Length : 2.30 Minutes
Risk Management (RM) - Diversification (Part 1)
In order to remain successful in the business of forex trading regardless of all kinds of changes in market dynamics, one needs to clearly understand the concept of risk and applies it effectively.
The main reason why majority of the traders eventually fail to be profitable in the long run is due to the fact that they take the importance of risk management too lightly. Many of them either take too much or too little risk, because their definitions of risk are unclear and subjectively based on emotional conditioning.
There are few main misconceptions when it comes to some important aspects of RM such as diversification, drawdowns and position sizing. In order to implement a correct and adequate level of risk one must clearly understand what each of these aspects can contribute to build an effective RM strategy.
For many traders diversifications simply means to enter multiple positions involving multiple currency pairs at the same time. Conventionally, we have been told that diversification is supposed to reduce risk exposure. As such, most amateur traders for the sake of diversifying trade dozens of different currency pairs at the same time and they end up sinking faster due to over diversification. Because they often do not realise that diversification achieves its risk reducing benefits only if there is little correlation between the pairs one trades on.
For example, let’s say you risk 1% of your account per trade and you decide to go EUR/USD and AUD/USD short, and USD/JPY long. In this case you are increasing your risk exposure because somewhat USD value plays an important role in the success or failure of all these three trades as all of them are involved with USD.
In fact, in order for the trades to be profitable USD has to appreciate in value against the EUR, AUD and JPY. Therefore technically your risk level is no longer 1%. All three could go against you if there is a strong increase in the USD value.
To sum up, diversification will only reduce your risk exposure if it is implemented correctly. In fact, if currency pairs are not well diversify, diversification could increase your risk level significantly. Thus, it is important to do not trade a same currency more than once, but if you do, adjust your risk level per each trades involving the same currency accordingly.