Text Size A A A A

 


Reducing Futures Trading Risk Through Diversification

Risk. It is one of the most critical elements in trading and perhaps the least understood. One of my favorite definitions of the word comes from the preface of Peter L. Bernstein’s Against the Gods: The Remarkable Story of Risk. Bernstein points out that risk comes from the early Italian riscare, which means “to dare.” In this sense, risk is a choice that allows you to define what will happen, rather than remain a victim to the vicissitudes of the unknown. Knowledge, of course, helps define how free we are to make choices to our gain. Understanding how risk can be reduced through diversification will make you freer to dare to make choices that enhance your futures trading gains.

The purpose of this article is to show you why a well-known concept—diversification—works and how it can reduce risk in your futures trading. As always, the perception and management of risk plays a critical role on the bottom line of a trader’s account.

Although diversification is taken for granted now (intuitively it has always made sense to not put all of your eggs in one basket), its quantification is one of the pinnacle achievements in risk mastery. And it came about only very recently in human history. Harry Markowitz published “Portfolio Selection” in the Journal of Finance in 1952 but did not receive official recognition for it until 1990 when he was awarded the Nobel Prize in Economics.

Interestingly, Markowitz does not use the word risk in his treatise. Instead, he states that “variance of return” is an “undesirable thing.” Risk and variance have since become used interchangeably on Wall Street and in other fields requiring risk management. The variance of return is a numeric movement around the average return and is statistically similar to and measured by the standard deviation. The higher the standard deviation—the movement around the average—the more uncertain the outcome, or the riskier the return.

Markowitz proved that by combining non-correlated assets, the return on the “portfolio” will be the average rate of return of the assets, while the volatility or risk will be less than that of any individual asset.

More simply, diversification lets you spread your risk. Again, it’s the old idea of not putting all of your eggs in one basket. By spreading the risk, you can end up with a higher total number of eggs in the event of an accident. Some commodities fall, others gain, the returns are slightly lower, but so too are the risks.

How do you do this? Let’s look at an example. The following are (the equivalent of) the annual averages of three years of monthly returns and the standard deviations on the S&Ps and T-bond futures. I use annual data here to illustrate the effects of diversification and do not recommend holding these futures without strict money management rules (an improvement on diversification theory).

Cumulative: Cumulative:
S&P T-Bonds 50/50 60/40
Return 16.41 7.65 12.03 13.13
Std. Dev.  3.32 2.61 2.96 2.71

Obviously, the highest return on a static holding of these futures comes from the S&Ps, but at the cost of greater riskiness, a standard deviation of returns of 3.32 for a 16.41% annualized gain. But by allocating S&Ps and T-bonds into a 50/50 portfolio, some of the risk of the single futures S&Ps holding is taken away, as depicted in the reduction of the standard deviation of return between the two futures to 2.96.

Allocating 60% of the futures investments to S&Ps and 40% to T-bonds produces an even better result, or what Markowitz termed a more “efficient” portfolio. The return on the 60/40 allocation, while still below that of just holding S&Ps, is greater than the 50/50 allocation, but approaches the relatively less risky proposition of just holding T-bonds. Determining the efficient frontier of mean-variance “optimization” is beyond the scope of this article but is available in common statistical software packages.

One caveat. Diversification provides the mathematical advantage of lowering the volatility of any individual futures contract, but only so long as the contracts are not highly correlated. For instance, you will not receive the benefits of diversification by purchasing both crude oil and heating oil, or of both euro FX futures and Swiss francs. These pairs are highly correlated with one another and the simultaneous purchase (or sale) of each is the equivalent of taking two positions in the same contract.

Markowitz based his work on the variance of returns of US equities. In futures, the mathematics of reducing portfolio risk applies, but diversification also works because profits are derived from fundamentally different and unrelated forces. Soymeal, cocoa, gold and heating oil have fundamentally different factors determining their values while stock prices are generally highly correlated with the broad market. By diversifying into different asset classes, you are not putting all of your eggs into the basket dependent on the stock market rising.

Moore Research has an interesting table of correlations from the past 180 days for front-month futures contracts (http://www.mrci.com/special/correl.htm). Positively correlated futures have a value of 80 to 100. Negatively correlated futures generally have a value of –80 to –100 (and act more as a hedge). Contracts with values near zero are experiencing the least correlation with one another and could present some of the best opportunities for achieving the benefits of participating in multiple uncorrelated markets simultaneously.

Another reason to diversify in futures is to ensure participation in major market moves. Markets go through range-bound periods where they do not make significant upside or downside progress (approximately 60% of the time). By trading multiple markets, you have a greater chance of getting in on bigger up or down trends and reaping the gains that can come from participating in explosive moves.

Another way to diversify is by trading using multiple approaches. You may daytrade S&Ps, bonds and the more liquid futures based on a discretionary interpretation of market dynamics and position trade using a mechanical systems approach in markets with which you have less familiarity. At the same time, you could apply a short-term or swing approach that would be providing diversification in a different time frame as well as in a trend/counter-trend approach (swing traders will fade the prevailing trend for short-time periods).

Enhancing Returns Through Choice

One of the problems with most efficient portfolio models, including Markowitz’s, is that they assume you cannot enhance returns by choosing between different asset (futures) classes and that your positions are static, that you hold onto losers. Besides using stop-loss and risk-management strategies, a solid approach to enhance the effects of diversification is to stay with the most dynamic markets, up and down. These can be identified in a variety of ways from the Futures Indicators Page. Stay with the strongest momentum markets. We calculate the most dynamic up and down markets for you daily on the Momentum-5 and Implosion-5 lists, respectively.

To ferret out the markets that are most likely to make an explosive move, keep an eye on the relative volatility lists—the 6/100, the 10/100, and the Multiple Days Low Volatility lists. An inherent feature of markets is that low volatility situations will revert to normal (higher) volatility averages, producing larger-than-normal moves. Combine these lists with the directional indications from the Momentum Lists and Trend Matrix to enhance the effects of diversification by staying in the best, and best moving, futures markets.

To summarize, here are reasons to diversify:

1. To lower daily risk.
2. To ensure participation in major moves.
3. To reduce overall, gross exposure.
4. To offset unexpected losses where one system will generate a loss and another will generate a gain.

 

Sourced from: https://www.tradefreedom.com/en/learnbettertrader/exclusivetradeart.asp?s=3