Wednesday, 22 March 2017
Using currency correlations to diversify our investment
Diversification is a key issue in every trader’s career that has to be addressed sooner or later. Why? Because it helps you make more money and be exposed to less risk. But let’s be organized and read a good definition from Investopedia before moving forward.
“Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.”
After this definition, there are three elements we should pay attention to:
Example: if your only position is a long EURUSD and the Fed unexpectedly rises interest rates, the pair will probably move lower, forcing you to close the order and loose some money. However, if you diversify your portfolio by opening different positions your profits or losses won’t be determined by only one trade but rather by the total result. Following this example, if you had a long USDJPY, then you would compensate your EURUSD drawdown.
Higher returnsExample: the key principle for higher returns is that when things go north, especially using correlation of currency pairs, you would profit not from one single position, but from all of them, leaving you with a juicy amount of money on your pocket.
Larger exposure to opportunities
Example: the logic behind is pretty simple. If you have one position, your results will be determined by a few economic events. On the other side, if you start trading multiple assets, then your opportunities will be open to a vast number of events global scale.
So… what is currency correlation and how it can help you diversify your investment?
According to Investopedia, “correlation is the statistical measure of the relationship between two securities. The correlation coefficient ranges between -1 and +1. A correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. A correlation of zero implies that the relationship between the currency pairs is completely random.”
In simple words, it measures how two different assets are related and therefore, have potential to work together to move into one direction or opposite directions.
Example: let’s say you are a faithful trader of EURUSD. Without diversifying, you probably just place one, two, or infinite number of orders just for EURUSD. However, there are few pairs just like the GBPUSD or AUDUSD that are strongly correlated with the price action of the EURUSD pair. So if the EURUSD moves north, those other pairs are likely to follow that same direction. On the other hand, there are pairs such as the USDJPY that display a negative correlation, which means it will most probably move on the opposite direction.
In case you are wondering what correlates with what, check out this free tool: https://goo.gl/TWux94
Ready to go traders!