Correlation, diversification and risk parity

Sizing each trade correctly is only half the job. The other half is how positions combine — because risks that look separate can secretly be the same bet.

Correlation hides concentration

Correlation measures how two assets move together, on a scale from +1 (move identically) to -1 (move exactly opposite), with 0 meaning unrelated. The trap: three positions sized at a careful 1% each look like 3% of total risk, but if all three are highly correlated they behave like a single 3% position. One bad day takes all three down at once.

Long EUR/USD + Long GBP/USD + Long AUD/USD
-> all three are essentially "short the US dollar"
-> a dollar rally hits all three together: not diversified, just leveraged

Diversification done right

Real diversification needs positions that are genuinely uncorrelated or negatively correlated, so a loss in one is often offset by another. Holding twenty things that all rise and fall together is not diversification — it is one big position wearing a disguise. Always ask what your positions have in common, not just how many there are.

Risk parity

Risk parity is an allocation idea that flips the usual approach. Instead of putting equal money into each position, you allocate so that each contributes equal risk. A volatile asset gets a smaller dollar allocation; a calm one gets a larger one — so no single position dominates the portfolio risk.

Equal-money:   50% volatile asset / 50% calm asset
               -> the volatile asset drives almost all the risk
Risk-parity:   smaller % in the volatile asset, larger % in the calm one
               -> each contributes a similar share of total risk

The practical rule

Size each trade to 1-2%, then check the portfolio: cap your total risk across correlated positions, and weight by volatility so one asset cannot quietly dominate. Surviving requires managing the book, not just the trade.