Author: Clinton Lee.
If you are trading
a mix of Verticals, Calendars and Iron Condors across highly liquid indexes
like the DJX, DIA, MNX, QQQQ, RUT, SMH, SPY and XSP, is your trading risk
adequately diversified? No.
In choosing the
MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in
these Indexes: for example, AMAT (Applied Materials) is a component of all 5
Indexes. Bear in mind the MNX and
the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference
being the MNX is an European styled cash settled Index and the cubes (QQQQ) is
an American style stock settled Index.
Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP
- both the SPY and the XSP track the S&P 500, the SPY is American style
stock settled and the XSP is European style cash settled. Duplication is not
diversification. Even if you
allocated capital to the smaller versions of the Dow: DJX, the European style
cash settled version of the DIA which is the American style stock settled
version. Moreover, if you extended
capital allocation to trade the RUT, thinking you are diversifying into
small-cap stocks and away from large-caps, you just sunk more of your trading
capital into equities. Again, you
cannot achieve diversification by adding more capital in the same asset
class. You need to learn how to
trade options without concentration risk in stocks. Do not confuse asset category (market capitalization) with
asset class.
This is where there
is a need to understand Intermarket relationships. Intermarket analysis requires the simultaneous analysis of 4
main Asset Classes: Currencies (U.S. Dollar remains most liquid of all major
traded currencies), Commodities, Bonds and Stocks. Synchronizing
the rotation of asset allocation within your own portfolio lies in getting a
grip on how these four markets interrelate with each other.
Here’s the synopsis
of the relationships. Commodities
lead bonds, bonds lead stocks and stocks lead commodities. The cycle holds true at least in a
normal inflationary/disinflationary environment. Other than itself, Commodities affects 2 markets (Bonds and
Stocks); effectively, impacting 3 out of the 4 Intermarket relationships. Even if you do not trade Commodity ETFs
as part of your portfolio, you need to track Commodities as a leading economic
cycle indicator. The futures/Mini
Futures that you see on news headlines/trading screens are relevant only as
daily gauges for stock market behaviour.
They are not a cycle indicator across Asset Classes.
So, you may already
understand the criteria to define a "normal" economic cycle for the
Directional Relationships to behave "ideally" (see below); BUT, how do you determine which Asset Class is driving
the cycle? In other words, at a given point in the Intermarket cycle, how do
you determine which Asset Class has the DOMINANT Relative Strength to trade? See the Original Curriculum for a video-based
course, to learn how Relative Strength - a rotational algorithmic measure
is used to replace conventional Fundamental Analysis, as an asset allocation
technique.
Moving on, here’s
the Business Cycle in brief. Bonds
lead stocks, to trend in the same direction – except during deflation when
bonds rise and stocks fall. On
average bonds are 18 months ahead of stocks in rising to their peak or falling
to their bottoms; thereafter, stocks follow in the same direction. If bonds have not broken down yet, this
extends the gains in the stock market, acting as support for prevailing stock
market levels. The real risk
begins to build 5-7 months after the bond market peaks or bottoms, thereafter
the next 6 months stocks accelerate in the direction bonds have set.
Typically,
commodities and bonds have an inverse relationship: as commodities rise, bonds
falls but as commodities fall, bonds rise. Inflationary expectations affect
bond prices. US Dollar movements which is tied into Monetary Policy changes
affects commodity prices.
Commodities lead bonds 12–18 months in advance (it takes this long for
Monetary Policy to come into effect) and 24–27 months before the economy fully
absorbs the policy changes.
Now, the
relationship between commodities and stocks. Stocks tend to lead commodities.
Commodities are a hedge against inflation, with price inflation and higher
inflation expectations occurring towards the end of the business cycle.
Money and company
growth using credit (loans) takes time to make its way through the economic
system, from making prices rise to raising expectations on inflation. Thus,
commodities usually outperform at the end of the business cycle.
Rising bond prices
generally raise stock prices in recovery, with falling commodity prices
confirming an economic expansion phase is in play. As the expansion matures and
begins to decelerate, watch for bonds to turn down first (as interest rates
rise), followed by stocks.
Finally, it is
after commodities outperform stocks and start turning down, this signals the
end of an economic expansion with the probable start of activity decelerating,
then slipping into an impending recession.
Retail traders can
keep reading about the economics of inter–market analysis and asset
diversification. Though, they will not solve these key issues, every option
trader trading with USD $25-$50K or less, must deal with for retail asset
allocation purposes:
❑ How much capital is adequate to
sufficiently diversify risk away from any one Asset Class?
... if you can afford to diversify ...
❑ How do you practically reconcile the
multiple and continually dynamic macro-economic relationships, to trade in
relevant asset class?
Where
can I learn how to trade options profitably using Intermarket analysis
with retail asset allocation methods?
View Consistent Results, to see a profitable retail
option trader’s portfolio that is set up to cycle in and cycle out of
Intermarket relationships, between asset classes.