Forex

Diversification Within An FX Trading Account

A brief look at the different ways in which an FX trader can diversify within their account.

While there are an unlimited number of publications covering the advantages of portfolio diversification, few of them explore the possibilities of trading Forex along with typical stock, bond and real estate investments.  It is even more rare to find theory on diversifying within a FX portfolio.  Although fund managers are very aware of the importance of diversity, speculators often overlook its value.  As we have all come to realize, you can?t expect consistent success by being a conformist. 

As all currency traders know, the Forex market is a great way to hedge the economic risk of a pool of investments.  Studies have even suggested that the Efficient Frontier?s optimal portfolio is actually shifted outward by including commodities.  Meaning that for each additional unit of risk a higher return is attainable.

Because markets are often driven by human emotion and unforeseen events, it is impossible to predict future prices.  Consequently it is important to have a truly diversified portfolio of investment strategies.  The ability to profit without regard to its direction is a priceless advantage over buying stocks.  Investors should be willing to sacrifice some of the upside potential of a pure equity portfolio in order to preserve capital in times of a declining stock market.  This preservation can be done through alternative investments such as futures and Forex trading.

However, all traders that have experienced the treachery of the Forex market will agree that currency trading is challenging.  While the idea of diversifying a portfolio through trading may seem simple?that is far from the case.  In fact, most people that trade FX lose some, most or even all of their original investment. 

The FOREX market allows traders to control massive amounts of leverage with minimal margin requirements, some firms offer as much as 100:1 leverage.  For example, traders can control a $100,000 position with $1,000, or 1%.

Obviously, leverage can be a powerful tool for currency traders but should be seen as a double-edged sword. While leverage does contribute to the risk of a given position, it is necessary in the FOREX market.  This is because the average daily move of a major currency is about 1%, while a stock typically sees much more substantial moves. 

Due to the nature of the currency markets, it is very important that traders diversify within their trading accounts.  The keys to diversification in Forex, is not necessarily buying the Euro and selling the Swiss Franc.  True diversification can be achieved through the use if various trading strategies and talents.   In other words, traders should look to have a portion of their trading account managed by professional traders.  The purpose of this is not to say that professionals will ultimately have better results than you, but is simply for the purpose of diversification.  Regardless of skill all traders will go through periods of winning and losing trades, thus having more that one trader handling your account may decrease some of the volatility within a trading portfolio. 

However, there are more direct ways to hedge in FX trading.  Traders may increase their odds of success by trading spreads rather than outright currency pairs.  The net result of this strategy would be a decreased level of volatility, but also provides less profit potential.  In essence, traders that are trading spreads are simply placing one position in speculation and another as a direct hedge to protect against the possibility of an incorrect forecast. 

In order to construct a proper spread, it is important to determine the correlations between specific currencies.  The simplest example of this would be the Franc vs. Euro.  The Franc is extremely positively correlated to the Euro, but tends to have significantly smaller moves in terms of pips.  By posting both currencies against a common denominator, you can easily hedge any Euro position by taking the opposite Franc position. 

In order to construct a proper spread, it is important to determine the correlations between specific currencies.  The simplest example of this would be the Franc vs. Euro.  The Franc is extremely positively correlated to the Euro, but tends to have significantly smaller moves in terms of pips.  By posting both currencies against a common denominator, you can easily hedge any Euro position by taking the opposite Franc position.  See diagram on next page.

We have obviously just touched on the subject of diversity in the FX markets. Just as there are an infinite number of trading theories and strategies, there are unlimited numbers of ways to diversify any given position.  It is also important to note, that in certain market conditions hedging positions may fail resulting in losses on both legs of the spread.  Fortunately, this is relatively uncommon. 

Carley Garner is the Senior Analyst at DeCarley Trading LLC where she also works as a broker.  Her book, "Commodity Options" published by FT Press will be on shelves in January 2009. Visit www.DeCarleyTrading.com for your free subscription to Carley's e-newsletters and for details on the services she provides.  Carly is a Magna Cum Laude graduate of the University of Nevada Las Vegas, from which she earned dual bachelor’s degrees in both Finance and Accounting.Carley jumped into the options and futures industry with both feet and has become one of the most recognized names in the business.  Within months in the industry, she had published her first article in a nationally distributed periodical and hasn’t slowed down since.  She has been featured in the likes of Stocks and Commodities, Futures, Active Trader, Option Trader, Your Trading Edge, and Pitnews Magazine.  Carley is often interviewed by news services such as Reuters and Dow Jones Newswire, and has been quoted by the Investor’s Business Daily and the Wall Street Journal.  She has also been known to participate in Radio interviews. 

Carley Garner is the Senior Analyst at DeCarley Trading LLC where she also works as a broker.  Her book, "Commodity Options" published by F...

pssonice

Established member
900 12
a lot of sentences are resulting in the one and only sentence :
"In other words, traders should look to have a portion of their trading account managed by professional traders. The purpose of this is not to say that professionals will ultimately have better results than you, but is simply for the purpose of diversification. "

I wont add anything worthless to this sentence.

What is the main difference between trading the forex market and trading the stockmarket ? I cant see any differences. fundamentals and charttechnic as well as news are available the whole day long.
 

garethb

Well-known member
307 15
A piece of wooly thinking in the extreme. First "diversification" and "hedging" are bandied about as if they are interchangeable. And then it is recommended to trade a cross rate (only with double the costs - author must be a broker), as an example of what? a hedge?, diversification?, both?, neither?

Right up there with Ms Garner's previous submissions.
 

a_gnome

Well-known member
434 15
This article does look suspiciously like a prelude to the introduction of the Freedom Rocks method of trading. Since they have a multi-level marketing thing going on there seem to be a lot of posts on the "benefits" of hedging EURUSD with USDCHF and how this is "better" than trading out-rights and how somehow this is not the same as trading EURCHF.

There is a lot of mis-information on this topic which I have tried to address in the thread on Freedom Rocks at:
http://www.trade2win.com/boards/showthread.php?t=22364
(you need to scroll down to the 3rd page).

If this article is actually unrelated to this (and it is quite general and non-specific) then I apolgies to the author but there do seem to be a lot of similarities.
 
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martinengland

Newbie
3 0
looking for a good non dealing fsa regulated broker with ideally accounts opening with say £2000 or a non dealing us desk. Any comments welcome
 
Hedging

with a perfect inverse correlation, all risk is hedged but so is all return.
In inflationary times especially, thiswould result in a negative return vis a vis the real risk free interest rate. What is the point of this article please?
 

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Newbie
1 0
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