Direct from the desk of Dane Williams.
In yesterday's blog post, I talked about the idea of limiting my risk to just 2% of my account.
The responses I received in the comments, each had a common theme – traders mentioning that by sticking to this 2% risk rule, they could manage more open trades at once.
Now, It's a valid point I suppose.
But the key is making sure you’re keeping your risk at 2% per trade and not just taking a de facto, larger position via trading multiple correlated pairs in the same direction at once.
You see, as there is such a strong correlation between many of the currency pairs sharing a common currency, things get a bit tricky when it comes to trading multiple positions in the forex market.
Let me break it down.
Correlated forex pairs are those that tend to move together due to similar factors influencing them.
Think EUR/USD and GBP/USD due to both being majors that share the USD as the base currency.
Or EUR/JPY and AUD/JPY, both high ranging exotic pairs with exposure to the volatile Japanese Yen.
Now, while the idea of juggling multiple trades simultaneously sounds appealing, it's important to consider how your overall risk while trading correlated pairs plays into this.
Imagine trading two correlated pairs like EUR/USD and GBP/USD.
If both pairs are on a downward trend because of shared economic news, it's not as if you’re doubling your risk exposure – you’re actually more like compounding it.
The reason is that these correlated pairs are closely linked via their exposure to the US dollar.
As such, they react similarly to market events affecting that specific currency.
So, if one pair is going down, the other is likely to follow suit.
This means that if things go south, you’re not just dealing with one trade in trouble and hedged on the other – both trades will likely be hit equally hard.
If you had multiple 2% positions across these correlated forex pairs, you essentially just took a 4% trade.
Something that goes completely against your risk management profile and therefore something that you DON’T want to be doing.
To put it simply, it's like putting your money into two very similar baskets.
This concept often gets overlooked, but it's essential to not just think about individual trade risks.
It's also crucial to factor in how the pairs are linked and how that can impact your overall risk exposure across multiple positions you may have on at any one time.
In my trading strategy, I strive to strike a balance between managing risk and understanding the unique characteristics of the pairs I'm trading.
While diversifying trades can have its advantages, I am always trying to be cautious when it comes to correlated forex pairs.
So, even though the idea of having more trades going on simultaneously might seem tempting, I'm careful not to forget my core principle of risk management.
That being only risking 2% of my account on any one position at any one time.
In the intricate world of trading, where micro decisions can have a big impact on macro outcomes, I aim to adapt my strategies thoughtfully and ensure they make sense in the overall context of the market.
With that in mind, here's to finding the right balance between risk and reward!
Best of probabilities to you.