It has been said that the single most important factor in building equity in your trading account is the size of the position you take in your trades. In fact, position sizing will account for the quickest and most magnified returns that a trade can generate. Here we take a controversial look at risk and position sizing in the forex market and give you some tips on how to use it to your advantage.
The Undiversified Portfolio
In the book “The Zurich Axioms” (2005), author Max Gunther states that in order to break away from the “great un-rich,” an investor must avoid the temptation of diversification. This is controversial advice, since most financial advice encourages investors to diversify their portfolios to ensure protection against calamity. Unfortunately, nobody gets rich from diversification. At best, diversification tends to balance winners with losers, thus providing a mediocre gain.
The author goes on to say that investors should “keep all [their] eggs in just one or two baskets” and then “look after those baskets very well”. In other words, if you are to make real headway with your trading, you will need to “play for meaningful stakes” in those areas where you have sufficient information to make an investment decision.
To measure the relevance of this concept, one need only to look at two of the most successful investors in the world, Warren Buffet and George Soros. Both of these investors do play for meaningful stakes. In 1992, George Soros bet billions of dollars that the British pound would be devalued and thus sold pounds in significant amounts. This bet earned him more than $1 billion virtually overnight. Another example is Warren Buffet’s purchase of Burlington Railroad for $26 billion – a significant stake to say the least. In fact, Warren Buffett has been known to scoff at the notion of diversification, saying that “it makes very little sense for those who know what they are doing.”
High Stakes in Forex
The forex market, in particular, is a venue where large bets can be placed thanks to the ability to leverage positions and a 24-hour trading system that provides constant liquidity. In fact, leverage is one of the ways to “play for meaningful stakes”. With just a relatively small initial investment, you can control a rather large position in the forex markets; 100:1 leverage being quite common. Plus, the market’s liquidity in the major currencies ensures that a position can be entered into or liquidated at cyber speed. This speed of execution makes it essential that investors also know when to exit a trade. In other words, be sure to measure the potential risk of any trade and set stops that will take you out of the trade quickly and still leave you in a comfortable position to take the next trade. While entering large leveraged positions does provide possibility of generating large profits in short order, it also means exposure to more risk.
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