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I often say that risk control
is one of the most important things that a trader can learn. We see
a lot of talk about stops and position sizing but it almost seems
like forex investors feel like diversification is either a bad idea
or not possible for a currency trader.
What you will
learn.
- Asset class diversification
means investing inside and outside the forex
- Diversifying your
strategies within the forex can help smooth
returns
- Many dealers/brokers offer
other asset classes within the same account
- It is possible to
be diversified and trade actively at the same
time
There are two ways to look at
asset allocation and diversification. The first is to make sure you
are not exclusively invested in a single asset class. For example,
being solely invested in the forex or stocks or bonds leaves you
exposed to systemic risk. Systemic risk is the type of risk that
you can’t get rid of. Systemic risk covers anything from your
account being frozen through insolvency to catastrophic volatility
in a particular market because of an unexpected unknown.
The second way to take
advantage of diversification is by creating variety in the way that
you trade or invest within an asset class. For example, if you are
managing your forex positions one trade at a time, or with only a
single strategy, you are exposing yourself to focused risks without
any way to offset them. This creates volatility within your
account, and account volatility can mess with your trading
mentality.
Here are a few simple ways to
start building a diversification strategy. You will find some
example allocation ideas in this lesson and a little more detail in
the video.
Asset class
diversification
Usually investors will try to
spread their risk into other asset classes. The benefit is that
when one market is not performing well, another market may be doing
much better, and the combined return is much smoother. For example,
owning or trading bonds while some of your money is in the forex
and/or equities can smooth your overall returns.
When we talk about
asset-class diversification, there is a misconception that this
would not be helpful for investors that are actively trading the
market using a short-term time frame. That is incorrect. In fact,
asset class diversification, regardless of your trading timeframe,
has the following benefits:
- It spreads risk across a
larger pool of investments
- It creates an
awareness of the whole financial market
As a forex trader, you know
that changes in equity or commodity prices may impact your forex
trades and could create trading opportunities. Being active in
those other markets can help create an innate awareness of what
market forces are at play in the forex market.
Here is a sample
asset-allocation strategy. The percentages can obviously be changed
to suit your own investment preferences, but hopefully this will
give you a starting place for some ideas.
- 25% Equities: Could be the
SPDRs (Spiders) or an equity-market futures contract
- 20% Cash and equivalents:
Cash is king, and in a pinch, 90-day treasuries can be even
better
- 25% Forex strategies:
Long-term and short-term trading/investing strategies
- 30% Fixed income / bonds:
ETFs or managed funds can be a great alternative and can be
leveraged.
In the video, we will cover a
few specific ideas but you can explore on your own to see why even
professional managers will allocate their risk across
markets.
Strategy
Diversification
While investing in one trade
at a time is where a lot of new traders will start, doing so may
inadvertently expose you to a very concentrated level of systemic
risk. We look at strategy diversification as a mix of long-term and
short-term opportunities. Some strategies that could be used are
long-term and diversified within themselves already. We have some
strategy groups illustrating a few examples of those ideas on the
PFXGlobal.com website. Even within the portion of your portfolio
that you have set aside for active trading, you can benefit by
adhering to the following tips for avoiding too much systemic
risk:
Consider using consistent
position sizing when planning your trade
Using the same currency in
too many pairs may increase your risk exposure
Neutralize the USD, EUR and
JPY by mixing the crosses into your trading
Learn to hedge with options
or manage your risk with adequate stops
Video Archives
For a larger version of the video, right click and
select the full screen option.
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