Diversifying a Currency Trading Portfolio
As a trader, the old saying of not putting all your eggs in one basket comes in handy. While trading in one currency pair exposes you to better returns, the risks are usually high. Therefore, diversification is very important but it must be done so in the right manner regardless of the strategy that you are using. In this article, I will look at the topic of diversification and how you need to approach it.
What is diversification?
Diversification is simply a process where a trader (or investor) buys a number of assets to caution a downward trend. For instance, in stock trading, an investor can buy shares of Apple, Nestle, and Blackrock. The hope of the investor is that the shares will all go up. However, in case one or two company falls and the other company rises, then the loss will be mitigated.
Many day traders prefer to trade a single currency pair. For instance, there are those traders who believe in trading the EURUSD pair. The benefit of this is that it gives the traders an opportunity to study and understand the pair movements. Investing in a single pair also gives the traders a chance to avoid making simple mistakes. As I have stated in my previous articles, currency charts are moved by very many factors which a single trader might not be able to follow on a daily basis.
Keep the portfolio small
In creating a diversified account, I recommend that you keep a small portfolio. Having a small portfolio will give you a chance to mitigate risks and have a heads on in your portfolio. To the maximum, I recommend that you have a diversified portfolio of two or three instruments. For instance, you can sell EURUSD, buy GBPJPY and sell AUDCAD. There are a number of advantages of keeping such a small portfolio. One, it gives you a chance to monitor the portfolio and act on it accordingly. Two, having such a portfolio gives you an opportunity to assess the general environment, study the fundamentals and the technical details of the trades.
Before making an entry or exit of a diversified portfolio, the first thing you must always do due diligence by studying the fundamental analysis of the currency. In this, you should use the economic calendar and all the news sources available to you to study the market. For instance, if you are making a dollar purchase, you must understand the macro economic factors in the United States. In September or November, the FOMC is expected to announce the foreign exchange decision. This decision will be on whether to raise the interest rates or keep them the same. Now, before making the dollar purchase, you must be aware of these issues and how they will affect your portfolio.
In addition, you must combine your fundamental knowledge on each pair with the technical analysis. Technical analysis is simply the study of the charts using mathematical models. This analysis helps you to determine the exact position to buy or sell an instrument.
Managing the diversified account
As stated above, the goal of managing a diversified account is to mitigate risks of one currency pair. However, at times, all the currency pairs might disappoint. Using the above example, the EURUSD might go up, the GBPJPY low and AUDCAD high. In this situation, you should watch your account carefully to avoid the margin call situation.
To reduce risks, the first thing you should do is to calculate the risk exposure of the account and place stop losses where appropriate. As a rule, you should risk only 2% of the total funds in your account. A stop loss will help you prevent further losses up to the place where you can take losses.
The next thing you should do to mitigate risks is to use small lot sizes. The fact is that you can make a lot of money by putting a higher lot size. However, a high lot size exposes you to insurmountable risks.
Finally, you should always get out of the trade once your target has been reached. Continued stay in a trade can lead to losses.
In most cases, most of my most profitable trades have been on a single currency pair. However, in times of excess uncertainty and volatility, I try to cushion my trades by placing 2 trades. Before you do this, I recommend that you take time to understand each currency and all the market moving information.