Learn to minimize portfolio volatility without cutting positions

spreads and pairs trading

The measurement for volatility takes into account the magnitude of the vol, not the direction.

You obviously don’t want to be in high vol, directionless markets, unless you are trading option butterflies or condors that can take advantage of those types of markets.

Long / Short Equity Trades (pairs)

For equities, you can deploy what’s called a “pairs trade.”

Anyone can gear their portfolio for 100% RoR, but you have to be willing to endure a 40-60% drawdown both financially and emotionally. Hard to do. Slower and steady growth might be a better fit for your tolerance for risk as well as what you are looking to do professionally, such as running public money.

[I have a documented 100% monthly return, however I was in fact coming off of a 40% drawdown so my starting equity was only up 20% by the end of that reporting period/month.]

Spread trades are about relative performance between the two instruments, meaning your are looking for the long to outperform the short. There has to be high correlation between the two instruments else there is no relationship.

You can find good candidates for these types of trades by looking in each sector and going long the “best in class,” and shorting the dog. One of the best at doing this was Tiger Management’s Julian Robertson and his traders.

I wrote about pairs trading in Inner Voice of Trading where I was Long MSFT and Short NSCP figuring that Netscape was going to have a hard time getting clients to purchase a premium, albeit superior browser, while MSFT was giving Internet Explorer away for free.

One trade I’m in right now is Long PYPL and Short SQ in the mobile payment space. You have unlimited loss potential by being short a stock fyi.

Commodity Spread Trading

You can learn a lot about commodity spreads at Moore Research. Commodity spreads are a great way for newer commodity traders to get involved with those markets as you are both hedged and you are afforded lower margin requirements since you are simultaneously long and short the same commodity, but in different months.

Conclusion

By trading equity pairs or intra-commodity spreads, you cut the volatility in your portfolio yet keep the directional bias that will create the alpha. Risk-adjusted returns are the goal here.