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November 6, 2013

A Hedge for All the Right Reasons

Battle-ready traders may never know the direction in which a stock will travel but they can build a protective wall.

By

Rob Friesen

Today's traders are armed with countless tools, market and historical data and endless reams of analysis like never before. Despite this wealth of wares and information, traders lack one thing: a crystal ball. In other words, they have almost no idea where the price of a stock is going to go.

Having worked with hundreds of traders over the last 15 years, a problem I have witnessed is the need or desire to predict where a stock or the market is going to end up. Trying to predict tomorrow's closing price of a stock or where the market will be next week, for example. This endeavor can be futile, yet humans insist on the science of prediction. Trading indicators are often used in a predictive manner when they should just be acknowledged as a lagging instrument better used to determine where something is, rather than extrapolate a future price.

Rob Friesen

The drawback with thinking about where a stock is going to be is that it is based on an opinion and not on certainty. One can guess and speculate but he or she does not know for certain. Even if a trader had access to the most sophisticated software that crunches all known information, it would only be able to generate probability sets and projected variables and could never guarantee a closing price. As traders, we live in the percentages and not the absolutes.

The Best Intentions

Let's look at the good intentions of traders to generate profits:

Fundamentals: A stock can remain disconnected from its valuation. There can also be a significant difference between the quality of the company and its stock price. Stock pickers often make the mistake that because the stock's valuation metrics scream of a great deal that would then mean the stock price would appreciate. What if the stock price had been depressed for the last six months, but the trader just became aware of it now? Who's to say it has to go up in the next day, week or month?

Technicals: If others are looking for the same technical patterns, then there may be an argument for the pattern to repeat again with a similar outcome. A chart lets one see where a stock has travelled and technical indicators on a chart tell you how it travelled but this does not show where it will be. Chartist and Market Technicians need to live in the percentages and know that some trades placed on the best of patterns don't make a profit.

Statistics: Just because something moved to two Standard Deviations does not mean it has to snap back within the trader's designated time-frame. We must remember that standard deviation was designed for stationary analysis therefore using it on moving targets can be misleading. Additionally, the trader might not survive a move from two to three standard deviations and back to two. Statisticians often make the mistake that since a stock has not been somewhere before, it never will travel there. Proper risk management on the other hand would always consider the rare event and the new outlier.

News: The nature of news is that it is not predictable. How much is known or not known? What has already been factored in due to information leakage or insider activity? News traders often make the mistake that this piece of news has to move the stock, or they are looking for things to support the position they are already in. A more appropriate approach is that the proof is on the tape. That means that if a stock has been downgraded, but is moving up with volume and determination; either few parties care, even fewer saw the news, or the analyst had an agenda. Or, the bad news is already factored in.

The Fog of War

We are living in the "fog of war." We have our battle plans, instruments of warfare and some intelligence but there is ambiguity and victory is not certain. Blind sides can and will happen.

In the market, the blind sides come with many types of macro events; economic, central bankers, weather, global, corporate, technological changes, government and political. But a trader can strive to be market neutral and or macro neutral and still make money. This is a challenge for some traders and investors to understand; how is money going to be made when one hedges against most of the risks? Naturally, it seems that if you buy an oil stock long and then short another oil stock to hedge with, that would have a cancelling effect and the trader would make nothing except to pay commissions.

My battle trumpet blares out this message: Take the ideas you have, things that you have back-tested, patterns you have observed, indicators you use, software that screens, calculates or crunches for you, beautiful charts that give you visual cues, things you have learned from books, courses, mentors, and the web -- and use them as the basis to form long and short hedged trades.

Here's the plan: Identify catalyst-driven high-probability trades just like you have been trying to find all along, but this time pair the two trades together. You have a clear decisive reason for your long trade and a specific argument for your short trade. Could you be wrong on both? Yes, but let's consider the other possibilities.

You pick Home Depot (HD) versus Lowes (LOW). HD has a catalyst and set-up you like for a long trade. LOW looks like it is stuck against an area of resistance so you decide it is an adequate short or hedge.

Scenario 1. Both stocks move up. If HD outperforms LOW, you make money.*
Scenario 2. Both stocks move down. If HD falls less than LOW, you make money.*
Scenario 3. HD moves up and LOW moves down, you make money.
*(on a position adjusted relative percentage)

If you had only purchased HD as your naked long trade, you would have only one chance to make money versus the three scenarios I described above.

How could a trader lose money?

Scenario 1. Both Stocks move up. If HD underperforms LOW, you lose money.*
Scenario 2. Both Stocks move down. If HD falls more than LOW, you lose money.*
Scenario 3. HD (the stock you are long) moves down and LOW (the stock you are short) moves up against you and you lose money on both stocks.
*(on a position adjusted relative percentage)

Is This a Fifty-Fifty Confrontation?

It seems like you could lose or make money in similar fashion. It is not. According to your research, you have clear probability arguments for each bias you choose, and you have determined a positive expectation for each trade. Remember: your argument was that HD had the probability to outperform LOW, as HD was a good long and LOW was a good short based on your research and observations.

Since these stocks are in the same industry and have averaged a correlation of 88 percent, the potential for a Macro Event or market movement hurting you are substantially reduced over any single-sided trade. If there was an unexpected sovereign debt default, for example, the market may go into a tailspin and both HD and LOW should fall with it.

Now what if you didn't want to "pair" up something in the same industry group but rather wanted to be long a stock from the Integrated Oil Industry and short a stock from the Regional Airline Industry, could this be done? Yes, so what are the arguments (probability basis) for the long trade? The arguments for the short trade? Just remember that as you step outside of the correlated and co-integrated pair trades, you do take on more risk. The potential moves and opportunity usually increases along with that risk but we need to be mindful that all effort made to lower variance can protect against risk of ruin, or capitulation and usually increases returns over the long sample.

What if you had a stock that announced it was increasing its regular cash dividend and simultaneously announced an upcoming special stock dividend. Could this be a reason to go long this stock? Could you pair it up with the SPY (SP500 ETF)? Yes, as the SPY is extremely liquid, tightly traded and many major liquid stocks have membership in the SP500, it is a suitable hedging instrument. Other Sector ETFs can be used like XLB for Basic Material stocks or XLF for Financial Stocks.

What if stock ABC had three up days in a row giving you the historical probability of a 62 percent chance of an up day for the 4th day. Another stock XYZ in the same Sector reveals from a backrest that it has a 23 percent chance of an up day after seven up days in a row. Assuming there were a reasonable sample of these historic events to have confidence in the numbers, could you go long ABC and short XYZ?

What if GLD had an overnight move of 5 percent? From research you had done, you discovered that every time this had occurred ABX was weaker that next morning and for the entire day than NEM. Both are in the Basic Materials Sector and Gold Industry specifically. If you dig into the fundamentals and business practices of both companies, you may find that there is a reason that these two stocks act this way. This could give you more confidence, knowing there is an explanation. If you could not find an explanation but a pattern only, you would still need to rely on the probabilities from the pattern you discovered.

A trader's methods can certainly overcome the day-to-day market fluctuations and strange behavior. The next time you find a reason to buy a stock, think about the potential for the market to crash and think about how many things could affect your trade. Next time - improve your edge. Hedge!

Rob Friesen is president & COO of Bright Trading.

 

The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com

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