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Old 10-06-2011, 02:29 PM
Shawn W. Cooke Shawn W. Cooke is offline
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Default Basket Trading Strategies

This goal of this writing is to bring a better understanding to exactly what you are trading when you trade an entire market index like the S&P 500. Furthermore to shed some light on some alternative strategies with higher probabilities. This article will cover the following:

-Basket Trading Guidelines (broad concepts)
-Basket Trading Exchange Traded Funds vs. Exchange Traded Funds
-Basket Trading Exchange Traded Funds vs. Stocks
-Basket Trading Stocks vs. Stocks

The broad concept of Basket Trading commonly involves going long a Basket of Stocks or Exchange Traded Funds and shorting a second Group of Stocks or Exchange traded funds. These trades aren't just for swing traders. These trades may last only minutes or up to a few days and may include as many or as few stocks or Exchange traded funds as a trader wants. This tactic and the analysis that goes along with it work naturally with how cash flows in the Stock Market.

Here is why:

The SEC establishes concrete rules that Mutual Fund Managers have to adhere to. Without getting overly detailed, the policies require that the Money Managers keep their assets invested to a particular extent at all times. Short Selling is also not an option for Mutual Fund Managers. So the only way for Money Managers to raise cash to participate in an up trending market is to sell a part of their holdings. Naturally, they sell their low beta safe haven sectors like Consumer Staples, Utilities and Healthcare sectors. The proceeds from this liquidation get used to participate in the riskier sectors that generally get bought in an uptrend like Energy, Financials, Technology or Consumer Discretionary. Price action like this is typically referred to as a "Risk On" price environment. 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. Price action like this is typically referred to as a "Risk Off" price environment.

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 the SPY ETF 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 makes for a much less choppy trading environment and I'll tell you 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. The Standard and Poors 500 has a huge (and I mean huge) contrast in its weightings between Big and Small cap stocks. Here is something to think about:

-About 50 of the 500 stocks in the S&P 500 (thatís a measly 10%) control half of the weight in the entire index. That means the remaining 450 Companies control the other half.

-About 65 of the 500 stocks in the S&P 500 (thatís a measly 20% of the actual number of stocks in the index!) control about 65% of the weight in the entire index. Once again, the remaining 435 companies control the other 35%.

That second statistic really get's to me. Just to say it again, 435 of the 500 companies control about 35% of the weight in the S&P 500. Examples of stocks with the highest weightings include Proctor and Gamble, Berkshire Hathaway, Phillip Morris, Johnson and Johnson and Pfizer. As you might imagine, it would be very hard to depend on names like these for volatility. There are many different trading tactics 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 individual 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 technique 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 standalone 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.

If youíd like more information about the Excel Basket Trading tools we offer for simultaneous order entry for multiple securities, please feel free to visit us at
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