Trading is full of risks and as with anything that is connected to potential losses you will want to protect yourself from a worst case scenario. Even though it is impossible to protect yourself 100% from all losses, there is a strategy that will minimize the amount of money lost on bad trades. This technique is known as diversification. To diversify your trading means that you minimize any potential losses by mixing a variety of investments made at any one time within your portfolio. This form of risk management is effective, because even if a single trade goes bad it will not have a big impact on your overall trading success rate.
So far it does seem that diversification is a good idea to help minimize losses. The next issue to address is the case of over diversification. Let all things when a good idea is taken to extremes it becomes dangerous. Over diversification means that you lose focus in your trading. In Forex how you can diversify is straightforward. You can choose to either use different time frames, or break up your position sizes to smaller lots or choose different currency pairs. Most trader use a combination of two of the above. The reason for keeping it simple is that they do not want to lose focus.
Focus in your trading is crucial for trades who wish to grown their accounts in the shortest time possible. You have to balance the defensive stance of money management and a more aggressive outlook in your trading. Focus does not mean that you do not diversify, instead it means that you have to choose where and when to diversify.
Take for example, you decide to trade the EUR/USD and go short with it. With your money management rules you have decided that all trades you take you will use no more than 5% of your account. At the same time to prevent a loss if the trade goes against you, you split the 5% into two portions. You go short on a 5 minute time frame and you go short on a longer time frame. Thus for both positions you are holding a 2.5% of your account in each. The reason for going short on both positions is that the trend is a downward trend. So let's say the 5 min time frame hits the stop loss and you get knocked out of the trade. The longer time frame makes you some profits. In the end you have broke even and that is a good thing. You have successfully protected your account.
Now let us say that you over diversified your positions. Same EUR/USD trade and you went short on the 5 minute frame. Then you picked another currency pair say the GBP/JPY and once again you choose a third currency pair to diversify into, say the AUD/USD. You split your 5% into 3 portions and trade all 3 pairs simultaneously.
Even reading the description becomes confusing much less to say trading the actual trades. The probability of losing on all 3 is much higher because you aren't focused enough. True and behold you lost on 2 trades and you won one. In the end it is one step forward two steps back.
Diversification is a good idea and should be practiced by all traders. It will keep your account alive for a longer period of time and help you weather out bad storms. Do not fall into the trap of over diversification. Keep your positions always at eye level, do not allow yourself the luxury of set and forget, for when a trade moves against you it moves fast and before you know it you have been hit with an irreversible situation, you have lost money.
Dr. Joshua Geralds is a successful Investment Specialist with over twenty years experience increasing the income of people world wide. Visit http://www.pipsalot.com to learn how to make steady profits through safe trading and down load your FREE e-book "Money Management" for a limited time only! |
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