What is a Basket Trade?
A basket trade is an order to buy or sell a group of securities simultaneously. Basket trading is essential for institutional investors and investment funds who wish to hold a large number of securities in certain proportions. As cash moves in and out of the fund, large baskets of securities must be bought or sold simultaneously, so that price movements for each security do not alter the portfolio allocation.
Understanding Basket Trades
To consider how a basket trade is beneficial to an investment fund, suppose an index fund aims to track its target index by holding most or all the securities of the index. As new cash comes in that could increase the value of the fund, the manager must simultaneously buy a large number of securities in the proportion they are present in the index. If it were not possible to execute a basket trade on all of these securities, then the rapid price movements of the securities would prevent the index fund from holding the securities in the correct proportions. (For further reading, see: 5 Things You Need to Know About Index Funds.)
A basket trade typically involves the sale or purchase of 15 or more securities and is generally used to purchase stocks. Such baskets are typically measured against a benchmark or tracked against an entity, such as an index, to measure their returns.
Baskets can also be used to trade currencies and commodities. For example, an investor may create a basket that includes soft commodities, such as wheat, soybeans and corn. Most investment or brokerage firms that offer basket trading require a minimum investment amount.
The distribution of dollars between various components of a typical basket can be determined using various types of weightings. For example, a dollar weighting criteria distributes the overall dollar amount for the basket equally between its components. A basket trading strategy that uses share weighting will divide the overall amount equally between blocks of shares.
- A basket trade is a portfolio management strategy used by institutional investors to purchase or sell a large number of securities at the same time.
- Trading baskets can be an eclectic mix, from collections of securities to soft commodities to investing products.
- Different types of weighting criteria are used in baskets.
Benefits of Using a Basket Trade
- Personalized Choice: Investors can create a basket trade that fits their investment objectives. For example, an investor seeking income may create a basket trade that includes only high-yielding dividend stocks. Baskets might contain stocks from a specific sector, or that have a certain market cap. (For more, see: How Can I Find Out Which Stocks Pay Dividends?)
- Easy Allocation: Basket trades make it straightforward for investors to allocate their investments across multiple securities. Investments are typically distributed using share quantity, dollar amount or percentage weighting. Share quantity assigns an equal number of shares to each holding in the basket. Dollar and percentage allocations use a dollar amount or a percentage amount to distribute securities. For instance, if an investor is using a dollar amount to allocate $50,000 across of basket of 15 securities, $3,333.33 of each security is purchased.
- Control: A basket trade helps investors control their investment. Decisions can be made to add or remove individual or multiple securities to the basket. Tracking the performance of a basket trade as a whole also saves time monitoring individual securities and streamlines the administrative process.
Example of a Basket Trade
Suppose an investment fund wishes to take advantage of the volatility in an index. The fund manager creates a Long/Short basket to track the index. The basket does not actually contain securities. Instead it has a collection of call and put options.