In this review, we will consider a trading method called “Basket Trading”. With its help, you can diversify risks and use a market-neutral trading strategy.
What is Basket Trading?
“Basket trading“(from the English” basket “- a basket) is a method according to which not one asset is used for trading, but a whole set of several financial instruments (a basket of instruments). For example, instead of trading one currency, you focus on a basket of multiple currency pairs, or instead of trading stocks of one company, collect a basket of stocks of several promising companies in a particular industry.
The most popular way to create an investment basket (portfolio) is to find a group of undervalued instruments counting on their subsequent growth. These can be stocks, currency pairs, targeted investment funds (ETFs), cryptocurrencies, and other assets. One such example is the portfolio of a legendary investor Warren Buffett: he tries to invest in the most promising stocks.
“Basket trading” means trading one or several baskets of related instruments. The peculiarities of this method are the diversification of risks by several instruments and the possibility of creating a market-neutral portfolio that allows you to make money in different market conditions, regardless of the specific direction of the trend. Below we will look at trading strategies based on the use of a basket of instruments.
How to use “Basket Trading” in trading?
There are two main trading strategies using the “Basket of Trading”: investment (directed trading) and market neutral (arbitrage).
It is a directed trading strategy using a basket of instruments. Suitable for various investment ideas, allowing you to diversify the risks of investing funds. Instead of investing all funds in one asset, there is a proportional distribution of funds across several instruments. These tools tend to be interconnected and share similar characteristics.
In terms of the stock market, it would be investing in shares of several similar companies instead of buying shares of one company. For example, you expect health sector stocks to rise amid the fight against coronavirus infection. Instead of investing all the funds in one most famous company, it would be wiser to distribute investments among the shares of several companies in this sector. This will make it possible to neutralize corporate risks – the shares of one company may not rise due to internal reasons, but the rest will most likely meet expectations.
With regard to the foreign exchange market, this will not be an investment in one currency pair, but in several at once. For example, based on fundamental analysis, you would expect the US dollar to decline in the short term. Instead of selling the dollar against one currency (eg the euro), a basket of multiple currencies can be used. For example, you can distribute funds into three parts (or more) and open buy positions in EURUSD, GBPUSD, AUDUSD pairs. As a result, the risks of investing in one currency pair are reduced, investments are distributed across several currencies at once.
Market neutral strategy
This trading strategy involves the simultaneous buying and selling of several interconnected instruments. The meaning of this strategy is to track the price difference of correlated assets and use price deviations from the average values to open oppositely directed positions. The calculation is based on the fact that after the end of the deviation period, the price difference will again return to the average values, and as a result, a profit will be obtained.
In relation to the stock market, this can be the sale of shares of several companies that have already shown good growth, and the simultaneous purchase of the corresponding number of shares of other companies in the same sector, which have just begun to rise in price. It is expected that the sharply grown stocks will “lag behind” or even correct, and the stocks that have just begun to rise will catch up with them, making it possible to fix the total profit while the difference in the average prices of these two baskets decreases.
In the foreign exchange market, this can be a basket of multidirectional positions for currency pairs. For example, if the pound has significantly deviated from the averages to other currencies, and is expected to strengthen, you can buy the GBPUSD pair and simultaneously sell the EURUSD and AUDUSD pairs in proportions corresponding to the value and volatility of the pairs. As a result, the position is market neutral in relation to the US dollar.
It is expected that if the dollar grows, the pound will decline to it less than the euro and the Australian, the total profit will be brought by the sales of EURUSD and AUDUSD. And in the event of a decline in the dollar, the expectation is for a more significant growth of the pound than the euro and the Australian, the total profit will be due to the strengthening of the GBPUSD pair. To search for statistical deviations and calculate the proportions of open positions, various specialized programs are often used – indicators, advisors, scripts.
Advantages and Disadvantages of “Basket Trading”
Like other trading methods, “Basket Trading” has certain advantages and disadvantages:
- Diversification of risks. When using a basket of instruments, the dependence on the dynamics of a single asset is reduced. With the correct forecast of the market direction, “successful” assets will pull out those that may turn out to be “unsuccessful”.
- The ability to use market-neutral strategies based on the relationship of the assets used, insensitive to changes in the direction of the market trend.
- A wide range of assets used, suitable for working in various financial markets (Forex, stocks, cryptocurrencies, commodity market, and others).
- The complexity of the method, it is necessary to monitor a large number of instruments at once.
- Increased risk during extraordinary market events. Statistical patterns and relationships that have proven themselves well earlier can bring losses in new, changed conditions.
- The need to use various specialized programs (scripts, advisors, indicators) to find statistical dependencies and calculate the value of positions.
“Basket Trading” is suitable for working in various financial markets. It can be used both to diversify investments and to open market neutral positions on related assets. To successfully use the “Basket Trading”, you need to study all the “pros” and “cons” of this method and practice on a small real or demo account.