December 2, 2013

A Hedge for All Reasons

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

By 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 still 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, I have often witnessed this problem, the need or desire to predict where a stock or the market is going to end up. Traders try, for example, to predict tomorrow's closing price of a stock or where the market will be next week. This 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 to extrapolate a future price.

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 sure. Even if a trader had access to the most sophisticated software and could crunch 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 then means the stock price will appreciate. But what if the stock price had been depressed for the last six months and 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 traveled, and technical indicators on a chart tell you how it traveled-but this does not show where it will be. Chartists 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, that does not mean it has to snap back within a 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, a trader might not survive a move from two to three standard deviations and back to two. Statisticians often make the mistake of assuming that since a stock has not been somewhere before, it will never travel there. Proper risk management, on the other hand, always considers the rare event and the new outlier.