Trading Risk Management Strategies, Part 3
|Hello traders! In the first two parts of this series on risk management, part one covered a simple trade management technique and how to limit trading activity and part two discussed using correlations to either the dollar index or different commodities to help choose more effective turning points. This week we’ll discuss diversification and weekend gaps.
In every Online Trading Academy class that I teach, the topic comes up about diversification. Often, a student will ask, “Why do I need to be diversified if I’m actively trading all of my positions?” Well, contrary to popular belief, not every one of our students is an active trader! Many people come to us for help managing their entire portfolio, not just their day or swing trading accounts. In these “wealth buckets,” new students have often times invested in things their broker/financial advisor told them to invest in. You might be surprised at the stocks/funds/ ETFs that I have seen in the same portfolio! A recent student showed me a copy of his statement, which included Facebook, Amazon, Google (now Alphabet), Twitter, LinkedIn, Tesla and a bond for “safety.” If this student would have sent in this portfolio to everyone’s favorite CNBC personality and asked, “Am I diversified?” the answer would have been a resounding “No!” (Or even a buzzer sound.) As many of you know, most of these companies are internet/technology/social media plays: hope those sectors keep going up forever! One quick reversal and months of gains will be wiped out.
So, how does this apply to Forex trading? If you are an active trader who is managing just one position at a time, it doesn’t. Please keep reading as there will be another topic for you later! If you are interested in trading more than one currency pair at a time, it definitely applies to you. Obviously, in a six stock portfolio, having 5 of them directly related to the internet industry is not diversified. But what happens when a trader is long the EURUSD, long the GBPUSD, short the USDJPY and short the USDCHF? What this trader has done is actually gone short the US Dollar in every position! (If you are brand new to forex trading, all of our trades are done in currency pairs. When long the EURUSD pair, you basically BOUGHT the EURO currency while at the same time SOLD the US Dollar currency. If you went short the USDJPY pair, you SOLD the US Dollar currency and BOUGHT the Japanese Yen currency.)
What might a more diversified Forex portfolio look like? Perhaps this trader could be short the EURUSD, long the USDJPY, long the AUDCAD and short the EURGBP. This way, no more than two positions are taken on the same currency at one time and both positions are on the same side (long or short) the individual currency. As the more experienced readers know, this is a tad on the simplistic side as we always must look at the individual charts to determine which side of the trade to be on! Occasionally the charts require you to be long the US Dollar in one pair while short the US Dollar in another pair, etc., etc. Again, this is for discussions sake.
Our next topic of risk management discussion is the weekend gap. As you probably know by now, the Forex market opens Sunday afternoon and closes on Friday afternoon in the United States. Since the market is open 24 hours a day during the week, many traders will “swing trade,” holding trades for days at a time. Stock traders know the regular market opens at 9:30 am EST and closes at 4pm EST, which means you can’t get out of your positions until the following day when you hold past 4pm! Occasionally, news might come out to drive your stock the wrong direction post or pre market and those traders can do nothing about it. Every day there are stocks that “gap” (open the next day at sometimes a significantly different price than where it closed the previous day). Again, because Forex closes on Friday afternoon we rarely have to worry about gaps during the week.
Usually the gaps in Forex are just a handful of pips, but once in a while a bit of news coming out over the weekend might cause gaps of many dozens of pips! A risk management rule that I have in my trading plan is to exit all Forex trades by Friday afternoon; this helps me enjoy the weekend just a bit more! Another great thing I’ve found using this rule is that very often I can re-enter the same trade that I exited on Friday at a better price! (It is trading, after all!)
So there you have it. Two more rules for risk management are: not “putting all of your eggs in one basket” by diversifying your position selection and possibly not holding over the weekend when a large gap could wipe out some serious profits.
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