The topic of risk diversification begins to interest almost all traders at different stages of their trading experience. Someone comes to diversification after having made a series of losing trades and is looking for options on how to insure themselves in the event of a “counter-move” of the price. Someone even trades only one instrument all his life, not wanting to enter anything else into trading. The case is quite rare, but nevertheless it takes place.
The topic of risk diversification begins to interest almost all traders at different stages of their trading experience. Someone comes to diversification after having made a series of losing trades and is looking for options on how to insure themselves in the event of a “counter-move” of the price. Someone even trades only one instrument all his life, not wanting to enter anything else into trading. The case is quite rare, but nevertheless it takes place.
Risk diversification – what is it?
Due to the fact that we work in the financial markets, we will consider the diversification of risks directly in the trading portfolio. Let’s start with a definition.
Risk diversification is a risk sharing strategy in which a trader invests his funds in different asset classes (currencies, stocks, exchange-traded funds, precious metals and commodities, cryptocurrencies, and so on).
Next, we will consider various diversification strategies, which can be studied in more depth in the future.
1) Diversify with currencies
The topic of risk diversification begins to interest almost all traders at different stages of their trading experience. Someone comes to diversification after having made a series of losing trades and is looking for options on how to insure themselves in the event of a “counter-move” of the price. Someone even trades only one instrument all his life, not wanting to enter anything else into trading. The case is quite rare, but nevertheless it takes place.
- Group #1. This group includes currency instruments, where the base currency is the national currency, and the quoted USD. Example: NZDUSD, AUDUSD, GBPUSD and so on.
- Group #2. In this group of currency instruments, the base currency is the national one, and the quoted one is JPY. Example: EURJPY, CHFJPY, GBPJPY, etc.
- Group #3. Here, the national currency is the base currency, and the quote currency is any third world currency. Example: EURCHF, AUDCHF, GBPCHF.
All currencies in each of the groups are allies against the quote currency: in Group #1 – against USD, in Group #2 – against JPY, in Group #3 – against CHF. If the index of the main currency in any group grows, for example, the dollar index, then all allied currencies within this group decrease (NZD, AUD, GBP). In turn, currency instruments, where the “greenback” is the base currency (USDCAD, USDCHF, USDJPY), are growing along with USDX (US dollar index). In relation to allied currencies from Group #1, these are opposing pairs. It is important to understand that the movement of quotations of allied currencies during the session coincides, as well as the opponents’ currencies, but they are in different directions among themselves. Given this, a trader can easily pick up a currency instrument to diversify the risks of his unprofitable foreign exchange transaction.
2) Diversify with stocks
Experienced traders like to diversify their risks with global stocks. This is due to the fact that the movement of quotes is easier to predict using technical analysis. Also, the further fate of the shares can be predicted by the reports of companies, their statements, plans and other factors.
Often, traders add two types of stocks to a portfolio at once: one with high risks that bring higher dividends, the other – low-risk “blue chips” that give stable but lower profits.
3) Diversify with CFDs
Unlike stocks of companies, this method of diversification is good because with the help of CFDs you can earn not only on growth, but also on falling prices. Some investors use this tool to hedge positions to buy the same real shares by opening a trade in the opposite direction on the same asset, but using CFDs. Some investors short CFDs on several assets at once, thereby minimizing their risks.
4) Diversify with industry tools
Professional investors prefer to diversify their risks in different markets. This allows you to reduce risks or partially, and sometimes completely, compensate for losses. Some of the investors distribute their portfolio of shares across different sectors in order to reduce “drawdowns” in some industries. Someone hedges their foreign exchange transactions, for example, in the gold market, because. The precious metal has historically been considered a safe-haven asset. At the same time, other “safe haven” currency assets (for example, the Japanese yen) may not work at this time due to fundamental economic factors.
An example of diversifying a currency transaction
Now we will use an example to show how a losing currency transaction was hedged for the EURUSD currency pair. As you can see in the chart below, the trader opened a 1-lot EUR/USD buy trade at the beginning of June 2021. The fundamental background and technical indicators pointed to the continuation of the uptrend in the medium term. The deal was opened during a short-term weakening of the single currency. However, a week later, the fundamental picture of the euro began to change dramatically, which caused its weakening. “Falled” and technical analysis. Given the new inputs, the prospects for the single currency for the next 1-2 years were disappointing. The trader decided to hedge the trade with the opposite pair, as we described in the first diversification strategy. To implement the task, the USDCAD pair was chosen. A deal to buy the US dollar was opened in mid-June 2021. When choosing the volume of the transaction, the fact that the Canadian dollar is a commodity currency was taken into account. This means that with an uptrend in the oil market, which was also predicted for the next few years, the “Canadian” would lag behind the euro in terms of weakening against the US dollar quite decently. In this regard, the deal was opened with a volume of 2 lots to compensate for the lag in dynamics.
At the time of writing, a little more than 1 year has passed. Deals are still open. We see that the euro has lost more than 1800 points against the dollar, which in monetary terms amounted to about 1800 US dollars. The Canadian dollar, however, as predicted, resisted the “greenback” more successfully. Oil, by the way, really rose in price during the year and supported the Canadian currency. As a result, the US dollar strengthened by only 900 points against the Canadian dollar. In monetary terms – about 1800 US dollars. As you can see, the trader calculated everything very accurately, taking into account the fundamental change in the situation in the foreign exchange market, the features of individual currencies and forecasts of price movements in the oil market. What to do next, you might ask? You can close both deals and end up with nothing in a year. You can wait until the euro “finds the bottom”, and this may happen in the medium term. Then close the deal with the Canadian dollar and watch how EURUSD will roll back, reducing the loss on the deal. It can be closed at some level or brought to zero. You can add one more deal to buy in the direction of correction. This is already as the trader wishes, based on his trading strategy.
Risk Control Options with Robots
Expert Advisor Risk Manager for MT4 is a very important and in my opinion necessary program for every trader.
With the help of this advisor, you will be able to control the risk on your trading account. Risk and profit control can be carried out both in monetary terms and in percentage terms.
For the Expert Advisor to work, simply attach it to the currency pair chart and set the acceptable risk values in the deposit currency or in % of the current balance.
Risk Controller Expert Advisor, a program that allows you to control the total risk of your trading advisors on your account.
With this program, you can control the maximum risk that will be allowed on the account for all advisors.
For example, you set the risk of 30% of the maximum drawdown, which means that if your equity trading robots exceed the risk of 30%, the Risk Controller will close all positions of advisers, and can also close all open charts, thereby preventing advisers from working further.
The Expert Advisor will be necessary for “restful sleep” when you trade averaging robots with martingale and want to limit the maximum losses from robots in case of force majeure or other unforeseen situations, because it is better to take a loss than to hope for a market reversal.
