Forex fundamentals (part 2)

4. Total margins contributed at opening a position on one market group shouldn’t exceed 20% - 25% of total capital.

The markets, forming one group, move more or less evenly. Opening big positions on each market group trespasses against the principle of diversification, so one should be extremely careful while investing funds into similar markets (for example, software, it-conculting, it-audit and so on). One shouldn’t neglect the very important rule of optimal investments of funds: in a varying degree they should be diversify. The capital should be invested in such way that the losses from one big deal won’t ruin the trader and if possible, will be compensated by the profits from other deals.

On the FOREX markets we can distinguish four main markets inside which the behavior of foreign exchange rates are similar enough: dollar zone, sterling zone, yen zone and euro zone.

5. Defining the degree of portfolio diversification.

Diversification is one of the ways of capital protection. A reasonable compromise between diversification and concentration is always necessary. More or less reliable funds investments can be reached by simultaneous opening positions on 4-6 markets of various groups – but no more. The more the negative correlation value between the markets is, the higher the diversification of invested funds are.

6. Defining the level of stop-loss orders.

Stop-orders are usually positioned over the period of the trader’s absence from his working place. Their main aims are to save the trader form ruining (stop-loss execution) and to provide them with additional (stop-profit).

The stop-loss value depends, firstly, on how much the trader is ready to lose at one deal and, secondly, on his calculations of the market situation.

For example, the trader has S dollar deposit. When opening a position he lets in the losses in the amount of L% of deposit amount.

Suppose that the 100,000 contract was opened with USD buying against CHF selling and at this the opening price was p₁.

Buy USD 100,000;

Sell CHF p₁ x 100,000.

On what p₂ level should the trader position an order not to exceed the level of admissible losses SхL?

If the order on the p₂ worked, the position loss would be:

Loss=-CHF (p₁-p₂)х100,000.

On the other hand, the loss shouldn’t exceed USD SxL, or in CHF - SxLxp₂. Consequently, we have:

(p₁-p₂)x100,000=SxLxp₂,

from where we get the following expression for the order level:

p₂=p₁-p₁ xSxL/(SxL+100,000).

It’s necessary to note that at defining the stop-order level the trader should consider the reasonable combination of technical factors, price and considerations for private capital protection. The more changeable the market is, the further the stop-loss order levels should be from the current price level. It is in the trader’s interests to position the stop-order as close to the price level as possible to minimize the losses from bad deals. At the same time too “hard” top-orders can lead to undesirable position liquidation at short-term price fluctuations (“frictions”). The furthest stop-orders are not sensitive to “frictions” but can lead to substantial losses.