The forex has many nuances like heavy leverage and unique margin. A lack of understanding of these factors has lead many new forex traders to empty their trading accounts. Building solid rules and managing consistent trading methods are key in this market. Learn what you need to know to profit in this chapter.
There are two ways to look at asset allocation (the way you divide your investments) and diversification as a forex trader: you can invest in multiple markets and you can diversify your forex positions and pairs.
Investing in Multiple Markets
The first way to diversify is to make sure you are not exclusively invested in a single asset class. For example, being solely invested in the forex, 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.
Diversify Your Forex Positions and Pairs
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 and lead to losses.
Start Mixing it Up
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 demonstration.
Asset Class Diversification
Investors usually 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 it would not be helpful for investors that are actively trading the market using a short-term time frame. This 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 Percent Equities: Could be the SPY (SPDR S&P 500 ETF) or an equity-market futures contract
20 Percent Cash and Equivalents: Cash is king, and in a pinch, 90-day treasuries can be even better
25 Percent Forex Strategies: Long-term and short-term trading/investing strategies
30 Percent Fixed Income / Bonds: Exchange-traded funds (ETFs) or managed funds can be a great alternative and can be leveraged.
Here’s a chart of a heavily forex-weighted asset-class diversified portfolio:
Asset Class Diversification
In the video demonstration, we cover a few specific ideas, but you can explore on your own to see why even professional managers will allocate their risk across markets.
Forex Strategy Diversification
While investing in one trade at a time is where a lot of new forex 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.
Here’s a very simple sample forex portfolio breakdown:
Forex Asset Diversification
Tips for Avoiding Systemic Risk
1. Consider using consistent position sizing when planning your trade
2. Using the same currency in too many pairs may increase your risk exposure
3. Neutralize the USD, EUR and JPY by mixing the crosses into your trading
4. Learn to hedge your positions with options or manage your risk with adequate stops
Source:www.learningmarkets.com
