The inner workings of diversification in the trading sphere

The inner workings of diversification in the trading sphere. Source: freepik.com

Diversification basically allows traders to spread the risks associated with their positions. Trading small volumes of a number of different instruments at the same time instead of a large volume of one particular instrument can help to mitigate the effects of sudden volatility and unexpected movements.

The goal of diversification in trading is essentially to allow a trader to avoid overexposure to any one particular instrument while mostly protecting potential profits. Doing so means that the effects of sudden spikes and plunges, which are not uncommon in derivatives markets, are much less pronounced.

Having a basket of uncorrelated trades usually results in some of them making profits while others make losses.

However, in many cases traders choose to trade a range of instruments that are somewhat but not very strongly correlated. For example, if a trader wanted to buy half a mini lot of gold, they could simply buy 0.05 XAU-USD. However, if this trader knew that a major event in the US such as a presidential election was approaching, they might split the position into different symbols. Buying only 0.02 XAU-USD and splitting the rest between XAU-EUR, XAU-GBP, and XAU-AUD would be an effective technique to avoid the worst losses if this trade went badly because of volatility affecting the dollar.

The end result in either case is usually that the profitable trades cover the losses made by the unprofitable ones in any given period of three months or more, other things being equal. The fact that a contract for differences (CFDs) does not usually expire means that traders can hold on to lacklustre trades if the circumstances permit. Such trades might later become profitable. However, traders should avoid stubbornly holding bad trades.

On the other hand, not diversifying can lead to much larger losses much more quickly. A surprising item of news can have a major effect on some symbols in the forex market, for example, but others might be only minimally affected or not affected at all.

This can be illustrated well if you look at the charts of several distinct but related instruments, such as a comparison of the Australian dollar against each of the US dollar, euro, and yen over a certain period.

One popular method of diversifying among traders of CFDs is to trade instruments from a range of different countries. These countries often have very different economies with different drivers.

For example, tensions over trade in 2018 and 2019 had a significant negative effect on currencies like the New Zealand dollar, while others such as Mexico’s peso were less sensitive to this particular factor.

Diversifying across countries also allows traders to focus somewhat more on currencies that are more active or which are perceived to have a divergent valuation. As well as metals and forex, crude oil and indices are also good opportunities for diversification in the right circumstances.

The objective in each case is to avoid too much exposure to one symbol while maintaining most or all of the potential profit from trading that symbol.

Many forex traders focus on emerging markets when diversifying. There is a high potential for growth in countries such as South Africa, among other emerging markets.

For typical forex traders with limited funds, trading a range of major and minor currencies is a popular strategy for diversification. This is especially true during periods of greater economic certainty around the world because emerging currencies tend to react positively to such conditions.

A simple example of diversification is when a trader’s allocation ranges from EUR-USD all the way to extremely rare pairs such as TRY-ZAR. Other examples of diversification include trading gold and silver in combination with more volatile major currencies.

Diversification can also be a useful tool when combined with technical analysis. For example, let’s say that a trader thinks the next meeting of the Federal Open Market Committee will be negative for the dollar and the Fed will cut its funds rate.

At the same time, they note that the dollar-yen has been strongly oversold for some time. In this situation, the trader might buy both the euro-dollar and the dollar-yen.

Critical to successful diversification is finding a broker which offers a broad range of symbols, especially forex pairs.