Spread Betting and Portfolio Diversification

Published by Filipe R. Costa on Thu, 24/03/2011 - 18:08

A central issue in financial spread betting is money management. You can possess an excellent set of entry and exit rules and be a very lucky guy, but without proper rules applied to money management, you won’t be successful.

One of the main questions arising in your mind when you want to place a bet is how much should I stake? Most professional traders don’t risk more than 2% of their total funds in a single trade. At the same time, they don’t take too much leverage, and they try to diversify their portfolio when opening several trades at the same time.

In this article I will take on the diversification issue, assuming you already know about stake per trade and leverage. Let’s then suppose you follow the 2% rule regarding risk per trade. You do your homework and decide that there are twelve airline companies that are currently a buy. If you decide to take on all of them, you will be risking 24% of your funds, which would be spread over twelve companies. Do you think that is good money management?

Each company has a correlation with the market it belongs to, and a correlation with the sector in which it is operating. When you buy a share, it is expected that it will somewhat move according to the broad market, and also somewhat according to its sector. Given that all your investments are from the same market and sector, you are holding a portfolio that is very similar to owning the relevant index for that sector, and you are risking 24% on that index.

You should evaluate correlations between every potential investment before you start building a portfolio. If you are going to open twelve trades, then you’re best placing money across several different companies from different sectors. You may also spread the money between long and short positions to reduce correlations. Remember that when the market is falling it will drag everything. Even your best long positions won’t hold in such bear markets. If you have some shorts you will be better off. You should try to keep correlation as low as possible or even negative in certain situations.

Nowadays the World is complex and inter-connected. It’s very difficult to find uncorrelated investments. When the Dow 30 is rising, it is pushing the FTSE 100 higher, at the same time oil rises because of better economic prospects, and probably Gold and the US dollar are declining. Of course there are many events affecting each instrument differently that make the correlation be less than one. But you should be aware that spreading your money over several instruments is not enough. The correlation between those investments is key to financial spread betting as it is for traditional trading. A long-term investor is more averse to this correlation than a short-term trader. As a spread betting trader you can accept some correlation but always take that into consideration when calculating your total risk, or don’t be surprised if your funds disappear very quickly.