or more, you might be eligible for portfolio margin*—in a word, more leverage. Portfolio Margin is a method available for qualified accounts for computing required margin for stock and option positions that is based on the risk of the position rather than the fixed percentages of Regulation T and strategy-based margin calculation methods. Portfolio margin uses theoretical option pricing models to calculate the loss of a position at different price points above and below current stock or index price. The largest loss identified is the margin required of the position
Portfolio margin requirements are typically anywhere from 25% to 60% lower than standard margin.
Portfolio margin looks at the theoretical profit and loss on your positions across a wide range of stock prices in one day, while identifying the max theoretical loss and setting that as the margin. Put simply, strategies use up less capital in a portfolio margin account. So you can get more leverage, more diversification, and apply complex hedges like selling index options against a stock portfolio, all while having a larger percentage of your capital available to potentially take advantage of other market opportunities.
But at the 19th hole, don’t consider it a free buffet. Portfolio margin can potentially lead to greater returns, but significantly greater losses, too. Leveraging portfolio margin should be an evolution in your trading career. It’s a strategy, like anything else. So engage it when you’re comfortable and understand how to use it as a way of reducing capital expenses per trade.
Qualified margin accounts can get up to twice the purchasing power of a cash account, but with added risk. Learn the benefits and risks of margin trading.
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*Portfolio Margin will only be approved for accounts of
qualified traders who can support the risks associated with greater leverage
ability. Use of Portfolio Margin involves unique and significant risks,
including increased leverage, which increases the amount of potential loss, and
shortened and stricter time frames for meeting deficiencies, which increase the
risk of involuntary liquidation. Client, account, and position eligibility
requirements exist and approval is not guaranteed. Carefully read the Portfolio Margin Risk Disclosure Statement, Margin Handbook,
and Margin Disclosure Document for specific disclosures and more details. You may also
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It is the client’s obligation to evaluate the risks of portfolio margin when making investment decisions. TD Ameritrade reserves the right at its sole discretion to decline a client the use of portfolio margin. In the event TD Ameritrade decides to terminate a client’s use of portfolio margin, the client’s account may be converted to the standard margin account. The conversion of a portfolio margin account to a margin account may require the liquidation of positions.
Margin trading increases risk of loss and includes the possibility of a forced sale if account equity drops below required levels. Margin is not available in all account types. Margin trading privileges subject to TD Ameritrade review and approval. Carefully review the Margin Handbook and Margin Disclosure Document for more details. Please see our website or contact TD Ameritrade at 800-669-3900 for copies.
Diversification does not eliminate the risk of experiencing investment losses.
It is not possible to invest directly in an index.
Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade. Options involve risk and are not suitable for all investors.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
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