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Reducing, Managing, and Controlling Risk |
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Inherent in every trade is a certain element of risk. All successful traders always know the amount of risk that they are subjecting their portfolio to, and will do everything possible to reduce this risk. They will then enter into their trade with the expectation that the market could do anything and that they have accepted all the risk. The most common way to reduce avoidable or unavoidable risk is by diversifying a portfolio. |
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Diversification enables traders to earn the same or higher profits while experiencing the same or a lesser amount of avoidable risk. Typically traders will diversify their portfolio by either trading contracts that are not highly correlated or trading different methodologies. Why do most traders decrease their portfolio, and increase their cash holdings when they are nervous? Because cash doesn't correlate to anything (the common belief). |
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In order to properly diversify your portfolio, you must understand the concept of correlation. Correlation occurs when a security (stock, commodity, or derivative) reacts to another security in a positive, negative, or neutral manner. Two securities that are positively correlated will rally and decline in price in lockstep with each other. Good examples are T-bills and T-bonds, or the S&P 500 and the DJIA, which normally track each other. A perfectly negatively correlated security is inversely in lockstep with another. Instead of both going up together, one of the securities will rally and the other one will drop. Typically a negatively correlated market is the T-bond market and the CRB Index. Since the CRB generally tracks the inflationary forces in the United States, and bonds are adversely affected by inflation, whenever the CRB increases in price, bonds will decline in price. Figure 18-3 shows a negative correlation. Markets that are neutrally correlated move in a random fashion to each other. A good example is orange juice and crude oil. |
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The interesting thing is that the correlation factor between the different markets can strengthen or disappear overnight. The correlation factor is in a constant state of flux. There are times when the U.S. Treasury bond market could be positively correlated to the Dow Jones Industrial Average, and yet other times when they will be negatively correlated. Different markets can become correlated because of specific news events that affect their fundamental picture; at other times the correlation stops because of the news. |
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