Basket Trading for Beginners

In this section, we will discuss the following topics:

-Basket Trading Strategies (general concepts)
-Basket Trading ETF’s versus ETF’s
-Basket Trading ETF’s versus Stocks
-Basket Trading Stocks versus Stocks

The general concept of Basket Trading usually involves buying a Basket of Stocks or ETF’s and selling short a second Basket of Stocks or ETF’s. This trade can last as little as a few minutes or as long as a trader wants. It can involve as many or as few stocks or ETF’s as a trader wants. The concept makes sense when compared with the natural ebb and flow of money in the Equities Markets.

Here’s why:

Most Money Managers ETFs to Reduce Downside Volatility are bound by certain rules that require them to keep a certain percentage of their portfolios invested at all times. They are also forbidden from short selling. 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. When the uptrend is over, they sell the riskier sectors and buy back the safe haven sectors and the cycle starts all over. This is called a “Risk Off” market.

This is why trading an entire market index as a whole can lack volatility. When the S&P is moving up, generally a portion of the market is being sold (usually safe haven sectors). When it’s moving down, the opposite is occurring. This causes instruments like the SPY ETF or the ES E-Mini Futures contract to move in a choppier manner than most traders would like. That’s why it’s important to drill down and really look at what you’re trading. Many people trade the S&P E-mini contract but give little thought to the components within the contract. Careful examination of this trading instrument will show you that it is constructed to avoid volatility.

Basket trading provides higher probabilities than trading an entire index like the S&P 500 and here’s why. This S&P is Market Capitalization Weighted which means companies with larger Market Caps hold more weight in the index. Large Cap holdings in any portfolio will dampen volatility and every trader knows how badly volatility is needed to be a profitable trader. However McGraw-Hill (the managers of the components of S&P) really take it to extremes. Read on…

Trading a Market Cap Weighted Index as a whole should not be a problem except for the fact that with S&P, the contrast between Large Cap and Small Cap companies is huge. Consider this:

-Only 10% of S&P holdings (that’s 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) can really dampen volatility. The top weighted index holdings include names like Johnson and Johnson, Phillip Morris, Berkshire Hathaway, Proctor & Gamble and Pfizer, to name a few. I’m not sure about you, but I could never make a living trading blue chip names like these because they lack volatility. And let’s face it, all Trading Strategies share one common goal: to get into a trade where there will be volatility so that the price moves quickly away from your entry point and into profitable territory.

If you trade the S&P 500 as a whole index, during any trend (up or down), part of the index is being sold and part is being bought. This keeps all moves to the upside or downside more dampened (less volatile) than you might see if you were Basket Trading the sectors or stocks separately.

Basket trading would involve going long the four riskier sectors while simultaneously shorting the three safe haven sectors. This smooths your trade out dramatically reducing the back and fill price action that you normally see when viewing the entire market as one instrument. To take it a step further, consider only trading the leading weighted stocks in the growth sectors and shorting the leading weighted stocks in the safe haven sectors. This will provide even further upward yield.

Follow the link in this sentence to learn more about Basket Trading Strategies [] and other tools we offer for simultaneous order entry for multiple securities.

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