Forex Diversification

I was reading Simon's blog where he believes that trading multiple currency pairs is not diversification.  Like he states, going long the GBP/USD, long the EUR/USD, short the USD/CHF, and short the USD/JPY is betting against the U.S. dollar.  If you trade these 4 major pairs, is this diversifying your forex trades or would you be better off concentrating your efforts on only 1 of these pairs? Craig mentions in a comment that he believes that the best course of action is to trade 1 system on a handful of the least correlated pairs.  Simon says that another trader recommends trading multiple systems on 1 pair to diversify.   

I personally have been concentrating on trading the GBP/USD for over 6 months now, but on and off I feel compelled to look at the other pairs, mainly the USD/JPY, EUR/USD, EUR/JPY, USD/CAD, AUD/USD, GBP/JPY, and the USD/CHF.  My thinking was that I didn't want to rely on only the GBP/USD to generate trade signals for me but after reading Simon's post, I'm rethinking this a bit.   I think a combination of the 2 methods above may be my best course of action at this point.  Currently I really only have 1 system that I follow on a daily basis but I'm always on the prowl for more.  I have yet to attempt to regularly apply this to other currency pairs but maybe I should test it on other less correlated pairs.  It may be easiest to put the process in list form as follows:

1. Find a system that gives an "edge" trading the GBP/USD.
2. Find other currency pairs that are least correlated to the GBP/USD.
•  According to Oanda's heat map of currency correlations, the USD/JPY and EUR/GBP are the least correlated pairs to the GBP/USD.  (see heat map below)
3. Test the system on these least correlated pairs.

Is there a better way of diversifying your forex trading other than going outside the forex market to futures, equities, etc? Another thing to think about is whether going this route is neglecting the correlated pairs and the chance that this system may be more successful on them than the GBP/USD?  

 

 

 

 

 

 

 

 

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Currency Correlation

Some of you may not have heard of currency correlation, so I’ll explain its usefulness.  Basically, the correlation number gives you an estimate of how closely pairs move together or how opposite their actions are over a period of time.  Knowing how closely correlated currency pairs are is a great way of measuring exposure and risk. 

This information is extremely useful when you have an open position and wish to open another position.  For example:

I have an open AUD/USD short position.  I notice a possible long setup with the EUR/USD.  I want to find out what the correlation is between these 2 pairs.  Consulting a 5-day correlation table shows a correlation value of .24.  What this tells us is that the correlation is low and the 2 pairs don’t move in the same way.   Therefore going short on AUD/USD and long on EUR/USD should not affect each others position.

What if the correlation was high between 2 pairs.  The correlation between the EUR/USD and USD/CHF on a 5-day correlation table is  -.96.  This tells us that there is an extremely  negative correlation between these pairs.  This number indicates that these pairs have a strong propensity to move in opposite directions.  Therefore, going long in one and shorting the other would be almost the same as doubling up on the position.  As a result, this would open your portfolio to a higher amount of risk. 

I obtain my currency correlation tables from http://www.mataf.net.

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How do currencies move in relation to each other?

Everyday I learn something new and I’m thankful for that.  It was interesting to learn from an article about the changes in currency correlations.  I know that going long on EUR/USD and long on USD/CHF would generally lead to a negated or nearly zero profit or loss.  But throughout the year, there can be a drastic change in correlation between currencies.

For instance, the 1 year correlation for the GBP/USD and NZD/USD is .826 but the 1 month correlation is .140.  Knowing this information will allow you to effectively diversify your porfolio.

Check out the article, How do currencies move in relation to each other?

To read more about currency correlation and how you can calculate it yourself, go to Using Currency Correlations to your Advantage

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