How to Diversify Your Forex Trading Portfolio to Manage Risk
The forex market is one of the most liquid and, yet, one of the most volatile financial markets in the world. That volatility, however, serves up plenty of profit opportunities for traders of all sorts—if they can manage the risk. Most forex traders understand that the leverage involved in trading currencies is a double-edged sword, with the potential to yield soaring profits as well as to inflict deep losses on trading accounts. But for many traders, understanding leverage on an intellectual level does not guarantee that they will avoid becoming emotionally unhinged when faced with the prospect of losing a significant amount of money.
Diversification in the foreign exchange is a key method for reducing and eliminating the risks taken. Unlike other investment vehicles, a forex account can't be diversified by year, quarter, or month. However, you can still construct a diversified account by investing in various currency pairs, choosing different trading strategies, and making trades in various timeframes. Complementary financial instruments can also add a layer of protection to your account.
What is Portfolio Diversification
Portfolio diversification represents the strategic practice of spreading investment risk across multiple, uncorrelated assets and approaches to reduce overall portfolio volatility. In forex trading, this concept extends far beyond simply trading different currency pairs—it encompasses a comprehensive approach to asset allocation that includes various instruments, strategies, and timeframes.
Currency Pair Diversification: Rather than concentrating on a single pair like EUR/USD, diversified traders spread their exposure across major pairs (EUR/USD, GBP/USD, USD/JPY), cross pairs (EUR/GBP, AUD/JPY), and carefully selected emerging market currencies. This approach reduces exposure to individual currency-specific risks and central bank policies.
Why is Diversification Crucial for Forex Trading
The euro's stay against the Swiss franc was very short-lived. On January 15, 2015, when the Swiss National Bank removed its currency peg, traders holding only EUR/CHF positions found themselves facing huge margin calls and saw their account balances drop close to zero in a matter of minutes. The rich-get-richer, poor-get-poorer nature of many concentrated trading strategies hit home with this sudden move. Though many pair traders consider themselves to be market-neutral, being neutral in the EUR/CHF also means being neutral in the euro itself, a rather imprudent stance given the currency-risk/sovereign-debt link.
Concentration risk in forex trading manifests when traders focus exclusively on familiar pairs or strategies. In the March 2020 market turmoil, risk-off sentiment affected traders holding commodity currencies like the AUD and CAD. These traders concentrated in the aforementioned currencies and suffered because of that concentration.
How to Achieve Effective Diversification in Forex Trading
Start with core currency pairs (EUR/USD, GBP/USD, USD/JPY, USD/CHF), which provide the best liquidity, the best spreads, and the most trading opportunities. Add cross pairs (like EUR/GBP, AUD/JPY, and GBP/JPY) to give your portfolio more diversity. Carefully and in small amounts, add some emerging market currencies (like ZAR, TRY, etc.), which can really hit it big for you in an uptrend but which are far more risky and less liquid.
Today's trading strategy blends far more than just currencies. It is a far broader mix that incorporates commodities and shares as looks to catch the big market moves that affect currencies.Take gold and silver. Suitable for trading as contracts for difference, they work as inflation hedges and serve to some degree as safe havens. Their relationships with currencies make trading them on that basis a suitable part of a modern currency trading strategy.
Conclusion
One of the most fundamental yet sophisticated risk management methods in currency trading is Forex diversification. This guide has taken you through the idea of proper diversification—how it goes well beyond trading a few different currency pairs, and instead revolves around a more systematic, and definitely more sensible, approach to portfolio construction in the Forex market. This type of construction allows for a mix of not only currency pairs, but also different types of trading strategies, along with different timeframes for holding those trades. It even allows for a bit of ongoing optimization.
For more info:-
Comments
Post a Comment