Traders can spread out their positions in order to minimize market risk while optimizing their chances for success. Many professional Wall Street traders look for ways to increase their probabilities for success in a trade by diversifying the number of positions they take within a given sector. Diversification tends to increase the odds that if the sector does move in the anticipated direction, other stocks that the traders have selected will move that way too.
Diversification among individual stocks within one sector spreads out the alpha, or individual, risk inherent in each stock. Every stock in the marketplace is subject to both market risk (beta) and stock-specific risk (alpha). The market risk (beta) of a stock refers to how it moves in conjunction with the motions of the broader market. The beta risk of a position is the risk that the broader market will turn against you, pulling the stock you are long with it. Some stocks have higher betas than others, which means more exposure to the fluctuations of the market. Stocks that have a beta of 1 should move in step with the market. If the market is up 2 percent, a stock with a beta of 1 on average should also be up 2 percent. If a stock has a beta of 2, then it moves at twice the rate of the broader market. If the market were up 2 percent, a stock with a beta of 2 would be up 4 percent.
The alpha risk of a stock is the individual risk inherent in every issue. This includes risks that cannot be foreseen, such as fundamental news specific only to that stock. By selecting several issues within a given sector, traders protect their portfolios from the chance of having individual positions turn against them or alpha risk.
Suppose a sector trader is bullish on the hardware sector, for example. Instead of putting all your money into one stock, you can go long in several stocks by allocating less money to each one. Instead of buying $50,000 worth of International Business Machines
(IBM), you would buy $10,000 worth of five different stocks, such as IBM, Dell Computer (DELL), Hewlett-Packard (HWP), Compaq Computer (CPQ), and Gateway (GTW). The number of shares you purchased of each would depend on their prices. All five of the issues are correlated. This is called basket trading, and it reduces the alpha risk of a portfolio but not the beta risk. Basket trading involves added expense in terms of commissions and spreads, but it provides insurance against individual stock risk.
Some traders look to reduce the beta risk as well. There are various ways to reduce the broader market risk, including hedging with futures and options, pair trading, diversifying among sectors, and using different long to short ratios.
One way to reduce broader market exposure is to hold both long and short positions of correlated stocks. The ratio of your long to short exposure should be in accordance with the current underlying trend of the market, combined with individual stock selection. If the trend as you perceive it is up, and you want to reduce broader market risk, then your long to short exposure ratio should be long by 2 to 1, but a minimum of 2 to 2. This means that for every two long positions you hold, you hold at least one short position.
The long to short exposure ratio could be spread out among sectors so it would not adversely impact the conviction you have on a specific industry. Reducing the beta risk by taking concurrent long and short positions only works when the different sectors you have selected have similar betas. For example, if you like the hardware sector but don't especially like the software stocks, and you think the broader market will rally as a whole, your strategy might be to go long two hardware stocks and short one software stock. If you are more neutral on the market, then you might hold two longs in the hardware sector and two shorts in the software stocks. Because the hardware and software sectors have similar betas, this strategy should reduce your beta risk.
Was this article helpful?