Diversification in Forex Trading | How to Do It?

The key to achieving success in investing is to be a master of risk and return calculation. This is because these two elements are highly correlated but are unfortunately often overlooked by many traders and investors.

Risk and return calculation could be easily interpreted as “how much am I willing to lose to potentially make a certain amount of money？” However, risk indicates that there is always a possibility of making a loss in every trade placed. The return on trade is often stated in percentage and is a random variable beyond control.

For example, if you are willing to lose $10 to make $50 potentially, your risk and return ratio is 1:5; if you are ready to lose $10 to potentially make $100, then the risk and return ratio is 1:10.

The old adage “dont put all your eggs in one basket” may sound cliché, but it applies to every trader and investor regardless of the market in which one participates. Diversification allows investors to reduce the overall risk associated with their portfolio. However, this could also limit potential returns.

To fully comprehend the benefits of a well-diversified portfolio, we must first define correlation, which is the tendency of two currency pairs to move in the same direction. The correlation coefficient between the various pairs that comprise a portfolio determines the degree of risk involved. The correlation can be positive if both pairs move in the same direction (for example, both pairs rise or fall) or negative if one currency moves one way and the other moves the opposite way (for example, one security goes down, and the other goes up).

To illustrate in a more straightforward way, if a trader is trading all 3 pairs that are related to the Eurodollar, such as EUR/CAD, EUR/USD, and EUR/AUD. If the Eurodollar is gaining momentum, the trader in a long position could be making three times the profit. On the flip side, if the trader has a long position while the Eurodollar reverses, he could make three times more losses.

A traders goal is always to outperform the reference market benchmark over a medium-long term time horizon. The unwritten rule for achieving excellent currency portfolio diversification is that the more pairs used, the greater the likelihood of outperforming the reference benchmark. It is critical that the pairs are not correlated with each other, or as little as possible, because the return of the portfolio components will move independently.