Risky Business – Part Three

This is the next installment in the area of risk management, particularly through diversification. I mentioned in the last post that the first type of risk management I employ is what I call Time Diversification. In other words, I like to scale into a trade across time.

The next area of diversification is in the underlying market. I think this is what most people think of when they consider diversification. The challenge I have is to find markets that are not too heavily correlated. For example, if I were to place a trade on the SPX and the RUT, there is a good chance they will win or lose together. When one increases, the other usually increases.

Market correlation is also ever-changing and we have to shift underlying markets to reflect that. Lately, for example, oil has been tracking the major markets quite closely. But that has not always been the case. In fact, for a long time it was rising oil that was blamed for a falling stock market. This is an ongoing analysis, but generally I bounce between equity indices, oil, metals, agriculture and real estate.

Once I determine what markets I want to trade I have to consider how to trade them. There are lots of ways to do this, so to keep it simple I generally use ETFs or Indices. These are also handy for directional trades. One of my favorites for bearish trades lately has been RKH (Regional Banks) as the financial markets have been hammered.

So, what does this do for my overall risk tolerance? As I mentioned previously, my overall tolerance for risk is 2% of my total capital per trade. In other words, in a worst case scenario I don't want my account going down more than 2% because of this trade. Given that, how does diversification in different underlying markets impact capital allocation? I've made the decision that each underlying is different enough that each one gets a fresh capital allocation. In other words, if I am willing to risk 2% on an oil trade, I might also risk another 2% on a SPY trade, believing that it is not likely I will lose 4% by doing both trades if they do not move together.

Good Trading…