Warrior Trading Blog

What is a Basket Trade and How do They Work?

Basket Trade

A basket trade is an order type where you purchase or sell a group of securities. Basket trading allows you to pinpoint a specific sector, or a type of stock like higher dividend payers, that you believe will outperform.

You can also target asset classes other than stocks, including currencies, commodities, and bonds. There are several benefits to purchasing baskets of shares. This includes diversification which reduces the volatility of purchasing individual shares.

Basket trading is practiced by institutional investors and hedge funds, but can also be utilized by retail traders.

Why Do Investment Funds Trade Basket Trades?

You might wonder why basket trading is an active form of trading? The reason is simple, and it relates to the thousands of index Exchange Trade Funds (ETF)  and mutual funds that hold securities.

If an ETF or mutual fund is mandated to track a specific sector such as financials, they need to purchase all the securities that make up the index.

As cash flows in an out of the ETF or mutual fund, the manager of the fund needs to simultaneously purchase and sell large volumes of shares of the securities in direct proportion to the underlying index.

If the fund could not buy all the securities in 1-block, then a scenario could arise where some of the stocks would move away from their price target, as they start purchasing individual shares.

Many institutional basket trades involve more than a dozen individual shares. Generally, these baskets are measured against a specific index.

What Types of Baskets are Traded?

In addition to basket trades that involved the purchase of shares of stocks that make up an index, some baskets are purchased to track commodities and currencies.

A commodity basket might include shares that track an underlying commodity basket of futures contracts such as the Invesco DB Commodity Tracking ETF. This ETF tracks the movements of 14-different commodities, but most of the basket is made up of energy and precious metals.

You can mimic a commodity basket on your own by purchasing ETFs that track commodity prices.

Examples of Basket Trades

For example, if you want to invest in something 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 that you want by the weighting levels, to determine how many shares of each ETF you need to buy.

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 US Dollar Index Bullish Fund ETF tracks the movements of a basket of currencies versus the US 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.

The manager’s trade-in and out of currencies to keep the index weighted correctly. You could also create your own basket trade by purchasing ETFs that track currency pairs.

For example, if you wanted to only purchase the Euro, the Yen and the British Pound versus the US Dollar 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 would weigh these ETFs in any manner to generate your currency basket.

What are the Benefits of Trading Baskets?

There are several benefits to using a basket trade.

First, you can target specific sectors or stocks to help you customize your trade. Additionally, when you trade baskets you are diversifying.

By holding a basket of stocks, commodities or currencies, you can reduce your exposure to volatility. Additionally, you reduce the risk that one individual share experiences an adverse market change, which might substantial losses.

When you combine one or more assets, you reduce the overall volatility. This is the case unless the correlation is perfect. Correlation is a statistical term that describes if two or more assets move in tandem.

A correlation coefficient of 1, is a perfect correlation. A correlation coefficient of negative 1, is a perfect negative correlation.

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.

Bottom Line

A basket trade is an excellent way to generate customized risk. Baskets are traded all the time by investment funds and ETF managers who are looking to trade blocks of stocks to track a specific index.

Sector ETF, as well as Index ETFs, are one of the most popular forms of trading for mutual funds and hedge funds. The purchasing and selling of large blocks of shares by funds provide market liquidity.

You might 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.

Besides allowing you to personalize your investment goals with basket trades, this investment approach provides diversification.

Lastly, a basket trade is generally less volatile than owning individual shares. This is because the volatility of a basket is lower than individual assets, helping you avoid large losses from an adverse market move.

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