Are You Doubling Your Risk Without Knowing It?

When trading numerous currency pairings in your trading account at the same time, always be conscious of your RISK EXPOSURE.

Trading AUD/USD and NZD/USD, for example, is virtually the same as having two identical transactions open because they normally have a positive correlation.

Trading in multiple pairings may make you think you're spreading or diversifying your risk, yet many pairs tend to move in the same way.

As a result, instead of lowering risk, you're increasing it! Unknowingly, you're putting yourself in even more danger.

This is referred to as overexposure.

Let's take a look at an example using two strongly connected pairs over the course of a week: the EUR/USD and the GBP/USD.

According to the table, this specific pair has a high association, with a sexy correlation coefficient of 0.94. EUR/USD is the peanut butter to the jelly of GBP/USD! As though it were oil and water. Like Ben & Jerry's ice cream!

Okay, I think you get the idea. The purpose is that the two couples clasp hands and skip together while singing “Kum Bay Yah.”

Currency Correlation Example #1: EUR/USD and GBP/USD

Here are their 4-hour charts to show you that numbers don't lie. Take note of how they both travelled down in the same way.

Returning to the topic of risk, we can see that starting a position in both the EUR/USD and the GBP/USD is equivalent to doubling up on a position.

If you buy 1 lot of EUR/USD and 1 lot of GBP/USD, for example, you're effectively buying 2 lots of EUR/USD because both the EUR/USD and the GBP/USD will move in the same direction.

To put it another way, you're increasing your risk. You don't have two opportunities to be incorrect if you purchase EUR/USD and GBP/USD!

You only have one shot because if EUR/USD falls and you are stopped out, GBP/USD will almost certainly fall and you will be stopped out as well (or vice versa).

You wouldn't want to purchase EUR/USD and sell GBP/USD at the same time since if EUR/USD rises, GBP/USD would most likely rise as well, leaving you with nothing.

You're mistaken if you believe your profit or loss will always be zero. The pip values of EUR/USD and GBP/USD are different, and just though they are closely connected doesn't imply they constantly move in the same exact pip range.

Within currency pairs, volatility is erratic.

The EUR/USD pair can rise by 200 pips, but the GBP/USD pair only rises by 190 pips. If this happens, the losses from your short GBP/USD trade will eat up the majority, if not all, of the earnings from your EUR/USD strategy.

Let's pretend that the EUR/USD pair moved up 190 pips, while the GBP/USD pair moved up 200 pips. You would have undoubtedly suffered a setback!

Going long one currency pair while shorting another strongly connected currency pair is exceedingly unproductive.

You're not only paying for the spread twice, but you're also limiting your profit because one pair eats into the earnings of the other.

Worse, because to the varying pip values and ever-changing volatility of currency pairings, you may wind up losing.

Currency Correlation Example #2: EUR/USD and USD/CHF

Let's take a look at a different scenario. This time, the EUR/USD and USD/CHF are involved.

The EUR/USD has a highly negative connection with the USD/CHF, whilst the GBP/USD has a substantial positive correlation.

It has a perfect correlation value of -1.00 when we look at its one-week correlation. It doesn't get much more diametrically opposed than this, people! They're Tom and Jerry, not Ben & Jerry's!

EUR/USD and USD/CHF are like fire and water, Bugs Bunny and Elmer Fudd. Superman and kryptonite, Boston Celtics and Los Angeles Lakers, Manchester United and Liverpool.

These two pairings are moving in very opposing directions. Examine the graphs:

Adopting opposing viewpoints on the two negatively correlated pairings is analogous to taking the same stance on two substantially positive correlated pairs.

It's the same as doubling up on a position if you buy EUR/USD and sell USD/CHF.

If you purchase one lot of EUR/USD and sell one lot of USD/CHF, you're effectively purchasing two lots of EUR/USD, since if EUR/USD rises, USD/CHF falls, and you profit on both pairings.

It's vital to note, however, that if you do this, you've increased your risk exposure in your trading account.

In the case of the long EUR/USD and short USD/CHF example, if EUR/USD sank like a rock, both of your trades would most likely be stopped out, resulting in two losses.

Instead of doing both, you might have limited your loss by either going long EUR/USD or short USD/CHF.

Buying (or selling) both the EUR/USD and the USD/CHF at the same time, on the other hand, is typically detrimental because each deal is effectively cancelled out.

One side will profit, while the other will lose money, since the two pairings go in opposing directions as though they despise each other's guts.

As a result, you either make a little profit or lose money since one pair eats into the earnings of the other.

Or you might just lose money owing to the varied pip values and volatility ranges of each pair.