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Diversification is the only free lunch in the market. It comes with benefits and no disadvantages.

However, many traders have no idea what portfolio diversification actually is or how to maximize its benefits. There is more to a diversified portfolio than just a large pool of stocks.

We believe it is easiest to think about diversification in three layers:

1. Horizontal Diversification

Horizontal diversification spreads investment capital across several asset classes.

An investor using horizontal diversification may have market exposure to stocks, bonds, currencies, Treasuries or other asset classes at the same time. Within each of those asset classes, a prudent investor could use vertical diversification to maximize their benefits.

2. Vertical Diversification

Vertical diversification is what you are doing when you invest money allocated to the stocks asset class across several industry groups or within indexed ETFs like the SPDR S&P 500 (SPY), iShares Russell 2000 Index (IWM) or Dow Diamonds Trust (DIA).

This helps limit your exposure to unknown disruptions within individual stocks.

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3. Strategic Diversification

Strategic diversification is a way to think about using more than just “long” positions to invest in the market.

For example, option traders will sell calls against a long position to reduce account volatility. This is known as a “covered call.” (Learn how to trade covered calls.)

Over the long term, reducing volatility in this way has been shown to increase returns and reduce risk. But this is just one example of how to begin to diversify across strategies.

Strategic diversification is the answer to “what’s next?” when thinking about building a diversified portfolio. Many traders start with covered calls and similar strategies, and begin building on that knowledge to create a management plan that improves their ability to achieve better returns with less risk than they could have otherwise.

John Jagerson is a contributor to LearningMarkets.com. To learn more about him, read his bio here.