Some Thoughts About Basket Trading
Basket trading can be a useful way of diversifying your risk, but it can also increase your risk. We have just added some great "risk management" related resources for you on our website here: https://financialsource.co/some-thoughts-about-basket-trading/
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We have a quick question here from a new subscriber saying that he has often heard us talk of basket trading and wanted some more clarity on what we mean by that.
As always thanks for the question, so in simple terms basket trading just means that we are trading a specific currency against a basket of other currencies.
I think the best way for me to display this would be to open up a page where we have all the pairs for a specific currency on the board, so let’s get that up for a second.
So, on this grid, we have all the major Euro pairs as well as the EUR currency index, for those of you with tradingview the code for it is EXY.
So, looking at basket trading, when we say basket trading, we are referring to selling or buying a particular currency against multiple other currencies, so if we used this entire basket as an example, with this morning’s PMI release, we could have sold the EUR against each of these majors.
Now the reason why we sometime sell of buy something against a basket is as a means of diversifying our position. For example, the EURGBP is a great example of why this works for many traders.
Firstly, we know we wanted to sell the EUR after the PMI’s, but we obviously don’t know what the rest of the day holds for other currencies right? Something can happen throughout the day that makes another currency even weaker than the EUR, and we if ended up buying that currency against the EUR and that was our only position we would lose a trade that could have worked out great.
So, looking at this example, if we sold the EUR today against all of the majors, we would have made money on all of them, expect on the EURGBP, so even though EURGBP would have been a losing sell, all the others would still be in profit, so the main reason for doing basket trading is to try and limit our risk by not just trading one currency against another.
There are some caveats to this though, basket trading is usually only a good idea if you know what you’re doing, because if you are not careful you can end op over-leveraging your trade and that can get really dangerous.
So, if you do take a basket trade make sure that you are not risking your full amount of risk on each of them, you can split your risk, so if you usually risk 1% per trade, you can split that trade into 4 as an example and risk 0.25% on each clip and split it over four different pairs.
The other challenge with this is that it can be really tricky to manage multiple positions once volatility starts ramping up, for example, instead of watching your key levels on just 1 pair and your pivots and ADR’s on just one pair you now have multiple pairs to worry about.
Now, you might argue that the main reason why we use sentiment to choose currency pairs is because we try to pick a strong one against a weak one, so why trade something that is not expected to have the opposite strength or weakness.
The aim with this is not to find the ideal sentiment pair, the idea with this is to diversify against unknown sentiment shifts, like in the example of the EURGBP, but sentiment is still something you will consider.
For example, in today’s session we had two strong currencies in play, the USD and the JPY and there were reasons for that, so choosing just the USD or the JPY would be a much better option than choosing all 7 of them, just as an example.
So, hope that helps with the question, any other ones don’t hesitate to let us know.
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