This editorial will focus on these subjects:
-Basket Trading Guidelines (general concepts)
-Basket Trading with ETFs versus ETFs
-Basket Trading with ETFs versus Stocks
-Basket Trading with Stocks versus Stocks
The general concept of Basket Trading generally involves buying a Basket of Stocks or ETFs and selling short a second Basket of Stocks or ETFs. This trade may last as little as a few minutes or as long as a trader wants. It may involve as many or as few stocks or ETFs as a trader wants. The concept makes sense when compared with the true ebb and flow of money in the Equities Markets.
Heres why:
The SEC sets concrete rules that Mutual Fund Managers have to follow. Without getting too detailed, these rules require that these Money Managers keep their portfolios invested to a certain extent at all times. Short Selling is also not an option for Mutual Fund Managers. This means that when the market as a whole moves up (when I refer to the market, I am referring to the S&P 500), Money Managers participate in the uptrend by selling portions of their holdings in safe haven sectors like Consumer Staples, Healthcare and Utilities to raise capital. They use the proceeds from that sale to invest in riskier sectors like Technology, Energy, Consumer Discretionary or Financials. This is called a Risk On market. If and when the up trending market runs out of steam, the price action reverses and money pours out of riskier assets and back into safer assets. This is called a Risk Off market.
Hopefully you’re starting to see why trading an instrument like the S&P 500 as a single instrument may really be a lot less volatile than most traders need. In an uptrend, half of the S&P is being accumulated while half is being distributed and in a downtrend, the exact opposite is happening. Naturally, this makes for a choppy trading instrument in the S&P Futures or ETF than might be had if isolating the individual sectors for a Basket Trading technique. This explains why careful sector analysis is so essential. The S&P E-mini or ETF’s are some of the most popular instruments to trade amongst new traders, but very few give thought to what is going on inside that trade. With some very quick scrutiny, you will notice that Mcgraw-Hill, who chooses the components of the S&P, really attempts to build this index to avoid volatility which explains why trading it as a whole may be a losing proposition.
Basket trading provides higher probabilities than trading an entire index like the S&P 500 and heres why. The S&P is called a Market Cap Weighted Index. In this type of index, the larger the Market Cap of a company, the more weight it holds in the index. Every trader knows that Large Blue Chip companies are not very volatile and therefore, will slow down the movement of any index they are a part of. But the S&P 500 is one of the least volatile trading instruments out there and here’s why.
-Only 10% of S&P holdings (thats only 50 of the 500 companies) control more than 50% of the weight in the index.
-To take it a step further, only 20% of the holdings (100 out of 500 companies) control more than 65% of the weight in the index.
In short, what this means for you as a trader is that trading S&P as an instrument (which is the most commonly traded instrument among new day traders) may really dampen volatility. Examples of stocks with the highest weightings include Proctor and Gamble, Berkshire Hathaway, Phillip Morris, Johnson and Johnson and Pfizer. Im not sure about you, but Ill never make a living trading blue chip names like these because they lack volatility. There are many different trading guidelines with different entry techniques but all of them share one goal which is to have your position get profitable in a small amount of time so that you may put a stop loss under it and contain your risk. To do this you need volatility.
Careful examination of each sectors weight will show you that the risk sectors that we talked about above do in fact hold more weight in the S&P 500 index. What this means for you as a trader is that in a “Risk On” trading environment, the market will naturally move up even though some of the safe haven sectors are being sold and the opposite will happen when the market turns into a “Risk Off” market environment. This has a dampening effect on the moves that occur in the entire S&P 500, especially if you compare these moves to those you would normally see from the individual sectors themselves.
A typical Basket Trading idea would be to buy the most aggressive risk sectors or stocks, while at the same time, selling (shorting) the most neglected safe haven sectors or stocks. This approach to trading makes your positions price action move in a more direct manner and removes the backing and filling from the chart that you normally would see when trading the S&P as a stand alone trade. You might also just consider trading the highest beta stocks in each sector as opposed to trading an ETF of the entire sector. This is just another way to increase volatility.