Why it makes sense to trade different asset classes

Why it makes sense to trade different asset classes

The main reasons for trading different and not just one asset class is that it generally leads to:

1) better risk diversification,

2) more trading opportunities,

3) and tends to generate better outcomes.

Traders in today's markets have a wide variety of asset classes to choose from, each with their own distinct qualities and dynamics. Being successful requires understanding the key factors that drive prices for stocks, currencies, commodities, and bonds so traders can make informed decisions, be that on a macro-economic, geo-political, fundamental, flow or technical analysis basis.

Despite having a plethora of different asset classes to choose from, most traders only trade one market or asset class. They probably do so because they believe to ‘know’ or ‘understand’ that market or asset class whereas they might feel less well informed about other asset classes.

Yet, in most cases people trade what they are used to or what their peer group (family, friends or fellow traders) is interested in or what is currently covered in the news or deemed to be ‘hot.’
Most of IG clients’ trading volume is also concentrated around a dozen or so indices, stocks, FX pairs and commodities. Within these asset classes usually the more volatile markets seem to be preferred to less volatile ones by the majority of traders.

Better diversified risk through trading different asset classes

By not focusing on just one asset class but trading, for example, a currency pair and a share or stock index, risk is usually reduced. The reason for this is that a trader then doesn’t have all their eggs in one basket.

A diversified portfolio, meaning one which is invested in not just one market but in several - ideally not correlated - asset classes, spreads the risk of unforeseen events negatively affecting a trader’s position(s). A high correlation between assets means that they tend to go up and down in tandem, a low correlation that they do not react in the same manner to external events.

That is to say, if one trade position is under water, the other(s) might not be if the markets traded aren’t correlated or are inversely correlated. For example, if stock indices rapidly fall, usually bonds and the gold price rise, the latter because of flight-to-safety flows. A potential loss in one asset class trade may therefore be mitigated by a potential profit in another asset class trade.

It is important to note, though, that if one were to, for example, have five 2% (of total trading capital) long positions in several global stock indices, this would equate to 10% overall risk as stock indices tend to be highly correlated, especially with regards to US indices.

A trader who has, let’s say £10,000 of trading capital at their disposal, and risks 2% (i.e. £200) on buying the S&P 500, 2% on the FTSE 100, DAX 40, Euro Stoxx 500 and Nikkei 225 in effect has the equivalent of a 10% (5 x 2% = 5 x £200 = £1,000) exposure on these ‘long’ stock indices positions.

Similarly, if a trader buys 2% of EUR/USD, AUD/USD and GBP/USD, they are basically selling 6% of the US Dollar (USD) as all these currency pairs are highly correlated. They rise in price when the US dollar depreciates but fall in price when it appreciates.

If a trader were to buy EUR/USD and USD/JPY, though, their exposure would be minimal and in effect be that of trading the EUR/JPY pair as the US Dollar exposure would cancel itself out in each currency pair. The trader would be buying the euro and selling the US dollar (EUR/USD) and buying the US dollar and selling the Japanese yen (USD/JPY) which equates to buying the euro and selling the yen (EUR/JPY). In this example the currency pairs aren’t highly correlated.

When only trading one market or asset class, diversification is more difficult to attain. A trader who only invests in UK shares, for example, would likely take a hit if the FTSE 100 or FTSE 250 indices in general were to decline, dragging most of its constituent shares with it.

More opportunities by trading different asset classes

A trader who likes trading a highly volatile stock such as Nvidia, for example, will see phases during which the share price moves less than it usually does or trades in a sideways, low volatility trading range.

During low volatility periods where no clear trend can be made out, other asset classes such as commodities (gold, silver, oil etc.) might experience high volatility. During those times a trader thus has more opportunities to trade their style or approach outside of their preferred asset class than within it. This greater choice can lead to more profitable outcomes but can, of course, also increase a trader’s losses if they don’t pay the same attention to their secondary choice asset class trades as they do to their first choice one.

Trading different asset classes may lead to better outcomes

Even though it might be based on anecdotal evidence, traders who diversify their risk by trading different - un-correlated - asset classes and who seek out better opportunities in other asset classes than in their preferred one tend to achieve better returns.

Skills needed for stock trading

When trading stocks fundamentally, it is essential to follow company-specifics such as earnings reports, revenue growth, Earnings-Per-Share (EPS), dividend yields, market share, profit margins, competitive forces, and leadership changes. Broader sector and industry trends also impact stock performance, so traders need to understand cycles and secular shifts.

Technical analysis like support and resistance, moving averages, momentum indicators, trends and trading volume can be monitored as well. Some traders may even wish to trade in an exclusively technical fashion and take no fundamentals into account.

Overall market sentiment and systemic risks from macroeconomic events or geopolitics should also be incorporated into stock trading.

Forex trading skills

In the forex market, macroeconomic factors like interest rates, GDP growth, and inflation are dominant drivers of currency valuations. Central bank policies and global risk appetite are critical, so fundamental traders must stay up to date on geopolitics, economic data releases, and monetary policy guidance.

In addition, technical analysis may be used in conjunction with fundamental analysis or on its own to identify key levels, trends and whether these are likely to continue or end in the near future.

Commodity trading skills

Commodity trading involves a distinct set of inputs, with supply and demand fundamentals being integral. Weather disruptions, strikes, wars, and other natural or political factors can impact supply greatly. The overall pace of global economic growth and activity affects demand across many commodities. Fundamental traders need to understand the market dynamics of storage costs, production lead times, and other structural forces. Additionally, looking at positioning among large speculators and seasonal trading patterns may also be beneficial. Again technical analysis can be used as an additional, yet separate, tool in a trader’s tool box as and add on to fundamental analysis or on its own.

Knowledge needed for bond trading

For bonds, traders have to track the macroeconomic themes of growth and inflation very closely, as they directly impact central bank policies and yield curves. Knowing the schedule of upcoming debt auctions and modelling how much issuance the market can absorb is also important. Monitoring credit ratings and risk premiums, especially during times of economic stress also needs to be done. Technical analysis on benchmark yield curves and their spreads can help in identifying key levels and trends.

Cross asset trading

The diversity across stocks, forex, commodities, and bonds requires nuanced approaches by traders. Focussing on the unique characteristics of each asset class in order to make informed trading decisions grounded in both fundamental and/or technical analysis is key.

By being flexible and open minded, combining macro and micro perspectives and having a comprehensive understanding of risk management, traders can effectively navigate today's complex markets.

The key is to understand the unique characteristics, market drivers and relationships for each asset class.