Last Updated on October 21, 2022
Trading and investing can be very risky, and it is well known that diversification is one of the most time-tested ways to reduce risks. This is where the Forex basket trading strategy comes in, but what is forex basket trading?
Basket trading is a trading strategy where you simultaneously trade a group of different securities. In forex, basket trading involves buying and selling different currency pairs at one time where the market lines up with the aim of reducing risks and maximizing profits.
In this post, we take a look basket trading strategy in Forex, and at the end of the article, we present a forex basket trading strategy.
What is the Forex basket trading strategy?
Basket trading is a trading strategy where you simultaneously trade a group of different securities. In forex, basket trading involves buying and selling different currency pairs at one time where the market lines up with the aim of reducing risks and maximizing profits. That is, instead of trading one currency, you trade a basket of currency pairs.
Due to the positive and negative correlation between different currency pairs, some positions may cancel each other. Correlation between assets and trading strategies is one of the most crucial elements when you are putting together a portfolio of trading strategies. We recommend reading our previous articles about the subject, something that is a must-read if you are serious about trading.
- Uncorrelated assets and strategies – benefits and advantages
- Does your trading strategy complement your portfolio of strategies?
Correlation means that, when you open positions in different assets, the profitable ones will more than make up for the losing ones, and in the end, you have a net profit. To accomplish this, you have to look at a particular currency pair that has a clear trend (bullish or bearish). Based on the strength or weakness of the 2 currencies, you can establish the general direction of that particular currency pair, and once you have done that, you can choose your basket of currencies.
The most important thing about trading basket currencies is that it creates diversification, which helps you to manage risk. As you know, the most challenging part of forex trading is finding the right ways to manage your risks. When you are able to properly manage your risks, you stand a higher chance of being profitable. However, the most important factor is to make sure you have a positive statistical trading edge.
Another good thing about basket trading it takes away the need to be totally right in both your analysis of the market and choice of currency pair. By using forex basket trading you can detach yourself from this concept of being right on every trade. If you think you can win every position, you can’t be farther from the truth. With basket trading, you can let the market do its thing while you win some and lose some. The key thing is that you make profits when you’re right.
Forex trading basket indicator example
To help you really understand forex basket trading, we will try to describe an example.
Let’s say you have performed your analysis and come to the conclusion that the USD is weak and would keep declining for some time. Assuming you want to go long four lots on the EUR/USD, you will have to be totally right that the EUR/USD in particular would rise. If you are right that the USD is weak but for some reason, the EUR doesn’t rise, you will not make any profit or may even lose even though your analysis about the weak USD is right.
On the other hand, with currency correlation, you can spread the risk around by trading 1 lot in four major currency pairs against the USD.
Most of the time, the majors are moving in correlation, just at different speeds. So, if the EUR/USD doesn’t rise so well when the USD is weak but GBP/USD, USD/JPY, and AUD/USD did well as anticipated, you would end up profitable, unlike when you trade only EUR/USD and EUR falters. With basket trading, you are only required to be mostly right or wrong, rather than totally right or wrong.
Forex basket trading is often used by automated traders, hedge fund managers, and large institutional investors who have a lot of capital to invest. The strategy allows them to more effectively manage their business. Many traders create basket trading using a hedge or independent currencies to reduce risk. Hedging purpose is when there is trading for long and short currency pairs together. But small retail traders also use basket trading as a way to manage risks.
Outside the forex market, investors can use basket trading to manage their portfolios by creating a basket trade that fits their investment objectives. Basket trades make it straightforward for investors to allocate their investments across multiple securities.
Some of the methods used include dollar and percentage allocations, which entail distributing a dollar amount or a percentage amount across different securities. It becomes easy to add or remove individual or multiple securities from the basket. Moreover, it is easier to track the performance of a basket trade as a whole than monitor individual assets.
How to implement Forex basket trading
Here are the steps to using the Forex basket trading strategy:
- Analyze a certain currency and determine the trend: You should find a particular currency pair that has a clear trend, which can be bullish or bearish.
- Select a basket of currency pairs: After determining the general direction of a particular currency pair based on the strengths and weaknesses of the two currencies, select a basket of currencies that correlate with the first pair you analyzed. The currency pairs must not have the same base currency or quote currency but must be a pair of the currency you analyzed earlier. For example, if your analysis shows that the JPY would strengthen, then you are expecting a bearish trend in USD/JPY, so you also select GBP/JPY, EUR/JPY, and AUD/JPY.
- Distribute your position size across the chosen currency pairs: If you plan to risk 4% only, distribute it equally across the four currency pairs, with 1% on each currency pair.
- Trade according to your analysis: Go short on the chosen currency pairs since your analysis established that the JPY would strengthen. Note that if your analysis is wrong, you are likely to lose across all four currency pairs since they are correlated.
How do you determine the above? There is, in our opinion, only one way: you need to backtest and don’t use non-tested technical chart patterns or other forms for anecdotal evidence. If you are new to backtesting, we have a cheap beginner online course that might be of interest:
Also, please have a look at our two articles below to get a better grasp of what backtesting is all about:
Benefits of Basket trading
Here are some of the benefits of using the basket trading strategy in Forex:
- Basket trading helps you control your investments, as you can add or remove individual or several securities to the basket.
- Tracking the overall performance of the basket of transactions also saves time and simplifies the administrative process, as you won’t be monitoring individual and unrelated trades.
- Basket trading makes it easy for you to spread your risks across multiple instruments.
Forex Basket Trading Strategy (backtest)
We only trade a few currency pairs via regulated futures contracts, but we downloaded data for a few currency pairs to evaluate the correlation among them (spot prices).
For example, a low correlation forex portfolio could consist of the following pairs:
All of these pairs have on average pretty low correlations in many time frames like daily, weekly, and monthly. However, please keep in mind that you lose correlation the more pairs you throw into the equation.
The EUR/USD is the most traded currency pair and is pretty correlated with most other pairs. From the correlation matrix that we backtested ourselves, we believe AUD/USD seems to offer the lowest correlation to most other pairs. But as always, nothing stays the same for a long time in the financial markets, so this might have changed by the time you read this post and we encourage you to backtest yourself.
We don’t trade forex baskets. As a matter of fact, we find the forex market very difficult to trade because of the enormous amount of news and noise. Our experience indicates that news and trading has an inverse relationship in terms of profitability!
Let’s go on to make a simple backtest of a very simple and naive forex basket trading strategy taken out of the top of our head (only to make an example). Here are the trading rules and the settings in plain English:
- When the EUR/USD pair breaks above the upper Bollinger Band (using 150 days and 2 standard deviations), we go long at the close.
- We cover when the close breaks below the 150-day simple moving average.
- We take the opposite position in AUD/USD (we short AUD/USD when we go long EUR/USD).
The equity curve is pretty poor, to say the least:
However, what is more interesting is the relationship between the two different pairs. This is the different returns for each pair:
The tiny profits made in EUR/USD is offset by the large losses on the opposite short trade in AUD/USD.
Hopefully you see the potential effects and power in having uncorrelated assets and trading strategies!
Amibroker code and plain English
If you want the Amibroker code for this backtest and over 100 other trading strategies/ideas (taken from our landing page with our best free trading strategies), please check out our product:
Forex basket trading strategy – ending remarks
Hopefully, our simple (and naive) backtest shows how you can utilize uncorrelated assets and strategies to make trading strategies. Many institutional and proprietary traders use a forex basket trading strategy for the very same reason.