The importance of risk management can never be overstated when it comes to forex trading. Because the volatile nature of currency pairs due to the constant fluctuations in exchange rates makes forex trading inherently risky for all traders. There are a lot of things that you can do to minimise your exposure to market risk in an effective manner. From placing stop-loss orders to limiting the risk per trade and trading with a favourable risk/reward ratio, traders try different techniques to reduce the risk based on their risk tolerance level.
Another powerful strategy that you can follow for managing the risk of forex trading is diversification. This informative blog will help you to learn more about the topic and understand why diversification is required for forex trading success.
Decoding Diversification
Diversification is a popular term that is used in finance and the meaning of diversification in the financial market is to spread the risk by spreading your investments in different assets or instruments. Because, if you use all your capital or funds to buy one asset, you will encounter a huge loss if the asset’s value depreciates due to an unfavourable market situation. But when you allocate your funds to different assets, the downfall in the value of one asset will not lead to huge losses as you have money invested in other assets or instruments.
The Logic Behind Diversification In Forex Trading
Now that you have understood the meaning of diversification in the financial world, let’s learn about the logic behind diversification in forex trading. Before that, let’s look at some basics of currency trading. In the forex market, you will not be investing in a currency but instead, you will be speculating on the value appreciation and depreciation of different currencies by opening a trade position. Position trading is a strategy that is similar to investing due to the longer timeframe but it is still very different from typical investing. Other strategies like scalping, day trading and swing trading are focused on shorter timeframes.
The currency pairs that you trade with are priced on the basis of the value of the base currency quoted against another currency. Those who expect an increase in value of base currency will be opening a long position by placing a buy order and those who anticipate a fall in value will be shorting the pair by placing a sell order. The currency pair prices are expressed in pips which is the universal unit of measurement in forex. So, your profit or loss at the end of a trade depends on the number of pips by which the price has moved and you can use a pip calculator to quickly find out the accurate pip value in a currency of your choice.
Since the currency price movements are driven by a lot of geopolitical and economic factors, using all your funds to open positions in a single currency will make you financially vulnerable as the risk exposure is higher. Thus, experts suggest that you should add more pairs to your watchlist to manage the risk in a better way. Applying diversification in forex trading offers a lot of benefits to all types of traders.
Advantages Of Diversification
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Reducing The Impact of Risks
Diversification is not just about reducing the risk but more about reducing the impact of risks. Yes, your risk in a particular trade position will be minimised when you open a trade with a different currency pair. Along with that if the first trade results in a loss, the impact will be lesser in comparison as the second position will cover or offset the risk. In fact, popular trading strategies like hedging are also based on this theory. With a diversified portfolio, you won’t have to worry about the weakening of one currency.
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Protection Against Sudden Market Shifts
Another benefit of diversification is that you won’t suffer huge losses due to sudden shifts in market situations. Since the currency pair price movements can become unpredictable at times, even trades with a high probability of winning can turn into losing trades in an instant. Such risk can be controlled to a great extent by trading with different currency pairs after considering the level of volatility. Some pairs are more volatile than others and negatively correlated pairs can be traded to protect your account.
When volatility is high, you should be careful with the leverage that you use to trade with less margin and in this regard, a margin calculator can be of great help, as it quickly determines the margin to use for your trades in your base currency allowing you to diversify by adding different currency pairs to your watchlist.
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More Opportunities To Make Profits
When you are trading with a single currency pair, your trading opportunities will be limited to that one pair alone. But when you try trading with different pairs, you will find more opportunities to make profits and you can choose the best one. One tool you can use to determine the profit potential of a trade is a forex profit calculator that tells you the possible gains from the details you enter. Then, you can plan the trade well based on the results you want in the end.
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Improved Decision-Making Skills
When you are only focused on one or two pairs, all your decisions will be based on the one or two currency pairs that you are trading. This means your market knowledge will be limited and this will also limit the amount of options you get to pick from as a trader. When your options are limited, making a decision will be easier and your decision-making skills remain the same. But when you start exploring multiple pairs, you will have to consider different alternatives for choosing the best course of action which automatically improves your decision-making skills.
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The Broader Perspective
When you work on creating a well-diversified portfolio, you will have to do a lot of research to select the most suitable currency pairs based on your trading goals and risk tolerance. You can even choose other forex instruments such as forex indices, forex futures and more. When you learn about different currencies and the economic situations that affect them as well as the strategies that will complement the pairs, your knowledge will expand further and this gives you a broader perspective.
This makes you an independent thinker who considers different trade scenarios and market situations before arriving at a conclusion. This also helps you to follow a flexible approach and adapt to the changes in the market by switching between different pairs. Diversification is also helpful for attaining long-term success with a sustainable strategy.
Challenges of Diversification
Even though diversification can be very beneficial in the forex market, it is not free from challenges, especially for a beginner. New traders should focus on one pair in the initial period or else you might get confused and overwhelmed with the number of pairs that you have to consider for technical analysis. The correlation between pairs is another thing to take into account and choosing the wrong pairs to trade together will increase the risk instead of bringing it down. Over-diversification can also drain your trading account, so you need to strike a balance.
Sum Up
To summarise, diversification is a strategy that can not only mitigate the risks but also provide more profitable trading opportunities while also protecting you from sudden market shifts. It also improves your decision-making skills as you will develop a broader perspective as a trader.
