From the July 01, 2010 issue of Futures Magazine • Subscribe!

Risk management, position size and your portfolio

Another extremely important factor in determining when to adjust trade sizes is to watch the correlation of the markets. As we move toward a global economy, we are noticing more and more correlation between various markets due to the cross-investment of global markets as supply and demand curves converge between commodities and currencies.

Even markets that typically display inverse relationships have become correlated and this usually happens at the worst time (see “Things change,” below). The expansion of many companies with international exposure only adds to this correlation as we see markets moving in tandem more often than ever before. What we are seeing now is that because the globalized economy is so prevalent, major markets can move together, sometimes without much notice.

Chart

Chart

Take a look at the effects that China has had on our stock markets overall, and more directly on commodity prices for raw materials. In a heartbeat, China can put out a report that they are slowing building growth, and markets will plummet, and prices of copper and other building materials will go right along with it. These correlations are important to identify and monitor to adjust trade sizes in real time. These kinds of qualitative indicators can emerge out of thin air and must be watched carefully.

For us, we tend to notice that if the major world commodities such as oil and building materials begin to move in tandem for a period of two weeks, this triggers our indicators to decrease our position sizes. You then realize that although you thought you had a very diversified portfolio of commodities in various sectors, that because of this closely knit correlation of global exposure to supply and demand curves, you have a portfolio that really is quite small.

If you are long grains, metals, energies, the euro, stock indexes and the Canadian dollar, a strong rally in the dollar -- when those markets are particularly sensitive to it -- could teach you a harsh lesson. That lesson could be that you only have one very large position.

It’s almost as though the very definition of “diversification” is changing under our noses. It is becoming increasingly difficult to tell the difference between sector diversification and true movement, and the line is becoming blurred. As we continue to grow as a global economy, more attention to the correlation of the markets, indexes, companies that deal internationally, and the raw commodities’ supply and demand curves is necessary. Having a model that can account for fluctuations and correlations between these is essential to making solid decisions about adjusting trade size in real time to manage risk.

Being able to adjust your exposure in real time should be an element of every trading model. Having a model that is adaptable to trading conditions is one of the strongest tools to keep your risk exposure consistent.

Yiorgo Aretos is CEO of The TMP Group LLC, a CTA & consulting company, and can be reached at yiorgo@theTMPProject.com.

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