Time Crunch Trading

Money management can be much more involved than just defining the risk of a
specific trade or position. As a part-time trader you will probably be best off
if you stick to just a single open position at a time. The more trades you have
on, the more time you will have to commit to monitoring and managing them – time
you simply may not have. Better to have only one open position which you can
fully concentrate on rather than several splitting up your focus.

That said, traders with larger portfolios will sometimes want to spread their
risk around and diversify their trading activities. There are also times when a
great opportunity comes along that just cannot be ignored. That is when the
unified money management strategy comes in to play.

The portfolio side of risk and money management is where you must step away
from taking a trade-by-trade view of things and shift to a wider focus. Failure
to do so leads to an overly narrow outlook in which you fail to understand the
way that combined positions can increase or decrease your overall risk.

Correlated Trades

As soon as you have multiple open positions you have to consider the question
of their correlation. Do the markets or instruments you hold tend to move in the
same direction? Do they tend to move in opposite directions? This is extremely
important to the health of your portfolio.

Refer to the charts below. The top is Gold from early 2003 in to early 2005.
The lower one is EUR/USD (US dollars per Euro) for the same time frame. As Gold
is priced in Dollars, the metal tends to appreciate as the currency declines in
value (a rise in EUR/USD means the Dollar is losing value against the Euro). It
is easy to see the general correlation when viewing the charts.

Another example of correlated movement is equities and fixed income (interest
rates). Stocks and bonds (or notes) tend to trade in the same direction since
declining interest rates are generally positive for corporate earnings. They
mean lower discount rates when calculating discounted cash flows in that kind of
valuation analysis. You can see this in the charts below of the S&P 500 index
and 10-year Treasury Note prices respectively. While the amplitude of the
changes may differ, sometimes dramatically, both instruments trended in the same
direction from 1982 to 2006

.

In the increasingly global financial environment, markets are linked to each
other and influenced by similar things. Therefore they will often move in
similar ways, resulting in positive correlations (or meaningful negative ones
for that matter.).

This is extremely important in assessing your overall portfolio risk. It is
very easy to have highly correlated positions without thinking about it until
suddenly there is a large loss when both positions go negative at the same time.

Were you to actually calculate the correlation coefficient for Gold and EUR/USD
or Stocks and Bonds during the timeframes depicted in the charts on the previous
page, the result would not be 1.0. It is almost never going to be 1.0 in any
pair of markets or instruments. But it doesn’t need to be to create excess risk.

If you hold a position in two markets or instruments which are even modestly
correlated, the overall risk to the portfolio can be significantly increased,
theoretically up to double. This is often overlooked because if things go well
(both positions profiting simultaneously), the return on your portfolio is
higher than it would be otherwise.

The risk of correlated positions is usually only brought home when something
happens that makes both positions go negative at the same time. It could be a
news report or a data release, or just the normal course of trading activity
with no overt cause.

If such an occurrence takes place in your portfolio, for whatever reason, you
will be left staring at a larger than anticipated loss and cursing your
foolishness at taking so much risk. You should try to eliminate (or at least
severely reduce) the unfortunate experience of looking back with hindsight and
realizing that something different should have been done, which could have been
prevented by considering correlation.

The markets, however, do not always track each other. Even well correlated
ones will diverge from time to time.

Refer to points A and B on the S&P 500 and 10-Year Note charts which follow
as an example. While the 10-year dropped sharply between the two points, the S&P
barely ticked lower at all. (It is interesting to note that the fall from point
A to point B in the 10-year took place in 1999 representing a sharp rise in
interest rates - an omen of the collapse in stocks that would come in 2000?

These sorts of disconnects between the markets happen frequently.

Refer back to the Gold and EUR/USD example.

The charts above are taken from the first half of 2004, as a subsection of
the earlier charts which showed fairly well correlated movement. Notice that
these charts are not nearly as well correlated in the first half of the plot
period. During January and February Gold was in a down trend while EUR/USD
actually made a new high. Then the two flipped courses. Gold rallied through
March while EUR/USD dropped steadily.

It is exactly this kind of action which demonstrates why the trader must
always be aware of the current linkages and correlations when putting on
positions in multiple markets and/or instruments.

We don’t want to say that having multiple trades active is a bad thing and
should always be avoided. In fact it must be said that you can actually lower
the risk in your portfolio by combining multiple positions. That normally means
having positions with negative or near zero correlations.

The really important thing to take away from this correlation discussion, is
that you must think in terms of the future. It is all fine and good if one
market has a particular correlation coefficient when compared to another over
the last whatever period of time, but it means nothing if the markets do not
have the same linkage going forward.

Trading is about expectations and so too is money management. When looking at
the correlations between two positions (active or proposed), you have to make an
assessment (forecast, if you like) as to whether that linkage will change, and
if so, how. To do otherwise is like driving a car looking only in the rear view
mirror.

That ties in with our next topic.

Spreads

Something that needs to be addressed at this point is the concept of the
spread trade. It represents a middle ground between a single trade and a
multiple trade position. Often times, however, the spread is confused with
hedging.

A hedge is defined by what is trying to be accomplished - specifically, to
offset one or more specific risks associated with the position being held. It
is, as noted, comparable to taking out an insurance policy.

A spread position, on the other hand, is one in which offsetting trades are
made in two or more related, but different instruments. The objective is to
profit from the changes in the price or some other differential between the
instruments in question. This is not the same as a hedge, even though some tend
to equate the two. The spread does not have the insurance policy type
characteristics.

An example of a spread would be buying a 2-year note and selling a 10-year
note. In this case, you are making a bet that the interest rate spread between
the shorter-term and longer-term maturities is going to widen (yield curve will
steepen). Another kind of spread trade would be to buy gold and sell platinum in
expectation that the price of the former will rise more than the price of the
latter (or fall less).

To make a direct hedge/spread comparison, let us start with a long position
in General Motors stock. We bought the shares because we think GM is going to
see excellent earnings growth in the quarters ahead. We are concerned, however,
that the market as a whole might not perform very well in the near future, which
could put pressure on the price of the stock. As a result, we buy S&P 500 put
options, so that if the market does fall, we are protected. That would be a
hedge.

In this case, where we want to guard against a broad stock market decline, we
would NOT want to take a short position in another auto stock such as Ford.
While it might provide us some protection, one stock is hardly likely to provide
a good representation of the market as a whole, or even necessarily a market
sector. It is an inefficient hedge, as Ford-specific factors could be the
dominant reasons for variation in the price of Ford stock. Think about something
like a product recall which would certainly pressure Ford’s earnings, but is
unlikely to influence the general state of the automotive sector over much.

If, on the other hand, we think that GM is likely to take market share away
from Ford, then we can take a short position in the latter in conjunction with
our long position in GM. In that scenario we would expect GM stock to outperform
Ford stock, regardless of how the overall market performs. This is a spread
trade, which is also sometimes referred to as a matched pair trade.

The difference between the two positions is subtle, but important.

In both case we are taking opposing positions in securities we expect to move
in basically the same direction, though in the spread case we may expect GM to
rise and Ford to fall. In the hedge situation, however, we are trying to limit
our downside - at least as caused by one potential risk factor - which can cut
down our profit potential.

The spread trade, however, is basically open-ended. It can go in either
direction with a virtually limitless amount.