Last updated on August 19th, 2019
To reach the level of a profitable trader there are two opposing views. One is that to be successful you have to specialize by trading in one market alone. The other is that the only way to lasting profits is through diversification.
Whether you decide to specialize or diversify comes down to a number of factors. Each has strengths and weaknesses.
Becoming a Specialization Trader
The most obvious advantage to specialization is that you can focus all attention on just one market, whether that’s a currency pair, a company stock, or a bond sector. There’s certain simplicity in becoming a specialist. The specialist can learn their market inside out because they concentrate all of their time and effort there.
A good specialist will get a sixth sense for the technical and fundamental drivers that influence their world. They will know all of the facets that move the market day by day and month by month. The news flow, data reports, economic factors, and technicals.
An experienced specialist can react to events much faster because they will have a gut feeling that tells them if the market is overshooting or undershooting without having to do an in depth analysis that an outsider would.
That knowledge allows them to step in to make a profit from other people’s inexperience or to sit on the sidelines. This is why firms hiring professional traders nearly always employ them to specialize in certain markets.
Choosing a market
A forex trader who specializes will always have at least two currencies to consider. This is because currencies trade in pairs. For example, a Japanese yen trader will also have to consider the other side of the pair. Perhaps that is Australian dollars, New Zealand dollars or British pounds against the yen.
No currency trader can afford to neglect the United States dollar since it has such an overbearing influence on all currency markets. This means a specialized forex trader always has several things to contend with that are outside of their select niche.
Things are a bit easier for the stock trader. A stock trader who specializes will work one company and trade in those stocks alone. This would normally be a big corporation. Only big cap companies would have enough liquidity and daily range of stock movements for it to be worth the time of a dedicated trader.
The specialized stock trader will become familiar with the company and its background. That includes financials, its product lines, the major shareholders, its competitors, and its risk factors.
They will want to keep informed about every aspect of the company as far as is possible from the outside. They may even attend corporate events like annual general meetings (AGMs). A professional trader might be supported by a research analyst who also specializes on that company.
Bond traders will focus on one specific sector such as treasuries, gilts, high yields, distressed, or emerging markets. Then within those groups there are further sub divisions from time to maturity right down to a particular issue.
Drawbacks of specialization
The first disadvantage of specialization is a lack of opportunity. Whichever market is chosen there will always be times when that market is challenging. It may be flat, or going through a very turbulent or unpredictable period.
There can be long periods where the specialist is inactive. Through boredom or frustration the specialist may then be tempted to stray into markets they’re not familiar with when these seem to be offering easier money. There may be a temptation to take on more risky trades.
The second drawback is that there is little to no diversification. The specialist will trade long or short in his particular market. He may cover those positions with options or through other instruments.
But beyond that there isn’t very much in the way of spreading risk. If the trader is working on a proprietary trading desk then this doesn’t matter so much because risk is spread across the desk. But for a private trader there is no such safety net.
Finally specialists who focus too much can become blinkered over time and risk being blindsided by unforeseen events.
Becoming a Diversified Trader
A diversified trader is a generalist. The generalist sees all markets as interrelated so the idea of specializing in just one makes little sense to them.
The foremost aim of a trader who diversifies is to spread risk. Where the specialist goes deep the generalist goes wide. A trader who diversifies will work a group of markets; sometimes these will have a synergy with one another.
- Currency trader: High yields, commodity currencies, exotics…
- Stock trader: Energy, pharmaceuticals, techs, micro cap, utilities…
- Bonds: Sub investment grade, distressed, high yields, corporate…
- Commodities: Precious metals, industrial metals, energy markets…
As well as across markets, most generalist will diversify their style of trading as well. One strategy may be short, another long, one high risk, the other low.
The diversified trader limits their exposure to a single market and also ensures there are always enough trading opportunities.
Drawbacks of diversification
There’s only such much time available and the trader who diversifies has to spend that time wisely.
They have a lot of different markets to research which makes this kind of approach difficult for a private trader with limited resources. They also need to understand the often subtle interrelationships between markets.
The price of lower risk is lower profit through diversifying. The diversified trader will seldom be able to make the spectacular gains of the specialist. But then they also won’t make the crippling losses either.