Options Trading Strategies – Intermarket Analysis in Brief for Retail Asset Allocation

If you are trading a mix of Verticals, Calendars and Iron Condors across highly liquid indexes like the DJX,
DIA, MNX, QQQQ, RUT, SMH, SPY and XSP, is your trading risk adequately diversified? No.
In choosing the MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in these
Indexes: for example, AMAT (Applied Materials) is a component of all 5 Indexes. Bear in mind the MNX and
the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference being the MNX is an
European styled cash settled Index and the cubes (QQQQ) is an American style stock settled Index.
Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP - both the SPY and the
XSP track the S&P 500, the SPY is American style stock settled and the XSP is European style cash settled.
Duplication is not diversification. Even if you allocated capital to the smaller versions of the Dow: DJX, the
European style cash settled version of the DIA which is the American style stock settled version. Moreover,
if you extended capital allocation to trade the RUT, thinking you are diversifying into small-cap stocks and
away from large-caps, you just sunk more of your trading capital into equities. Again, you cannot achieve
diversification by adding more capital in the same asset class. You need to learn how to trade options
without concentration risk in stocks. Do not confuse asset category (market capitalization) with asset class.
This is where there is a need to understand Intermarket relationships. Intermarket analysis requires the
simultaneous analysis of 4 main Asset Classes: Currencies (U.S. Dollar remains most liquid of all major
traded currencies), Commodities, Bonds and Stocks. Synchronizing the rotation of asset allocation within
your own portfolio lies in getting a grip on how these four markets interrelate with each other.
Here’s the synopsis of the relationships. Commodities lead bonds, bonds lead stocks and stocks lead
commodities. The cycle holds true at least in a normal inflationary/disinflationary environment. Other than
itself, Commodities affects 2 markets (Bonds and Stocks); effectively, impacting 3 out of the 4 Intermarket
relationships. Even if you do not trade Commodity ETFs as part of your portfolio, you need to track
Commodities as a leading economic cycle indicator. The futures/Mini Futures that you see on news
headlines/trading screens are relevant only as daily gauges for stock market behaviour. They are not a
cycle indicator across Asset Classes.
So, you may already understand the criteria to define a "normal" economic cycle for the Directional
Relationships to behave "ideally" (see below); BUT, how do you determine which Asset Class is driving
the cycle? In other words, at a given point in the Intermarket cycle, how do you determine which
Asset Class has the DOMINANT Relative Strength to trade? Follow the link below for a video-based
course, to learn how Relative Strength - a rotational algorithmic measure is used to replace conventional
Fundamental Analysis, as an asset allocation technique.
Moving on, here’s the Business Cycle in brief. Bonds lead stocks, to trend in the same direction – except
during deflation when bonds rise and stocks fall. On average bonds are 18 months ahead of stocks in rising
to their peak or falling to their bottoms; thereafter, stocks follow in the same direction. If bonds have not
broken down yet, this extends the gains in the stock market, acting as support for prevailing stock market
levels. The real risk begins to build 5-7 months after the bond market peaks or bottoms, thereafter the next 6
months stocks accelerate in the direction bonds have set.
Typically, commodities and bonds have an inverse relationship: as commodities rise, bonds falls but as
commodities fall, bonds rise. Inflationary expectations affect bond prices. US Dollar movements which is tied
into Monetary Policy changes affects commodity prices. Commodities lead bonds 12–18 months in advance
(it takes this long for Monetary Policy to come into effect) and 24–27 months before the economy fully
absorbs the policy changes.
Now, the relationship between commodities and stocks. Stocks tend to lead commodities. Commodities are
a hedge against inflation, with price inflation and higher inflation expectations occurring towards the end of
the business cycle.
Money and company growth using credit (loans) takes time to make its way through the economic system,
from making prices rise to raising expectations on inflation. Thus, commodities usually outperform at the end
of the business cycle.
Rising bond prices generally raise stock prices in recovery, with falling commodity prices confirming an
economic expansion phase is in play. As the expansion matures and begins to decelerate, watch for bonds
to turn down first (as interest rates rise), followed by stocks.
Finally, it is after commodities outperform stocks and start turning down, this signals the end of an economic
expansion with the probable start of activity decelerating, then slipping into an impending recession.
Retail traders can keep reading about the economics of inter–market analysis and asset diversification.
Though, they will not solve these key issues, every option trader trading with USD $25-$50K or less, must
deal with for retail asset allocation purposes:

 How much capital is adequate to sufficiently diversify risk away from any one Asset Class?

... if you can afford to diversify ...

 How do you practically reconcile the multiple and continually dynamic macro-economic
relationships, to trade in the relevant asset class?

Where can I learn how to trade options profitably using Intermarket analysis with retail asset
allocation methods? Follow the link below, entitled “Consistent Results” to see a profitable retail option
trader’s portfolio that is set up to cycle in and cycle out of Intermarket relationships, between asset classes.
Why is it possible? I’m using optionable ETFs (Commodity, Currency, Emerging Market and REIT), as well
as optionable broad based/sector Equity Indexes, to trade the volatilities of each respective asset class. I do
not need to trade Commodities and Currencies directly. Remember, volatility can be added to/reduced from
the portfolio, as not all Asset Classes or Sectors or Individual Companies or Countries move up/down in
value ALL at the same time; and/or, ALL at the same rate.
----------------------
Thanks for reading my article,
Clinton Lee. Founder, Home Options Trading: a uniquely retail-focused option-centric trading firm.

Please see Consistent Results at http://www.homeoptionstrading.com/consistent_results/, displaying

the Model Portfolio's Performance YTD, updated each month-end. The portfolio models a typical retail
option trader's account up to USD $50,000. Here's the stats in summary:
 Return: Profit/Start of Year Cash Balance = $91,593/$58,380 = UP 157%.
 Win/Loss Probability = 60/68 = 88.24%.
 Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss) = 88.24% x $2.99 = 2.64.
 Positive Expectancy = (Win Probability x Average Win) - (Loss Probability x Average Loss) =
$1,347 per trade.

Preview an original 55 hour video-based course for online options trading from home, at
http://www.homeoptionstrading.com/original_curriculum.html
Purchase the curriculum and receive an $800 options basic course as a Bonus!

Clinton's career spans 16 years of treasury, finance and banking across Hewlett Packard, JP Morgan Chase,
Citibank, Royal Bank of Scotland (previously ABN Amro); and, is currently a Senior Liquidity Advisor at Bank
of America in its Global Treasury Services division. Despite the years in the finance/banking industry, it did
not help him directly grasp online options trading from home.