Financial institutions like banks, pension funds and investment trusts are some of the most active participants trading the global markets today. They have millions of euro of their private capital and client capital invested in the markets with the single aim of generating a strong positive annual return. For these institutions, proper exposure is the key facet to maintaining open positions. This approach should be no different for the individual trader. As a general ‘trading rule of thumb’, taking on more open positions accepts more exposure and hence more risk.
In accepting this risk they can trade many different markets at the same time. This is astutely managed by portfolio managers in the world’s top financial institutions and is only made possible through proper asset diversification.
Opportunity is endless when trading the financial markets. The fact that we can use our trading platform to view all of these markets, whether they be FOREX, commodities, equities or bonds, allows us to engage in each of these opportunities with instant interaction and although the key objective is to make profit, our first priority is protection.
So how do we as traders achieve this?
The solution is a combination of diversification through good market selection, and high trade quality (as a result of good technical analysis). To exemplify this, have a look at the small portfolio below.
If you were glancing through the portfolio and were intrigued as to how similar the assets are, then you are on the right track. The assets above are too closely correlated for many different reasons. They are all assets based in the U.K, all dominated in GBP, and for the most part, equity markets within the FTSE 100 index. The trade exposure with this portfolio is therefore simply too great as they are too closely linked to underlying changes in the price of the British Pound, as well as the local economic performance in the United Kingdom. If you have an even closer look, you can see the portfolio is also exposed to the Banking sector. As a result, a strong move in this sector alone could adversely affect the performance of this portfolio. One could only imagine how Britain leaving the Eurozone could affect it.
In Lehmann’s terms this is ‘putting all your eggs in one basket’. Not a good idea. Our mission as traders is always to recognise and appreciate the risks in trading these assets. It is therefore absolutely essential to choose your markets carefully and spread your risk through natural market diversification. This allows the trader to take advantage of good trading opportunities, whist avoiding compounding the amount of risk their portfolio will take on. Finding the right balance between risk and return is always the best path to consistent profitable trading.