Welcome back, traders! In this lesson, we will explore how to apply the principle of diversification to manage risk effectively within Deriv’s Volatility Indices. Understanding and implementing these strategies can significantly enhance your trading performance while minimizing potential losses.
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Understanding Diversification

Diversification is a cornerstone of effective risk management. In the context of forex trading, particularly with Volatility Indices, it involves spreading your capital across different indices and trades rather than concentrating on a single market. This approach safeguards your portfolio against excessive exposure to specific market movements and ultimately reduces overall risk.
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Risk Parity Strategy

A crucial method of managing risk is the Risk Parity strategy, which aims to balance risk across multiple assets. The core idea is to allocate your trading capital so that each trade contributes equally to the overall risk of your portfolio.

When trading Volatility Indices, you can implement this strategy by allocating capital to different indices based on their respective volatility levels. For instance, you would allocate more capital to less volatile indices like Volatility 10, and less capital to more volatile indices like Volatility 100.

By doing so, you ensure that no single index excessively impacts your overall risk profile.
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Calculating Capital Allocation

To determine the appropriate amount to trade for each index, follow these steps based on their volatility levels:

1. Identify the Volatility of Each Index:
   
   • Volatility 10 Index: 10% annual volatility
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   • Volatility 50 Index: 50% annual volatility
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   • Volatility 100 Index: 100% annual volatility
     
     
2. Calculate the Weight for Each Index:
   
   • Use the formula:
     Weight=1/Volatility
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   • For each index:
     
     • Volatility 10: 1/0.10=10
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     • Volatility 50: 1/0.50=2
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     • Volatility 100: 1/1.00=1
       
       
3. Sum of Inverse Volatilities:
   
   • Total: 10+2+1=13
     
     
4. Determine Capital Allocation Proportions:
   
   • Calculate the proportion of total capital allocated to each index:
     
     • Volatility 10: 10/13=0.769 (76.9%)
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     • Volatility 50: 2/13=0.154 (15.4%)
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     • Volatility 100: 1/13=0.077 (7.7%)

Adjusting for Leverage

Before allocating capital based on these percentages, it's crucial to consider how leverage impacts your effective exposure. Leverage can amplify both potential gains and losses, altering the actual risk associated with each trade.

To adjust for leverage, multiply the allocated capital by the leverage factor for each index. For example, with a total trading capital of $10,000 and given leverage:

• Volatility 10 Index (Leverage 5000):
  $10,000×0.769×5000=$38,450,000
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• Volatility 50 Index (Leverage 2500):
  $10,000×0.154×2500=$3,850,000
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• Volatility 100 Index (Leverage 1000):
  $10,000×0.077×1000=$770,000

These calculations determine your effective exposure for each index based on volatility and leverage, helping to balance the contribution of each trade to your overall risk.
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Conclusion

In conclusion, implementing proactive risk management strategies through diversification is essential for successful trading in Volatility Indices. By applying the principles discussed—such as risk parity and careful capital allocation—you can better manage exposure and protect your trading portfolio.

We strongly encourage you to apply and fine-tune these strategies in a demo account before shifting to live trading. This practice will help refine your techniques while keeping risk management at the core of your approach.