Last Updated on 3 November, 2022 by Samuelsson
One of the best ways to trade with minimal risk is to diversify the investment portfolio. While this is good, it is relatively hard to manage numerous trade orders in various assets to build a solid portfolio. This is why institutional traders make use of basket trading. Now, you may be wondering what basket trading is.
Basket trading is a portfolio management strategy often used by institutional investors to buy or sell a collection of trading assets using a single order. Investment firms, hedge fund managers, and other institutional investors make use of the strategy to improve the efficiency of their trading processes, maximize gains, and minimize risks.
To help you understand basket trading, we will discuss the topic under the following subheadings:
- What is a basket trade?
- Basket trading basics: How it works
- Which securities can be used for basket trading?
- Why investment funds prefer basket trading
- How retail investors can use the basket trading approach
- The benefits of basket trading
- Basket trading examples
What is a basket trade?
A basket trade is an investment management strategy that allows investors to trade a group of financial instruments using a single order rather than placing a series of orders to buy or sell each security individually. It lets you create a list of up to 50 stocks, called a basket, that you can save, trade, manage and track as one entity. This makes it possible to create a specific portfolio or index fund.
While basket trading is common among institutional investors and hedge funds, retail traders can use it due to its numerous benefits. It offers a seamless way to monitor your trading portfolio and pinpoint the assets that will likely outperform.
Basket trading basics: how it works
First, you should ensure you are eligible to carry out a basket trade. While your eligibility depends on the brokerage firm offering the basket trading service, investors are often required to purchase a minimum number of securities, say ten or fifteen. This entails that basket trading is best suited for investors with deep pockets who are willing to invest large amounts of money.
The distribution of dollars between various securities in a typical basket can be determined using a variety of weightings — shares, dollar amounts, and percentages. These weightings are allocated to the assets in the basket. The dollar weighting and percentage weighting methods, as the names imply, allocate a given dollar amount or percentage to each position in the basket. For instance, a dollar weighting method will distribute the overall dollar amount for the basket equally between its components. In the same manner, the share weighting method offers shares to each position in the basket. And as such, a basket trader using the share weighting method will have to divide the overall amount equally between blocks of shares.
A basket trade should contain about 15 assets, which are mostly stocks, and they are often measured against a benchmark or tracked against an entity, such as an index, to calculate their returns.
An index fund is a basket of stocks that all meet certain criteria. As stocks rise and fall, their weight within the portfolio changes daily. Basket trading allows the fund managers to efficiently buy and sell the number of securities needed to rebalance the portfolio. Basket orders also allow retail or institutional traders to create their index. For example, if an investment fund wants to profit from the index’s volatility, the fund manager would create a buy/sell index to monitor the index.
An investor can simultaneously buy or sell multiple positions using a basket, creating essentially one trade from multiple positions. However, it is necessary to know that the brokerage firm may require a given minimum investment amount to be able to open a basket trading order.
Which securities can be used for basket trading?
Basket trades are not limited to the purchase of stock shares to make up an index. They can also be used to trade commodities, currencies, and index funds.
A basket of soft commodities, such as wheat, soybeans, and corn, can include shares that track an underlying basket of commodities. You can also simulate a commodity basket by purchasing ETFs that track the prices of commodities.
A currency basket consists of a number of individual currencies. The weights of currencies are either determined by the trader or according to a strategy or program. For example, if a trader wants to accumulate a U.S. dollar position, they may sell the EUR/USD, GBP/USD, and AUD/USD and buy the USD/JPY, USD/CAD, and USD/CHF. Then, they put 20% of the funds into both the EUR/USD and GBP/USD. The other 60% of the funds are split between the other four currency pairs —15% each. Interestingly, institutional traders can use currency baskets to execute large volumes in multiple currency pairs quickly.
Why investment funds prefer basket trading
There are several reasons why investment funds opt for basket trading. It allows investment funds to manage their portfolio with ease. For example, if an ETF or mutual fund is required to track a specific sector, such as financials, they need to purchase all the securities that make up the index.
The investment fund may decide to track its target index by holding most or all the securities of the index. But as new cash comes into the index, resulting in the rise of the value of the investment fund, the fund manager must simultaneously buy a large number of securities in the proportion they are present in the index. The reason is that if the fund manager does not execute a basket trade on all of the securities, then the rapid price movements of the securities would prevent the index fund from holding the securities in the correct proportions. Also, by creating a basket trade to track the investment fund index, the investment fund can take advantage of the volatility of the index.
How retail investors can use the basket trading approach
Most retail brokers offer basket trading to all clients, thus making it possible for anyone, including retail investors, to benefit from the basket strategy. Although these firms typically do not charge investors additional fees for trading, a minimum investment amount is usually required in order to purchase a basket.
Retail investors can use the basket order to carry out multiple trades, especially when they do not want to carry out such trades individually. Additionally, traders can utilize the basket order to buy and sell various trading instruments simultaneously. Retails investors can also use the basket trading strategy when buying or selling all the stocks that gap up or down and are moving very quickly. They could use a basket order to close all those trades as well.
Please note that each position is shown individually in the account whenever a retail investor executes a basket trade. The positions can be closed one by one or once using a basket order.
The benefits of basket trading
Basket trading offers a myriad of benefits to investors and traders. Some of the key benefits of basket trading include the following:
- It provides traders with a personalized choice, allowing them to create the basket trade that suits their investment objectives. For instance, an investor seeking income may create a basket trade that includes only high-yielding dividend stocks as it is more likely to meet his trading needs and objectives.
- Thanks to basket trading, traders and investors can seamlessly allocate their investments across various financial assets. Traders can do this efficiently using any of the following allocation methods: share weighting, dollar weighting, and percentage weighting.
- Basket trade provides traders with optimal control over their investments. It gives traders the power to decide whether to add or remove an individual or multiple assets from their investment portfolio depending on their specific needs and goals. For instance, investors can arrange their baskets by a range of categories such as price, market capitalization, goals, or industry/sector. Also, traders in a basket trade have the right to choose the trading selected individual securities within a single basket or trading the entire basket. This function allows an investor to control the timing of any trades that they execute.
- It improves trade efficiency as it gives traders the ability to place multiple trades in just one order. With the help of a basket trade, traders and investors can track the performance of their investment as a whole, thus, streamlining the administrative process and saving time.
- Basket trades significantly reduce a trader’s exposure to volatility by a great percentage due to combining one or more assets in their trades. This, in turn, mitigates the risk associated with adverse market change that could lead to heavy losses.
- Basket trade gives room for an easy diversification of investment portfolios. Traders in basket trading can easily customize their trades and invest in various markets.
- Basket trades are a good way for investors to allocate their investments across the same sector or multiple sectors. You can also create a basket trade that fits your investment goals. You might want to combine several stocks in the same sector or have very high dividend baskets. You also might consider a basket trade that is purely growth stocks or even commodities.
Basket trading examples
Basket trading example 1: Stocks
If, for instance, a trader creates a strategy to buy all the Dow Jones Industrial Average (DJIA) stocks at the end of the day and sell them on the following open. The trader would simply set up a basket order to buy all the DJIA stocks with market-buy-on-close order. This order type, in the setting of a trade basket, allows all the trades to execute simultaneously at the closing bell.
The trader will do this as long as the DJIA is in an uptrend, as defined by various technical analysis metrics. Then, in the morning of the next trading day, a basket order is used to sell all the securities simultaneously, using a market-sell-on-open order. The process will repeat at each close and each open, assuming the DJIA remains in an uptrend.
Basket trading example 2: Commodities
When investing in an asset with exposure to petroleum, precious metals, and agriculture, you can purchase the NYSE: USO Oil ETF and combine it with the NYSE: GLD ETF as well as the NYSE: CORN ETF. The distribution of components in a basket can be accomplished by using various weightings. So if you wanted a basket that was 50% energy, 25% gold, and 25% agriculture, you could divide the total amount you want by the weighting levels to determine how many shares of each ETF you need to buy.
Basket trading example 3: Forex
Another type of basket trade is currency baskets. For example, one of the most widely traded baskets is the dollar index. For example, the Invesco DB U.S. Dollar Index Bullish Fund ETF tracks the movements of a basket of currencies versus the U.S. dollar. This basket tracks the movements of 6-currencies, which include: The Euro, Japanese yen, British Pound, Canadian dollar, Swedish krona, and Swiss franc. This ETF holds currency futures.
You could also create your basket trade by purchasing ETFs that track currency pairs. For example, suppose you wanted to only purchase the Euro, the Yen, and the British Pound versus the U.S. Dollar. In that case, you could purchase the NYSE: FXC Investco Currency shares Euro, along with the NYSE: FXY Investco Currency shares Yen and NYSE: FXB Investco Currency shares British Pound.
You might want to consider a basket trade to track a sector or have one that purchases stocks across many sectors but has robust dividends. In addition to purchasing shares of companies to create a basket trade, you might also consider taking currency or commodity risk.
Overall, a basket trade is a good way to minimize our risk exposures. This is because it is generally less volatile than owning individual shares. As you may know, the volatility of a basket is lower than individual assets, helping you avoid large losses from an adverse market move. This shows that besides allowing you to personalize your investment goals, basket trades allow you to diversify your portfolio effectively, thus keeping risk at its barest minimum.