As the age-old adage goes, never keep all your eggs in one basket. In the same way, forex traders should look to diversify their trades, instead of putting all their money in one currency pair or trade. This is what increases the chances of survival, even during highly volatile markets. Diversification is a key element in managing risk in the forex market.
Risk diversification is a process that allows traders to mitigate the risk of huge losses in case the market suddenly moves downwards. Each currency pair entails a different market and the correlation between these markets offers sufficient scope for diversification.
Understanding the correlation between different currency pairs and even individual currencies is the most important factor in risk diversification. Correlations are complex in the forex market and can lead to overtrading and overexposure. Intra-market and inter-market correlations are common in this market.
Here’s a look at some key things to consider when diversifying in the forex market.
The first step in diversifying your portfolio is to divide your money. Traders may consider using the Pareto principle (80-20 split) for dividing their money. Pareto said that 20% actions lead to almost 80% of the effects. In risk diversification, 20% of one’s capital provides flexibility. Traders can figure out new trading strategies and have a buffer and free margin for recently entered trades with this amount. The remaining 80% can be invested in trading. This divides your trading account into cash and the money allocated for trading.
The US dollar is the world’s reserve currency and holds a key position in forex trading. It divides currency pairs into two parts: majors and cross pairs. Major pairs are the ones that have the US dollar as one of the currencies. For example, USD/CAD, GBP/USD and EUR/USD. CAD/JPY, EUR/GBP and NZD/CHF are examples of cross pairs. A trader may consider diversifying risk by investing in both major and cross pairs.
These two categories have different degrees of volatility, so trading strategies that need to be adopted for trading each type of pair will also vary. Major pairs trend more than cross pairs, so traders may consider dividing their money into 60-40, instead of 50-50, with a majority of the portion being allocated to major pairs.
Actively monitoring economic news or major world events can play a vital role in the decisions you make when to diversify your forex trading account. Traders may consider entering or exiting trading positions based on current events affecting the forex market.
For example, if any major announcement by the US government regarding its ties to China is due, a trader might consider only trading cross pairs or investing in just one or two major pairs, to avoid huge losses.
Along with the strategy you adopt for risk diversification, you need to consider some things to capitalise on the potential of diversification.
While diversifying your forex trading account, consider investing in a small portfolio. This will help you better monitor the changes in the market and mitigate risks. Investing in two or three instruments may be considered by traders for risk diversification. For example, you can buy the GBP/JPY, sell the EUR/USD and sell the AUD/CAD. A small portfolio will also provide you time to analyse the market conditions, study fundamentals and other details related to trading.
Due diligence, by analysing the fundamentals of a currency pair, is the first thing that should be done, before entering or exiting a position in a diversified portfolio. You may consider using an economic calendar and other sources of information for analysing the market. For example, if you intend to invest in the GBP, you should study and understand the economic factors affecting in the United Kingdom. Brexit is scheduled for March 29, 2019. Which deal is finalised for Brexit will impact the nation’s currency. You may also consider using technical analysis, along with fundamental analysis, to gain a better idea about whether to buy or sell a currency pair.
The ultimate goal of risk diversification is to mitigate the losses due to unfavourable movements in the forex market. There can be times when all the pairs you own could lead to losses. In this situation, you need to actively track price movements to prevent getting a margin call from the broker. For this, you could consider calculating your risk exposure and placing stop losses at appropriate positions to prevent further losses.
Using smaller lot sizes can help reduce risks too. Larger lot sizes mean higher exposure, which in turn means both higher returns and higher losses.
You may consider exiting a position after you have achieved your target. Sticking to a trade beyond the take profit level could lead to losses. Generally, the highest returns are generated by a single currency pair. But, during times of high volatility and uncertainty, you may consider placing two trades that aren’t correlated to reduce the risk of overall loss.
Inter-market correlations are also a part of risk diversification in the forex market.
The price of oil and the Canadian dollar are directly correlated. This means that oil prices will rarely fall if the price of CAD is rising, except when the Canadian central bank changes its monetary policy.
Globally, gold is generally priced in USD. Gold (XAU/USD) and AUD/USD are highly correlated due to the influence of gold mining on the GDP of Australia.
The Japanese yen has a very low interest rate and is the most desired currency for borrowing. Traders usually borrow in yen, convert it into USD and then buy in the US stock market.
Risk diversification is highly dependent on correlations and is one of the most effective strategies to adopt while investing in the most liquid market in the world. Improper understanding of correlations may lead to over-diversification. Traders who are able to figure out the right balance will have an edge when trading forex.