Investors have for many years used different classes of investment instruments to diversify their portfolios. Today, in addition to equities and stocks, there are many other classes that can provide diversification benefits. These include currencies, derivatives, commodities, and real estate. Currency or Forex trading has specifically gained increasing popularity among investors and investment communities.
Where and How Exactly Does Forex fit in an Investment Portfolio?
Many online traders know that diversification helps to reduce the risk of a portfolio. How to do it effectively, however, is an unclear matter that concerns most. Each investment added to a portfolio must provide some unique diversification benefits.
Bonds, for instance, are used as a hedge against economic downturn because equities generally depreciate during such conditions. However, if the economy continues to deteriorate and inflation worsens the hedging ability of debt instruments diminishes. The interest paid on the instruments is no longer enough to compensate for capital loss on equities. Real estate can also fail to provide significant investment risk reduction, as was witnessed in the 2008 financial crisis.
Diversification Benefits of Forex Trading
Currency trading has some unique characteristics that investors can leverage to diversify their portfolio. Unlike stocks that move independent of each other, currencies move in pairs and change relative to each other. When one currency in a pair is rising, the other currency is falling. You can take advantage of currency movement in either direction. If you believe the dollar will increase against the Yen in future, you buy dollars long. On the other hand, if the dollar is expected to fall in value relative to the Yen, you sell dollars short.
There are opportunities to make a profit in Forex trading whether the currency being held rises or falls in value. Currencies can balance a portfolio that is heavily invested in stocks. As an investor, you need to understand how stocks affect currency movements to efficiently identify profitable trading opportunities.
Flexibility of Trading Hours
When you invest in stocks and bonds, trading activity is limited to the stock market’s opening and closing hours. An investor that has invested in these instruments can only trade when the market is open. The Forex market is open 24/7, which means you can remain active around the clock. In addition to being able to access the market for a longer time and at your convenience, the real-time trading allows you to react quickly to market news and indicators.
With a portion of your capital is invested in Forex, you can balance your activity and avoid the risk of decreasing income when activity in the stock and bond markets goes down.
High Leverage Ratio
Leverage helps an investor to profit from exchange rate fluctuations. The Forex market has one of the highest leverage ratios and this is good for investors. Depending on the size of your position, and your broker, you can be allowed a leverage ratio of either 50:1, 100:1, or 200:1. A leverage ratio of 50:1 means that you are required to have 2% of the value of the trade as cash in your trading account.
Stock trading entities also allow for leverage when buying stocks but it is usually lower than that for Forex. The ratio is normally limited to 4:1 or 2:1 ratio, which implies that you need to have upfront cash equal to 25% or 50% of the desired trade.
The higher leverage ratio on Forex enables traders with little upfront capital to start trading currencies and build their portfolio quickly.
Volatility in Forex market is an opportunity
While volatility in equities market is viewed as a generally bad thing, it is an opportunity in currency trading. Experienced Forex traders know that rapid currency price fluctuations are opportunities to make quick profits. Thus, when other financial markets invested in become more volatile and riskier, you can use Forex to cover possible losses in your stock or bond positions.
Forex trading has become an investment option for many investors looking for ways to diversify their portfolios. It is not just lucrative but also powerful as an avenue for diversifying your investment portfolio and enjoying more balanced returns round the year. Other inherent features like ease of entry into the market and little initial capital requirement makes Forex a suitable option for any investor who wants to venture into online trading.
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