A Trader’s Guide to Hedging Strategies – Part III
Between now and the FOMC announcement due at 2:15 EST, action will likely slow to a cat crawl. What do you say we put on the polyester woot suit and discuss more on the subject of hedging?!
Oh yeah…
Hedging Exposure (when, why and a little on how)
We’re up to Part III now, which means we’ll really be getting down to business, right? I’m picturing algebraic formulas, flawless graphics and a glow in the dark game-plan we can velcro to our wrist.
That was the idea, but once again I’m looking at a draft which rambles-on esoterically, sometimes off-topic and without instructional diagrams.
What do you want for less than a cup of coffee? Hopefully this will teach more.
As already stated, I’m not the best candidate for illustrating the array of methods for hedging-off exposure. Using options, for instance, is a viable strategy, but I personally don’t trade options except for speculation (and a bit rarely at that; wanting to use options more for anticipating a big change in direction when premium is historically cheap). But again I am willing to (attempt to) convey how I go about this personally (lucky you!).
For better of for worse (in case you didn’t notice), I’m a market timer. When pros come on TV and say no one can time the market, they are talking about chumps like me. I use a variety of technical and fundamental criteria and at the end of the day I am going to push harder or softer, long or short, based on my interpretation of the current environment and an assessment of near-term/intermediate-term opportunity. I work on that interpretation continuously as the market trades, doing my best to recognize developing counter-trends (minor or major), and whether or not and how much to adjust, whether or not and how much to hedge, etc. I know from those same pros that a nice chunk of historical performance comes within a very short degree of time (that the majority of a market’s advance, or plummet, is contained within a relatively small number of trading days. I am especially keen then to position aggressively and in-line with direction of these significant market triumphs (or failures).
I want to know how to anticipate a major turn in the market, since some of the biggest one-day moves stem from such a shift, but that doesn’t mean I need to fully adjust before price-action actually confirms a change in trend. My tendency historically, like a lot of traders here perhaps, has tended toward arriving early to a trend-change party, as opposed to coming late. For this reason I try to discount, check and adjust this tendency and force myself to turn a little later, or at least hang out in market neutral-territory or out of the market altogether; depending.
The older I get, the less what I think makes any impression on me. I want to be the great reactor; especially in volatile times. Predicting in rocky times is for suckers and masochists.
If I am trading a market long and there are a multitude of strong charts (healthy leadership), an upward trend in advancing stocks vs. those declining (A/D-line) , a rising number of new 52-week highs, etc., I will look to press that trend regardless of my views on the economy, or any economic indicators informing the pros in my field. I don’t mind negative news, especially if the market is digesting it well and advancing in the face of it (quite like that set-up in fact). I will begin to slow down, however, when negative signs begin to appear and I will either neutralize, hedge-off, or exit the market altogether when these signs begin increasing.
Some of these disturbing signs include: evidence of major distribution; a breakdown of leadership; a lack of bullish stock charts; back-of-the-roller-coaster industry groups begin leading in terms of relative strength (RS), such as oils and other cyclicals, while at the same time financials and technology groups begin to lag; excessive bullishness relative to action (excessive bullishness in and of itself is only a cautionary sign, whereas rampant bullish contagion coincident with no price advance is a major red flag and will force me to adjust); rapidly rising interest rates (rates will always rise in the market ahead of the Fed increasing fed funds rates; follow market rates if you want to follow the Fed, since that what the Fed follows).
I don’t like shorting something simply because it appears too high, or buying when something appears low, attempting to prosper from a re-trace. I prefer placing bets on the more powerful force, or no bets at all – and while I may anticipate a counter move and reduce exposure for that reason, I’m almost never interested to play the smaller counter-wave. Somebody taught me a long time ago that if the zigs in one direction are greater than the countering zags, then focus on the zigs.
This flies in the face of our natural, comfort-seeking subjective tendencies, and is pretty much the reason why most traders are profiting only marginally, if at all.
I should discuss this in detail, since I see the mistake of attacking high-fliers made year in and year out (shorting for the zag instead of buying the larger zig; or simply leaving well enough alone which is a safe-enough alternative. PCLN and AMZN this year are a couple of examples. Oddly, a stock like GS was quite a popular short earlier in the year, when the trend was unrelentingly powerful, but I seldom see anyone attacking GS today (now that the name has been trending downward). We’ve got to detach our subjective ideas of where we feel a stock belongs. The market is a measure of supply and demand and everyone in this game knows that prices exceed reality on a routine basis (sometimes going further up or down than anyone in the crowd could predict). Why then fight something acting ridiculous when it is only apt to act even more ridiculous?
Doh!
If you were happy to short GS above 150 in July (when it was showing terrific power on the way to 193), then why are you not excited to short GS above 160 now (when it has been diverging negatively for a couple of months)?
I prefer to measure the underlying power behind a move. If it demonstrates real power, then I don’t apply any gauges of reality whatsoever. I might target where I think exit points might be best, in terms of trading, but I’m certainly not shorting something acting powerful just because it hit somebody’s idea of a target, or it loses touch with reality. Who needs reality anyway?
Here is a good example illustrating why we need to train ourselves against such tendencies. In the late 90’s YHOO was considered as overpriced a stock as has ever been seen. The stock ran (pre-split) from below 15 to above 80 in about a year and a half; and there has never been a stock so powerful which was so universally loathed. YHOO was literally laughed at by market pros and the public wasn’t going for such foolishness either (not yet). It was fools and fools alone who were buying YHOO above $80. Not everyone was shorting the name, but I know of many who did and were decimated for it; a real career changer. But to a man on Wall Street – YHOO was ridiculously overvalued.
Nobody questioned this. The fact that it had been under 10 or so was all the proof needed that YHOO (and all the internet names at that point) had gotten out of touch with reality.
All of this is meaningless and nonsense of course, especially when the clear perception out there is so universally negative AND a stock still acts only like a monster. And that last part is very significant. If no one else is going to ask the sexiest girl to dance, because she is too sexy I suppose; then from my experience it’s worth grabbing that tiger by the tail and running with it. By measuring the power of a move instead of anything practical, YHOO was merely a monster; nothing less. The fact that skepticism surrounded the giant move, and the stock was very liquid to boot – then let’s just say you don’t want to be shorting such a beast. You want to get in the pants of a name like that. Let the other losers play it safe.
Maybe you were there, but it is unbelievable what happened (in other words it makes perfect sense, which is why I love this game so much). YHOO punished anything and everything in its path as it only accelerated from there. Within another few months the stock traded above $200 and then, on news it would be added to the S&P 500 (ding ding ding) it lit the roman candle and launched to just under $250/share ($125 split-adjusted).
That was the all-time, all-time high in YHOO. A classic Prussian Helmut top; the likes of which should be understood like the back of your heaviest frying-pan hand (since that formation is going to hit you with about the same affect, once it develops).
And predictably, here is the scary (beautiful) thing. Recall that YHOO was universally loathed at $80. Well, that was because folks looked at it like it was a $10 or $15 stock. So what do you think happens to YHOO now, on the way down down down from the insane height of 250?
I’ll wait for you to guess.
Exactly. It became “oversold,” “relatively cheap” and “undervalued” at $180. This is the truth – the same subjective attitudes which held players back at $80 now somehow provided comfort to go ahead and pick up a bargain at 180, 150, 120, 90, 50, etc., etc., yikes, etc.
Dimwits?
So, I’m not saying that GS is in the midst of a round-trip back to $50, but it is interesting that I don’t see people discussing GS shorts on the boards anymore. AMZN right now is somehow more comfortable to people looking to short; apparently.
We’re talking about momentum trading, which gets a rather bad rap (thankfully!) from time to time. The thing is though, if a market is trending and volatility is sufficiently high (let’s say the VIX is >15, to keep it simple), then being on the right side of a momentum move is going to blow the random walk pros out their narrow little windows. You cannot randomly run a stock from 10 to 250 and then back to 10 again – there is something much bigger going on; something valuable perhaps!
Easy game then, perhaps. If you have real volatility and a real trend, then you have a market which can make you money.
Now, some of you might point out that both trend and volatility are a bit suspect in the present environment right now and you are correct. What better time for us to talk about it then? None better for me, actually. I don’t have the energy to talk theory when stuff is really flying. But there is much, much worse, trust me. This market is a little tough right now, but not impossible.
Now perhaps you begin to see I can only present my own method. I’m not as smart as the rest of the crowd writing about this (that’s by design, since smart was not buying going-up at YHOO at $80). Anyway, if I have a strong trend and volatility is good, how can I maximize that move without risking the frying pan to my head?
Buy the Beast and Short the Sick
That’s all I do. How much do I buy (in an uptrend), how much do I short (in a downtrend) and how much do I hedge (in both cases) depends on many many things (things I can’t necessarily teach; not now anyway). But suffice to say, the main element to protecting one’s position is to make sure you’re selling weakness and buying strength (remember, you need a strong trend – otherwise you are getting whipsawed by chasing, but if you have a strong trend I’ll argue you will do best by attacking strength long and skewering sickness short).
How much one varies exposure depends on the power of the move. If the market is partying like it’s 1999, you don’t need to hedge that tiger. Pick your entry spots and hold on; falling out of bed is harder than a 200% year. If it’s summer 1987, you should be finding your hedge becoming more and more dominant until at some point you are more short than long and the longs begin to act as the hedge. This is a rational, normal, madman approach to the markets as far as I’m concerned. How one goes about it has everything to do with style, but the basics in profiting from strong moves in the market have a similar foundation.
I save myself a lot of trouble by exiting stocks from industry groups slipping in relative strength (RS). I have not lived enough lifetimes for a proper data sample, but I can tell you with real anecdotal authority that I wake up to fewer names blowing up (due to surprise-negative news) by stepping out of groups which are declining markedly in RS. And while shorting the already-worst industry groups is not always the best strategy, identifying the new-worst industry groups is a must for educated shorting.
That’s a lot different than shorting the highest fliers.
The market is about supply and demand and large institutions have to move a lot of money around (often for very good reasons). Keep an eye on this rotation (week-to-week if not day-to-day; I’m watching hour-to-hour, but I’m a bit of a freak). It will pinpoint new leadership and it will save you from oncoming disasters. I can guarantee you that the vast majority of disasters breakdown in RS before the real drama with price begins. Unfortunately, every breakdown in RS does not equate to looming disaster, but that doesn’t mean you wouldn’t prefer to avoid such a potential risk, right? It’s better to exit something with a full head on your shoulders and miss an opportunity for gain than it is to end up with your head on a stick.
So we see that it may be more conservative to jump onto an out of control long going up, as long as it is going up, than it is to buy something trending lower. Thus, not only are you kicking the ass of your peers, because they are too timid to ride such a volatile beast, but they are more apt to define the better shorts at the same time (since those laggard lovelies they glom onto are demonstrating deteriorating demand vs. supply; why do I want to waste away in something like that?).
I’m pretty sure we didn’t talk much about how to go about hedging again here, but maybe its better like this. When the book comes out I’ll have to edit this section dramatically and import much of this speech elsewhere. Anyhow, I’ll look to try one more time with Part IV; magic markers and baby food formulas in hand; perhaps. In the meantime I’m hoping this is somehow useful. It is to me at least.
Don’t be overly reasonable. Reasonable is a of a heart-breaker in this business.
Homework: Transform yourself as more objective. Stop attaching what you think is normal to anything that has to do with the markets. Normal is changing every day around here, don’t tie yourself to a tree.
Previously in this series:
A Trader’s Guide to Hedging Strategies – Part II
A Trader’s Guide to Hedging Strategies – Part 1
A Trader’s Guide to Contractions
A Trader’s Guide to Sipping Kool Aid
Losing Like a Winner: A Trader’s Guide
A Trader’s Guide to Secondary Offerings (Part 2)
A Trader’s Guide to Secondary Offerings (Part 1)
A Trader’s Guide (Introduction)
A Trader’s Guide to Chasing Ambulances
A Trader’s Guide to Exhaustion
Mole here – I just wanted to tack on the long DXY odds for you guys:
We’ve got ourselves a whole cluster of support here – I chose 76.1 as the 100% mark.
Mr. Bucky has held at 76.55 near the long 76.43 RL. If it breaks through 76.1 then I think 75.6 is the next line of defense.
As usual the DXY odds calculator is brought to you by retracementlevels.com – swing over there to familiarize yourself with a diversity of valuable odds calcs for futures, currencies, equities, indexes, etc. These types of statistical tools are usually only available to institutional traders and you owe it to yourself to learn how to gauge your odds before placing a trade.
CD here – looking to regain the last word…
This entry was posted on Wednesday, December 16th, 2009 at 2:33 pm and is filed under Currencies, Retracement Levels, Trading Psychology. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
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