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Staying Objective

January 24, 2010

The last few days have certainly been scary for those who were heavily long. Knowing how to handle these kind of situations is what separates the men from the boys. As the market started turning south in the very early stages Jeff Pietsch of Market Rewind highlighted the importance of hedging The ETF Rewind exposure tool mentioned in the article is something that all the best hedge funds like  Renaissance Technologies use on a daily basis to reduce risk and stay consistent.  Another great example comes from  Charles Kirk who is another veteran market pro. I really like how he handled things and it struck me as being very sensible. Charles had trailing stops on all of his positions which is something he always emphasizes as a key risk management tool to preserve profits and protect you from big losses.  He happened to get stopped out during this pullback–finding himself sitting on a lot of cash. He took a day off to reflect and think about what to do next and came out with a special report the next day after spending a long time collecting his thoughts. This disciplined, common-sense approach is a timeless quality of all the successful market speculators of the past like Nicholas Darvas and William O’Neil.

I am personally always hedged and rarely take much of a net long or short position and was lucky/fortunate enough to have a couple winning days during this period. As a consequence perhaps I can offer some simple and objective advice:

1) If you find yourself in a tough spot–don’t beat yourself up or lament about what you wished you did etc. A soldier in the middle of a war would have no time or use for recriminations and neither should you.

2) Develop a game plan for what you will do NOW and try to pretend whatever P/L you have or currently had are irrelevant. Make the best decision for the present. The market is oversold in the short-term, if you were a short-term swing trader you would be long here and waiting to sell on a bounce. If you are holding a concentrated portfolio of risky stocks, swap that out for a position in a major index like the QQQQ to avoid catastrophic losses and wait to sell on that bounce.

3) Wait and watch following that bounce to see what happens. If the market firms up take an index position to play the upside. If the market and your favorite stocks threaten to break new highs you can now set some buy targets. THIS TIME make sure to set initial and trailing stops.

Additional Thoughts

1) Even thought the 20, and 50 day moving averages have been breached, we are still technically in a bull market– the S&P500 is above its 200ma and the trend is still higher(200ma is still rising).

2) Bull markets often correct to points at or below their 200mas, it is just a matter of time until this happens, and this correction could be the start of a move that reaches this point.

3) One of the most reliable signals that a new bear market has started is the Golden Cross a 50sma/200 sma crossover. This is your official signal that the game is over and the bear has truly returned.

Tips For the Future:

1) When a bull move has lasted a long time since correcting below the 50sma, or near the 200sma AND the VIX is very low compared to all readings over the past year the market is vulnerable for correction.  This is a time to purchase cheap puts or out of the money calls on the VIX to protect your long positions IN ADDITION to having trailing stops.

2) Another trigger that should encourage you to start hedging is when the RSI14 is near/at/or goes above 70 which happened on January 11th and gave you plenty of time. Previous corrections this year have followed the market reaching these levels. My recommendation is to use ETF Rewind’s exposure tool tool to sell short the appropriate ETFs to balance your risk so you are only exposed to alpha–the outperformance of your favorite stocks versus the market, instead of being exposed to the monster that is the market beta when things go south.

11 Comments leave one →
  1. Dave Svilar permalink
    January 25, 2010 10:25 am

    Timely post. I just began trading your Livermore stocks and came out a little bit ahead last week with a combination of initial stops, protective puts, and luck (ISRG). You mention some good ideas here, but I’d be curious to know your method for staying permanently hedged. I’m working on doing the same in my retirement account where I can’t use margin. Cheers.

    • david varadi permalink*
      January 25, 2010 1:00 pm

      thanks Dave, I enjoyed the run on ISRG too! definitely a little lucky! Anyway I will be delving more into position-sizing and risk management in the new few weeks as this is an area I have not covered.


  2. bgpl permalink
    January 25, 2010 2:34 pm

    hi DV,

    on risk management using
    – hedging
    – stops
    – position sizing / money management
    – multi-strategy trading fitting in multiple orthogonal strategies with different risk profiles together to get a better risk profile
    – simultaneous long / short within a strategy

    it would be great to hear your and other expert bloggers thoughts on this in some posts.. given that the insights are tremendous I think it will bring me and many others a lot of knowledge.
    The background of my question above is:

    i have not been able to find a way in backtests in which stops actually improve risk adjusted performance. I have to really put stops far away (4-5X ATR) to see them equal the performance of the same system without stops and provide the same risk adjusted performance
    – is it just psychological ? “I have a stop: i can sleep better”
    Would love to hear your thoughts on this.
    – i look at MAEs and statistics etc., to backfit the best ATR stop, but at the end of the day, it seems like it is very difficult to match the risk adj perf of the non-stop strategy..

    i can see hedging work well on systems to smooth out returns in market dislocation.. would love to see some of your thoughts on best ways to hedge:
    – using the underlying index
    – using options / futures so that the hedge uses less of the equity and more of the equity can be used pursuing alpha.. while the hedge being highly leveraged kicks in during big dislocations..
    Even in this case, should we hedge using puts on the index, or collars on individual stocks or …. ?
    – dynamic hedging: if we use techniques like the RSI(14) you mention : how can we still protect against “acts of god” or a very abrupt market condition like oct 1987..(abrupt crash in a bull market) or even 09/11 (though that came in a bear market)

    (c) at some point there was some discussion on multi-strategy systems but it sort of died down.. any thoughts ?

    best regards, bgpl

    • david varadi permalink*
      January 25, 2010 6:02 pm

      hi bg,
      a couple thoughts and I will be taking a look at some of these issues. first i think that if you are testing mean-reversion systems stops are not going to help you at all and will harm your profitability etc. For trend systems this is less true (though overly tight stops are harmful here too), but stops can improve certain systems reward/risk and overall profits. in general my research shows greater benefit in the area of position sizing versus using stops and the two are integrated. however good position sizing without stops does very well on its own. another area that is just as good and perhaps better is hedging–there are many ways to accomplish this and while there is no one best method, certainly different situations call for different types of hedging. when the market is volatile, options hedging makes little sense and shorting using an appropriate matched hedge is superior. position sizing should be a lot smaller too. but when volatility is low you are getting more benefit from options hedging by buying out of the money puts etc. You are also more likely to generate alpha selling short mismatched stocks that are likely to underperform–as the profitability of this hedge will be more stable above the 200ma.of course my answer is still overly simplistic and does not account for many of the factors involved in volatility arbitrage–ie correlations etc which help to improve this framework.

      I will be doing a position sizing article this week. with regards to (c) i will get there!


  3. Keith Piccirillo permalink
    January 25, 2010 2:51 pm

    How to this jibe with the above?

    • david varadi permalink*
      January 26, 2010 2:13 am

      hi keith, i know michael was simply trying to show that the crossover was not magical per se, but it does improve risk-adjusted return and absolute return. my advice is to use it as a tool to avoid going short prematurely which is what many people do every time the market breaks above the 200ma. the problem with using the 200ma is that it gives too many false signals and too many trades. as a side note the golden crossover is still one of the main strategies in MarketSci’s state of the market report, so clearly Michael feels it is of some use overall.


      • Keith Piccirillo permalink
        January 26, 2010 12:10 pm

        Much obliged.

  4. January 25, 2010 8:31 pm

    Wow, but this is a great thread. Thanks, guys. BGPL’s questions and DV’s answers are right up my alley with the testing and methods I have been using for a number of years now. Glad to see some restatement and corroboration of what I have been observing — and also enhancements to my own private brainstorming.

    • david varadi permalink*
      January 26, 2010 2:10 am

      thanks Dallman, hopefully I can expand more upon that summary soon.



  1. Staying Objective | Financial engineering resource center
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