It's no secret that diversification is an important part of being successful trading in the stock market. But when it comes to trading options, it's important not only to diversify your positions among different stocks, but to diversify them among uncorrelated assets. An example of uncorrelated asset classes would be social media and oil stocks. When social media stocks go down it should conceivably have very little impact on what oil stocks do in the future. Therefore, the positions in both sectors offer true diversification.
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In this video tutorial, I want to talk about the importance of uncorrelated asset classes or industries and sectors. As traders, we not only want to try to diversify among different stocks that we’re trading but also among different asset classes.
This can be done more specifically in uncorrelated asset classes. When we talk about uncorrelated asset classes, really what we’re talking about is the differences between trading social media stocks versus oil stocks.
Those would be two uncorrelated asset classes that you could trade. If something happens in social media space and some internet startups like Facebook or LinkedIn, it's probably going to have very little impact on what's happening in the oil sector globally.
Those are going to be pretty uncorrelated. Also, another uncorrelated example is going to be gold stocks and technology. The same thing, if something happened to the tech world with microchips or computer chips and software, probably not going to have that big of an impact on gold stocks globally or what gold is doing in general.
Those are going to be two really good examples of how you can use uncorrelated asset classes to trade. The guys over at Bespoke put together a good chart every year and this was from last year where they went back, and they did a correlation matrix on the percentage change, and they tracked it over the last 10 years with all of these different industries.
The way that you want to read this chart is this way. Down on this side, it’s all the same information as you have up on the top, so across the top, you have all the same different industries from consumer discretionary, energy financials, healthcare, industrial and materials, technology, telecom, you name it, it’s all there.
You can see the correlation factor is just about being as close to one as possible, one meaning that it's perfectly correlated with the next thing that it’s looking at.
In this case, you can see that the S&P is perfectly correlated with itself on the chart, but if you find something that has a correlation very close to one like consumer discretionary, you can see that if you're trading a stock that’s in that type of an industry or category, then it has a pretty high correlation to the S&P 500 as a whole.
The whole idea here is that you are at least aware of some of these correlations. A lot of them are pretty common sense like we said. Social media and oil stocks, that’s pretty common sense. Some of them might not be as common sense as you think, but it's important that you’re just aware of them.
In some cases, you can have stocks that are negatively correlated, and this would obviously be most of the S&P 500 as it relates to things like long bonds because bonds usually trade in the inverse of the general market.
You have a bond position or a dollar position, that’s usually going to trade inverse to most of the market. That’s why you see these negative correlations here. But this is a really good chart that you can have up.
Printout these slides from this video tutorial, use it if you want to. It’s just having an understanding of these different correlations. Here's my word of advice about this. Don't go overboard with doing all these uncorrelated asset classes.
Diversification in my opinion is the target or goal; it's not the destination. You always want to improve, but you always want to make sure that you’re just aware.
There’s no point at which you can have perfect diversification in your portfolio, but it’s this understanding that we just don't want to trade too many oil stocks or too many technology stocks or too many social media stocks.
We want to be just a little bit diversified in everything, and I think that that goes without saying that that diversification helps improve the chances of one thing falling out of bed and kicking it as being extremely negative to our portfolio.
For example: Recently, oil has had a huge slide, more than 50%. If we only had oil stocks, we’d be hurting right now, but we don't, we’ve got things all over the place.
Although it doesn’t feel good to have oil stocks as part of our portfolio, that doesn't mean that we’re going to be out of the game because oil fell.
We’re completely diversified across asset classes and strategy and stocks, and that's what helps keep us in here long-term when we have these unusual moves in securities up and down.
As always, I hope you guys enjoy these video tutorials. If you have any comments or questions, please ask them right below on the lesson page. Until next time, happy trading!