Managing Correlations - Should You Split Your Trades?
Correlations between currencies can be challenging to manage, but it’s not impossible. As long as you have a basic understanding of what correlation is and how it occurs between two or more pairs, strap in your seat belts for some excellent techniques!
When dealing with correlated pairs you can either:
- Split your risk between the pairs (let’s say 2 for argument’s sake).
- Only trade one position with full risk.
- Trade both until one starts showing promise. Then dump the stagnant position and find a way to add risk (size) to the trade that’s working for you.
NB – If you have no idea what correlation in the financial markets is, please let me stop you. Correlation between currency pairs or stocks needs an article of its own, so make sure you understand correlations and how they apply to the Forex market before continuing.
1. Splitting Your Risk
- By splitting risk, I mean halving your usual risk and placing both trades with only HALF of your normal position, meaning the total risk is not more than your limit for that account. Split risk usually translates into a smaller potential loss. I say this because if you were to trade both pairs with the full risk you’ve defined for your account, the loss would be doubled, But equally, a win would be doubled (don’t get carried away by the hope of that because if you want to trade bigger, rather increase your defined risk. Don’t do it by trading correlated pairs)
- If both trades end up losing, you are still within your risk parameters
- Splitting risk covers your downside. That’s pretty much it.
- If one trade ends up doing well and the other doesn’t, you will only get half of your typical Risk vs. Reward (RR)
- Eats up your MARGIN. Positions in the Forex market are much cheaper than stock trades, but you still need to watch how much margin you’ve used to be in your open positions to avoid any margin calls.
2. Picking one and sticking with it
- This approach is probably the least stressful. You pick whichever currency pair shows a set up first or whichever has the best set up.
- You’re able to use your full risk, which means you benefit fully if the trade is a winner.
- If you pick the wrong trade, you could end up with a loser or a breakeven trade instead of a winner. Though, you can’t be too hard on yourself because that would be out of your control and there is no way to predict this beforehand.
3. Playing it by ear (place both and manage)
- You would benefit from being in the trade that pays off.
- Limit your losses on a dud and maximize your profits on a winner
- It takes great skill and practice to execute. And no practicing on a live account or forward testing. You need to know before what kind of approach would suit you better and be more profitable according to your strategy.
- Takes time, patience, and attention to keep your eye on the market price for any signals from the market. For example, you may be wrong on both trades, or both trades might be in profit, or one trade could be working and one position not. WHICH ONE? And how should you react in each situation?
Personally, Picking one and sticking with is what I do, but many traders have had success doing it in various ways. I don’t like to trade anything correlated unless there is a bit of delay between the pairs (e.g. gold and silver sometimes lead the other in price action, which can serve as a sort of edge)
Then maybe I might trade correlated pairs, although I usually avoid even having correlated pairs on my watch-list. If something is correlating, I pick the one with the smoother price action (least wicks, fake-outs and stop hunts) and trade that for about a week or two and wait for the correlation to weaken before I look at both pairs again.
And THAT is another strategy you can employ when dealing with correlation. AVOID IT! Some of you won’t like to hear this, maybe because you feel you have to get involved in every single opportunity that the market throws at you? If that’s you, then be my guest, but usually correlating instruments are not worth the stress.
Now, some of you might find an edge in this phenomenon, and to that I say Good for you! It is possible to find a positive expectancy in this way.
Try your hand at it if you are keen to use the information in this article to guide your ideas about risk and how you want to approach the situation.
With the advantages and disadvantages I’ve listed, think about which risks you are ok with and which you are not willing to take.
Don’t bet the farm.
Don’t lose your shirt.
Cut the L.
Keep the W.