Retail traders may be familiar with the term “diversification”. Yet, as a risk management technique, there is limited effort to configure one’s trading portfolio to satisfy the basic tenets of diversification.
Using a mix of trading strategies (up, down and sideways) chosen from various underlying stocks across different sectors is arguably still concentration of trading capital in one asset class – equities. Not diversification. Even using equal-weighted Indexes and ETFs (majority are stock-settled), limits trading activity within the same asset class – equities, even though the Index/ETFs are bundled as a basket removing single stock exposure. Again, still concentration risk.
So, what is a more complete understanding of “Diversification”? How can you structure a robust home trading portfolio as a one time set up? ...
Adjust for Volatility and Probability
Adjusting the probability of volatility changes in the portfolio is the key goal of diversification. Trading capital needs to be allocated to different Asset Classes, Market Cap categories, Sectors and Geographies. Why? Volatility can be added to/reduced from the portfolio, as not all Asset Classes or Sectors or Individual Companies or Countries move up/down in value ALL at the same time; and/or, ALL at the same rate.
2 Key Risks
2 types of Risk are relevant for home traders.
Newer retail traders, often adopt a narrow interpretation of risk. Which is the risk of price change arising from unique circumstances to a specific security, as opposed to activity in the broader markets. It is also known as Unsystematic Risk. Price or Specific risk is the more common term. This risk can be diversified away, as it is specific to the product traded.
There is also Market risk, referred to as Undiversifiable/Systematic Risk. This is risk common to an entire class of assets. The value of investments may decline over a given time period simply because of economic changes or other events (political) that impact large portions of the market. With the market (that the product trades in), it is not possible to limit Undiversifiable risk to a point of it being neglible.
Still, addressing these 2 key Risks builds the necessary robustness into your portfolio for diversification to absorb shocks to your open positions.
Even if you have deep learning of how to adjust and repair option trades when you are hit with price risk specific to the underlying, you cannot repair the entire Sector the stock is in. You may not get the price to fix the trade for breakeven. Adjust trades for profit, not for breakeven and most definitely not during losses – exit as planned.
Portfolio construction is the cornerstone foundation necessary for the mechanics of volatility to work towards favourable odds.
Building Blocks of Your Portfolio
❑ Asset Classes: Equities (Stocks), Fixed Income (Bonds) and Cash Equivalents (Money Market instruments). Investment advisors typically add Real Estate and Commodities as asset classes as well.
For the retail trader, instead of stock, trading Indexes removes single-stock exposure. With an extensive range of optionable Indexes and 100s of ETFs available, it is unecessary to search for the next "super" stock. And tens of ETFs continue to be added each week.
The 3 Month US T–Bill is the “Risk Free Rate of Return”, used as a benchmark, if you stayed only in cash and did not trade any of the other Asset Classes. When FOMC (Bernanke et. al.) announces policy changes for the Fed Funds rate, it is this 3 Month T–Bill rate that is adjusted. And it is from this rate which the inter-bank determines the credit interest rate, from which your broker pays interest on the cash balances in your trading account. It is also this rate which commercial banks use to determine the short-term borrowing cost to price loans which companies borrow to satisfy their balance sheet requirements. There are also long-term optionable bonds.
For cash equivalents, Currency ETFs and European-style Currency Options would introduce a level of volatility more aggressive than a 3 Month US T-Bill; which, may be as aggressive as the volatility from stocks.
For commodities, there is a low negative correlation to stocks and bonds. Depending on the chosen commodity, you can add/reduce a level of volatility in your portfolio similar to what you would get with an Index/ETF; but, with the commodity's price action uncorrelated to equities. Make room in your portfolio to include non-correlated optionable commodities.
❑ Market Capitalization: Too often, an Asset Class is confused with the Asset Class Category. Describing “large-cap stocks” as an Asset Class is wrong. Market capitalization is a category within the Asset Class of equities. The categories are: Large Cap (USD 10 Billion+), Mid Cap (USD 2 – 10 Billion) and Small Cap (USD 250 Million – 2 Billion).
Just as you would not allocate all your cash to one Asset Class, avoid concentrating trading capital on only one Market Cap category. There are optionable Indexes for the various Market Cap categories.
❑ Sectors: Institutional money managers shift funds under their management between favoured and unfavoured Sectors. Any one Sector does not remain a Gainer or Loser. There is rotation of money between Sectors. Don’t over-invest in just a single Sector. For a chosen Sector, track the Institutional money flowing in/out of that specific Sector as confirmation to support the logic of your chosen trade strategy (up, down or sideways).
S&P uses the Global Industry Classification Standard (GICS®), an industry classification system jointly-developed with Morgan Stanley Capital International (MSCI), to determine the segment a company belongs to. There are 10 Sectors, 24 Industry Groups, 67 Industries & 147 Sub-Industries. Each Sector has a variety of optionable Indexes to trade it.
In trading Sectors, please be aware of the correlation versus non-correlation of products traded. The more commonly known relationships are:
❑ Changes in Energy (XLE) – especially Oil (OIH, OSX) impacts Semiconductors (SMH, SOX)
❑ Utilities (XLU, UTH, UTY) are negatively correlated with Semiconductors (SMH, SOX).
❑ Highest correlation is between Dow Jones and S&P 500.
❑ Canada benefits from rallies in oil – being the 9th largest producer of crude oil globally; while Japan – a major net oil importer – suffers. The tickers for this inter-play would be FXC/XDC (Canadian Dollar), FXY/XDN (Japanese Yen) and OIH/OSX (Oil).
❑ Gold (XAU, GLD) behaves like the Australian Dollar (FXA, XDA). Australia is the 3rd largest producer of gold globally.
❑ Top three currencies that have the tightest correlations with commodities are the Australian Dollar, the Canadian Dollar and the New Zealand Dollar.
❑ Gold/Silver (XAU, GLD) has very little correlation with other Indices.
After building the blocks of of your portfolio, you need to answer the question: How do I make trading sense of the dynamic relationships between Bonds, Stocks (using equity-based Sector Indexes and Geographic ETFs), Currencies and Commodities, WITHIN 30 minutes?
Find out more on how to synchronize retail–based allocation within your trading account as institutional capital shifts between strong(er) and weak(er) asset classes.
❑ Geography: A typical error in constructing portfolios is “home bias” – investing only in domestic US companies – limiting exposure to one country.
Liquidity in the US markets is made up of both US and Non-US companies. For e.g. Apple (AAPL) is parented in the US, while it operates in Asia and Europe as well . There are also Asian and European companies whose headquarters are outside the US; but, they are listed on the US exchanges contributing liquidity to the US markets. Non-US firms may well generate most of their cash outside the US; but, reinvest it back into the US via American Depository Receipts, known as “ADRs”. ADRs are denominated in U.S. Dollars, with the underlying foreign security held by a U.S. financial institution overseas. There are optionable ADR Indexes.
US and Non-US companies are not necessarily competing against each other, as cross-regional and global trade becomes increasingly connected, US companies often enter into Joint-Venture arrangements with Non-US companies. Especially in the Emerging Markets, where US firms need a local business partner to gain quicker and deeper access to domestic markets. A portion of the USD cash flows are likely to be repatriated back to the US. Investing in the Indexes of Emerging Markets is no more risky than investing in a US Index made up of only US companies. Arguably, with low correlation between domestic and foreign optionable products, it makes sense to reduce the overall risk in the portfolio with Non-US products.
”Emerging Markets” typically includes the Big Four countries: Brazil, Russia, India and China, grouped as “BRIC” in a Goldman Sachs thesis arguing these economies would collectively surpass the world’s richest countries in 2050.
Variants of BRIC include BRIMC (M for Mexico, BRICS (S for South Africa, BRICA (A for GCC Arab countries – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia & UAE and BRICET (E for Eastern Europe and T for Turkey). These countries have become collectively known as “Emerging Markets”.
To trade the Emerging Markets, you do not need to open an account inside Brazil, Russia, India and China, where the currency regulations make it costly (hefty taxes on dividend and income repatriation) with difficult paperwork for you to take the money out. Use the optionable Emerging Market Indexes listed in the US, as you are likely to already have a USD trading account in the US.
Remember as a self-directed options trader, it is options that you are developing as the core competency. Options remain your chosen derivative to diversify the portfolio, whichever Asset Class, Market Cap category, Sector or Geography you decide to trade. You do not need to trade the underlying asset classes directly – i.e. become a Bond trader or Currency trader – to diversify into them.
Feasibility of Diversified Retail Allocation
Is it realistic for home traders with accounts ranging from USD10K-50K to adequately diversify their portfolios to achieve an acceptable level of non-correlation? Yes.
Let’s use USD10K as the total trading capital available. Most money management rules typically advise allocating 1%-3% or 2%-5% per trade.
Using 5% as the higher end of that rule = 5% x $10,000 = $500 per trade.
Bond ETFs: 2 trades x $500 = $1,000
Sector Indexes: 2 trades x $500 = $1,000
Currency ETFs: 2 trades x $500 = $1,000
Geography: 2 trades x $500 = $1,000
Commodities: 2 trades x $500 = $1,000
$5,000 is below where a USD10K account is considered fully allocated out. $6,000/$10,000 = 60% of the portfolio is allocated out with 40% of cash reserved to restart trading in a business in the event that losses mount up. Typically, an allocation of ~60% is deemed to be “fully allocated”. Allocating 70+% of available cash would be an aggressive allocation (versus balanced). Reserve about 40% of capital to restart the home trading – blowing up your account is final – there is no bail out package for a self–funded business. As demonstrated it is possible to satisfy structured diversification with a full allocation, given a portfolio size of USD10K.
Typically, home traders should try to keep within a maximum of 10–12 open positions at any given point in time. Otherwise, there are too many positions to practically manage on an on-going basis. The "Trade Desk" is you, not a team.