If you are trading a mix of Verticals, Calendars and Iron Condors across highly liquid indexes like the DJX, DIA, MNX, QQQQ, RUT, SMH, SPY and XSP, is your trading risk adequately diversified? No.
In choosing the MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in these Indexes: for example, AMAT (Applied Materials) is a component of all 5 Indexes. Bear in mind the MNX and the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference being the MNX is an European styled cash settled Index and the cubes (QQQQ) is an American style stock settled Index. Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP - both the SPY and the XSP track the S&P 500, the SPY is American style stock settled and the XSP is European style cash settled. Duplication is not diversification. Even if you allocated capital to the smaller versions of the Dow: DJX, the European style cash settled version of the DIA which is the American style stock settled version. Moreover, if you extended capital allocation to trade the RUT, thinking you are diversifying into small-cap stocks and away from large-caps, you just sunk more of your trading capital into equities. Again, you cannot achieve diversification by adding more capital in the same asset class. You need to learn how to trade options without concentration risk in stocks. Do not confuse asset category (market capitalization) with asset class.
This is where there is a need to understand Intermarket relationships. Intermarket analysis requires the simultaneous analysis of 4 main Asset Classes: Currencies (U.S. Dollar remains most liquid of all major traded currencies), Commodities, Bonds and Stocks. Synchronizing the rotation of asset allocation within your own portfolio lies in getting a grip on how these four markets interrelate with each other.
Here’s the synopsis of the relationships. Commodities lead bonds, bonds lead stocks and stocks lead commodities. The cycle holds true at least in a normal inflationary/disinflationary environment. Other than itself, Commodities affects 2 markets (Bonds and Stocks); effectively, impacting 3 out of the 4 Intermarket relationships. Even if you do not trade Commodity ETFs as part of your portfolio, you need to track Commodities as a leading economic cycle indicator. The futures/Mini Futures that you see on news headlines/trading screens are relevant only as daily gauges for stock market behaviour. They are not a cycle indicator across Asset Classes.
So, you may already understand the criteria to define a "normal" economic cycle for the Directional Relationships to behave "ideally" (see below); BUT, how do you determine which Asset Class is driving the cycle? In other words, at a given point in the Intermarket cycle, how do you determine which Asset Class has the DOMINANT Relative Strength to trade? See details of an Original Curriculum, to learn how Relative Strength - a rotational algorithmic measure is used to replace conventional Fundamental Analysis, as an asset allocation technique.
Moving on, here’s the Business Cycle in brief. Bonds lead stocks, to trend in the same direction – except during deflation when bonds rise and stocks fall. On average bonds are 18 months ahead of stocks in rising to their peak or falling to their bottoms; thereafter, stocks follow in the same direction. If bonds have not broken down yet, this extends the gains in the stock market, acting as support for prevailing stock market levels. The real risk begins to build 5-7 months after the bond market peaks or bottoms, thereafter the next 6 months stocks accelerate in the direction bonds have set.
Typically, commodities and bonds have an inverse relationship: as commodities rise, bonds falls but as commodities fall, bonds rise. Inflationary expectations affect bond prices. US Dollar movements which is tied into Monetary Policy changes affects commodity prices. Commodities lead bonds 12–18 months in advance (it takes this long for Monetary Policy to come into effect) and 24–27 months before the economy fully absorbs the policy changes.
Now, the relationship between commodities and stocks. Stocks tend to lead commodities. Commodities are a hedge against inflation, with price inflation and higher inflation expectations occurring towards the end of the business cycle.
Money and company growth using credit (loans) takes time to make its way through the economic system, from making prices rise to raising expectations on inflation. Thus, commodities usually outperform at the end of the business cycle.
Rising bond prices generally raise stock prices in recovery, with falling commodity prices confirming an economic expansion phase is in play. As the expansion matures and begins to decelerate, watch for bonds to turn down first (as interest rates rise), followed by stocks.
Finally, it is after commodities outperform stocks and start turning down, this signals the end of an economic expansion with the probable start of activity decelerating, then slipping into an impending recession.
Retail traders can keep reading about the economics of inter–market analysis and asset diversification. Though, they will not solve these key issues, every option trader trading with USD $25-$50K or less, must deal with for retail asset allocation purposes:
- How much capital is adequate to sufficiently diversify risk away from any one Asset Class?
... if you can afford to diversify ...
- How do you practically reconcile the multiple and continually dynamic macro-economic relationships, to trade in the relevant asset class?
Where can I learn how to trade options profitably using Intermarket analysis with retail asset allocation methods? See Trading Profit | Consistent Results to view a retail option trader’s portfolio that is set up to cycle in and cycle out of Intermarket relationships, between asset classes.
Why is it possible? I’m using optionable ETFs (Commodity, Currency, Emerging Market and REIT), as well as optionable broad based/sector Equity Indexes, to trade the volatilities of each respective asset class. I do not need to trade Commodities and Currencies directly. Remember, volatility can be added to/reduced from the portfolio, as not all Asset Classes or Sectors or Individual Companies or Countries move up/down in value ALL at the same time; and/or, ALL at the same rate.
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