Portfolio diversification is a way of dealing with market risks beyond your control as a trader or investor. The concept of diversification has been a part of the investment world from the very beginning. Because an investor takes a long-term risk by holding on to a position for an extended period. But trading is quite different from it, but the need for diversification was still there due to the volatile nature of financial markets. Slowly, the idea of diversification was also adopted by traders who bought and sold various market instruments.
Since the forex market is the largest trading market in the world, traders dealing with volatile currencies should also pay attention to diversification to mitigate the risk. This article will discuss the perks of portfolio diversification in forex trading and how to do it best.
Meaning of Diversification in Forex Trading
The essence of diversification is putting your eggs in different baskets to avoid losing them all in unfavorable circumstances. Those who keep all their eggs in one basket will have to worry about the safety of that one basket all the time. But when they are divided into different baskets, the chances of losing them all are usually reduced to zero. The same theory of diversification is applied in forex trading as well.
The rules of diversification are essential, as they tell us to have backup plans for every plan. Trying out different options simultaneously is a form of diversification, be it the currency pairs chosen as trading instruments, strategies followed for trading, operating other trading accounts, or even delegating the portfolio management task to someone with more experience and expertise.
In short, diversification can be done in many different ways, but the end goal remains the same, irrespective of the method used. You are trying to reduce your risk of loss by diversifying your funds. This increases your potential for profits as your funds are not locked in just one currency pair or one type of trading. Even if you suffer losses in some trades, others can still be profitable. To calculate your overall profits, you can use a profit calculator. It is essential to have precise data on the profits and losses to know where you stand as a trader.
Practical Methods for Forex Trading Portfolio Diversification
1. Trade With Different Currency Pairs – This is one of the best ways to diversify forex trading. In the forex market, you can see different currency pairs with different characteristics. You can see teams that are less volatile and thus less risky. But such couples also have limited potential for profits. On the other hand, the highly volatile pairs enhance the profit potential but add up to the risk.
You can also see pairs that are correlated with one another moving in the same or opposite direction based on the type of correlation. Understanding currency correlation is essential for proper diversification in forex trading because if you trade two positively correlated pairs, the risk can increase, invalidating the very goal of diversification.
Most beginners are advised to start trading with one central pair only to make things easier and minimize the risk. But as you gain more experience in the market, you must be open to trading with different currency pairs as a means of diversification. So, you must take some time to study other currency pairs and add the best ones for your portfolio as per your risk tolerance and profit targets.
2. Follow the 80/20 Rule – You might have heard about the Pareto Principle, which is about following the 80/20 rule. Forex traders can follow this rule for the diversification of portfolios. The government is based on the theory that 80% of what we do contributes 20% towards the results. The rest of the 80% of results come from the 20% of what we do.
This rule can be applied by splitting your trading capital or funds into 80% and 20%. You must have heard about keeping a free margin in your account as a safety measure. The more free margin you have, the more safe you feel as a trader. It would help if you did not use more than 20% of your funds for trading. The rest of the 80% can be kept as a reserve.
The 20% of funds you use for trading will bring 80% of results, contributing towards the growth of your account with profits. In the worst-case scenario, you will also be safe, as you will only lose 20% of your funds if the market moves against you. This rule of diversification is crucial for safeguarding your capital.
3. Try Different Strategies – The golden rule of trading tells us to stick to our trading plan or strategy till the end without any deviation. But we can still get stuck with one project that may fail in the fast-moving forex market. Just figure out the market and trade accordingly. If the market is choppy, try to gain a few pips and exit the works instead of waiting for a significant movement and losing. You can use a pip calculator to determine the pips you should target on a trading day.
Don’t limit your potential by relying on just one strategy without any changes. You need to learn about different trading styles and experiment as and when required. I will never suggest switching from one system to another without reason, but be prepared to switch if the situation demands.
You can also try out different methods of analysis, different sets of tools, and different approaches to trading. Try out various time frames, trade setups, and techniques; sticking with one will make you stagnant as a trader in the long run. So don’t be afraid to try new things and trade responsibly.
4. Trade Different Sessions – As you may already know, the forex market runs round the clock with four major trading sessions, following different time zones as the currency market is very global and traders from all parts of the world engage in trading. Traders follow Tokyo, London, Sydney, and New York time zones per their preference.
The Tokyo session is targeted towards Asian traders, and the London session is the best time for traders from the EU. The Sydney session is catered towards Australian traders; American traders are most active during the New York session. One more key takeaway is session overlaps, which provide the most trading opportunities due to high trade volume and liquidity.
The overlap of London and New York sessions is ideal for anyone who trades significant pairs like EUR/USD. Here, the diversification is done by selling different sessions to tap into various trading opportunities. Each trading session has its uniqueness, and trying out other sessions allows you to find the best time to trade.
Perks of Portfolio Diversification in the Forex Market
- More Trading Opportunities – Those with a diversified trading portfolio will find many more opportunities than those without diversification. More opportunities also result in more potential for profits. Hence, your chances of success in forex trading will also go up with diversification.
- Limits Account Drawdown – As we mentioned before, diversification allows us to reduce potential losses, and therefore, you can easily keep the overall account drawdown within limits.
- Managing the Volatility Risk – Another perk of portfolio diversification is that it allows you to control the risk that comes with market volatility. Since the currency market is highly volatile, coping with the volatility gives you an edge as a trader.
- Less Stress – Diversification is also proven to be beneficial for the mental health of traders as you don’t need to stress much about the outcome of a trade when your funds are well-diversified to mitigate the risks.
Bonus Tip for Diversifying Your Forex Trading Portfolio
One bonus tip for diversification in forex trading is to try it on your demo accounts first. Demo accounts are the best for testing new techniques or strategies, and you should do the same for portfolio diversification. Ensure to incorporate trading tools to be certain about certain values pertaining to trading, like position size, margin, leverage, and more. Trying out trading in a simulated environment before risking any real funds in the trading process will allow you to find the best course of action for building a balanced portfolio.
Final Summary
To sum it up, I want to say that diversification is all about managing the trading account or portfolio so that you don’t suffer from unwanted losses due to the market forces acting against our anticipation. As traders, we do not have any control over the market, but we can always control our own risk by choosing different currency pairs, trying different strategies, and trading other sessions.
Read also: Top Guidance of Forex Trading in Malaysia
