The Machine Monthly Newsletter – May 2011
FROM THE DESK OF LARRY CONNORS
Welcome to this month’s edition of The Machine Newsletter!
As we continue to build new strategies into The Machine, May saw the launch of three of the strongest ETF strategies we’ve published to date.
The three new strategies are the Leveraged ETF Strategy, The ETF Extreme Strategy, and the ETF Limit 2 Strategy.
Even though we will not release the rules for these strategies because we want to make sure they are not disseminated
by other websites (and potentially lessening the edges), the strategies are in line with previous research we’ve published
on ETF trading. The one main difference is that the ETF Extreme and ETF Leveraged Strategies can trade on the long
side under the 200 day at more extreme levels. These strategies are intended to allow you to set aside capital for those
extreme pullbacks which occur in both bull markets and bear markets which have then historically moved quickly higher.
Trade Execution is now officially live with the first customers being boarded onto the BNY/ConvergEx platform with the
accounts residing at TradeStation. More accounts will be boarded by TradeStation over the next few weeks and then
they will be opened to everyone who has an account of $250,000 or more. Within the next few weeks two more brokers
will be added and BNY/ConvergEx will announce who they are once the partnerships are finalized.
For those of you on The Chairman’s Club version of The Machine, we’ll be holding a special 4-hour training class the
last Saturday in June. I have a verbal commitment from Joe Corona to spend part of the class teaching us how to trade
options with The Machine. Joe has over 30 years of options trading and training experience on both the floor and
upstairs where he was the head trader for Tony Saliba’s trading firm. Joe has taught previous options classes for us
and they are always among the most popular and highest rated classes we’ve had. The June month end session will be
special and I’m excited to have Joe join us to share his options knowledge with us.
Finally, please remember that we have on-going training for The Machine. You can find the training schedule within The
Machine. Also your Account Manager can guide you as to which classes are available and when.
Thank you again and I look forward to seeing you again at our monthly Users Group meeting and The Chairman’s Club meeting in June.
Larry Connors is CEO and co-founder of The Connors Group and TradingMarkets.com
USING THE MACHINE TO RUN A BALANCED IRABy: Darrell Kay of Kay Investments Inc.
In this article for The Machine Monthly Newsletter, I would like to focus on a strategy to add balance and smoothness to IRA (and other) accounts. I use a Machine portfolio I call AMP, for “All Markets Portfolio,” in my advisory business. Please visit my website at www.kayinvestments.com and contact me to discuss investment ideas.
In building a balanced portfolio we combine very different Machine strategies, including long and short, mean reversion, trend following, equity and ETF. Among the most important is the use of short strategies, which offer the opportunity to make money or reduce losses during down markets.
Unfortunately, IRAs cannot hold short stock positions, eliminating this valuable tool. We’re left with the task of building long only portfolios for IRA use – unless we can find workable alternatives to shorts.
One of the possible solutions is incorporating options – purchasing put options as an alternative to shorting
the stocks or ETFs. However, this solution is not without its challenges, including liquidity and investor
A very attractive solution is to incorporate the new Dynamic Hedging feature into IRA portfolios. Very
briefly, Dynamic Hedging entails holding an opposite position in a market index in the portfolio. Dynamic
Hedging can be implemented at 50% or 100%. For example, if the portfolio is currently net 60% long,
then a 50% hedge would call for a position of 30% short an index (for example the Russell or S&P 500).
The Machine models the outcome using the assumption that a short position would be allowed.
I’ve spent time testing this feature and find it fascinating. My initial fear was that hedging would wreck
the returns. While hedging clearly does reduce portfolio returns, it is much less than I expected when
using a 50% hedge. The benefit is a much improved drawdown profile. It also much improves the return
outlook for a bear market year like 2008. This creates a far better outcome than simply assembling a
highly conservative mix of long-only strategies.
There are a number of possible ways to implement dynamic hedging. Taking a short position in an
index ETF like the SPY would be easy to implement, but, of course, this will not work in IRAs. Inverse
ETFs are a possibility, but they are known to be a poor proxy for short positions over longer periods due
to their tracking error. In-the-money put options on index ETFs might work, except that some brokers
require very high liquid net worth. And the final option is to use index futures such as the S&P 500
e-mini contract. You also need to consider the fact that all of these alternatives can use
valuable portfolio equity.
The implementation of the dynamic hedge is relatively simple if you use futures contracts. A single mini
index futures contract will hedge approximately $60,000 of holdings. The commission overhead is next
to nothing. Further, mini futures can be margined using approximately 8% of their contract value. This
means they would occupy approximately 4% of portfolio equity (in cash) if implementing the 50% hedge.
Many brokers, including the one I use, impose no extra investor suitability requirements. Most importantly,
short futures are permitted inside IRAs. And finally, futures function very efficiently as hedges. That is why
they were created initially.
Dynamic hedging provides a different dimension than simply adding short strategies to a portfolio. It is a
tool for reducing volatility, smoothing returns and isolating alpha. Thanks to the availability of futures
contracts, dynamic hedging is simple to implement, contributes little overhead, and fits perfect inside of
MANAGING RISK THROUGH POSITION SIZING
This month the markets reminded us of the need to manage our trading risks. The silver bubble finally
popped and took down a number of traders down with it – individual traders and professional traders alike.
Traders who were overly aggressive paid a very high price. But for traders who had proper risk management
methods in place it was just a normal bump in the trading road.
So it’s a good time to discuss managing risk. With The Machine there are three core risk management tools
available to traders: (1) position sizing, (2) protective stops, and (3) dynamic hedging. Options can also be
used to help manage your risk, but are beyond the scope of this article.
All risk management methods can be viewed as a form of insurance. You are likely going to give up some
returns in order to protect your portfolio. So, when designing your portfolio, you need to consider what types
of “insurance” you want and how much return you are willing to give up.
Protective stops are the risk management technique most often discussed. Stops are used primarily to
reduce the corporate (stock specific) risk in your portfolio. Stops will often help to reduce the volatility and
increase the Sharpe Ratio of your portfolio, but they will almost always hurt your portfolio returns. And they
may not always give you the protection that you are seeking.
One of the main reasons that stops often hurt your returns is due to the cases where stocks gap significantly
lower. This can happen due to earnings or a variety of other reasons. This will cause your stop to be triggered
and often you will watch the stock climb all the back to where it had come from. Using stops in cases like this
does relatively little to protect your portfolio.
Hedging is another way to protect your portfolio. With dynamic hedging in The Machine, you off-set your
long positions by going short the market. Hedging is used primarily to mitigate market risk, especially
overnight market risk. Hedging can help you to sleep at night when world events are causing turmoil in
One of the best ways to manage the risk in your portfolio is through proper position sizing. Position sizing is
usually the easiest and often the most effective means of managing your risk.
A simple way to look at position sizing is as follows. Suppose you allocate 50% of your portfolio to a single
stock and that stock loses 50% of its value. Your account will show a 25% loss. On the contrary, if only 5%
of your portfolio is allocated to a single stock and the stock loses 50%, your portfolio will only show a loss of 2.5%.
As you build your balanced portfolios, The Machine contains thousands of strategy variations to choose from.
One of the criteria that you can customize as you build your portfolio is Maximum Positions. This is the first step
in introducing position sizing into your portfolio. As you build your portfolio, you can choose strategies that contain
as few as 5 maximum positions all the way up to strategies that can contain up to 20 maximum positions.
As a general rule, the fewer the total number of positions in your portfolio or strategy, the higher the CAGR (annual return)
will be. But, fewer positions will usually also result in higher overall volatility and increased drawdowns.
A strategy that has 5 maximum positions will have a large percentage of your capital allocated to each position. This can
lead to position concentration and greater the amount of corporate (stock specific) risk that you are taking on as you gain
exposure to the market.
Less Positions = More Aggressive
The larger the number of positions in your portfolio or strategy, the lower your CAGR, and the lower your volatility or
drawdown associated with that strategy.
More Positions = More Conservative.
As you build your portfolio, position sizing should be one of your key objectives. Suppose you have a $250,000 account.
You could decide that you would like to risk no more than 2% per position. This will mean that you should include enough
positions (also called “slots”) in your portfolio so that you have at least 50 positions for the entire portfolio.
One last thing to consider when designing your portfolio is that there can be overlap between different Equity Long Mean
Reversion strategies (and likewise between strategies in other groups). So if you have 10% allocated to a 5 slot SO strategy
and 10% allocated to a 5 slot Long Pullback strategy you could potentially end up allocated 4% in one stock even though each
strategy has a maximum allocation of 2% per position.
Proper position sizing can be your best friend in times when the segments of the market implode like silver did recently.
Of course, you will still feel the pain in times like these, but the pain will be minimal relative to what could have happened if
you were over-allocated in a particular stock or ETF. Preservation of capital is always Rule Number 1.
Phil Suarez is Director of Education for The Connors Group
THE NEWEST ADDITION TO THE MACHINE FAMILY:
There was a time, not so long ago, when exchange-traded funds (ETFs) were simply a proxy for index tracking mutual funds.
That is certainly not the case today. There are now over a thousand ETFs and they are used for every type of trading imaginable –
from day trading, to pairs trading, to portfolio hedging.
In early 2001 there were only 85 ETFs and only 10 had an average volume of over 1 million shares per day. Today there are
121 ETFs that average over 1M shares per day. It is easy to see why ETFs have become the trading vehicle of choice for many traders.
Despite the huge popularity of ETFs there are very few trading products that focus solely on ETFs. There is also very little in the way of
comprehensive ETF training available to traders. The new Machine ETF Trader was introduced this month to fill this void.
The Machine ETF Trader is the newest member of The Machine family. It is designed for traders that focus on ETFs. It contains over
32,600 quantified ETF strategies. Almost every type of ETF strategy imaginable is included in this product:
- Swing trading strategies (4-6 day average holds)
- Trend following strategies (3-6 month average holds)
- Day trading strategies
- Long strategies
- Short strategies
- Leveraged ETF strategies
- Country ETF strategies
- US-only ETF strategies
- Strategies with market order entries
- Strategies with limit order entries
- Strategies with scale-ins
- Strategies without scale-ins
- Strategies with stops
- Strategies without stops
- Strategies for when the market is above the 200 day MA
- Strategies for when the market is below the 200 day MA
- Strategies that are active both above and below the 200 day MA
- Strategies for volatile markets
- Strategies for quiet markets
- Strategies for IRAs and for margin accounts
With this type of selection of strategies, it is easy to construct a portfolio for any type of market and any sort of trading objective. And
The Machine makes it easy to combine diversified strategies and backtest the portfolio.
There are two aspects of The Machine ETF Trader, however, that make it stand out even more than the thousands of backtested strategies.
First, is the fact that the product comes with a comprehensive, all-encompassing 4-week ETF trading training course (included with an annual
license). This course covers everything you will ever need to know about trading ETFs from trading leveraged ETFs, to day trading ETFs, to
options, to constructing a portfolio for an IRA. And, of course, it covers everything you need to know about using The Machine ETF Trader.
The second key feature is the ability to use The Machine to directly send your portfolio trades to your broker for execution. Automated trade
execution through ConvergEx’s institutional grade platform went live on May 18th for qualified Machine users with TradeStation brokerage
accounts. More brokers will be coming on line shortly.
The ability to send your portfolio trades through The Machine will save you valuable time every day and minimize the possibility for order entry
The Machine ETF Trader should fill a huge void that previously existed in the world of ETF trading. For more information on this exciting new
product, click here. You can also contact your Account Manager or call 1-888-484-8220 ext 1 (international: 973-494-7314 ext 1).
Rob Davenport is Chief Marketing Officer for The Connors Group
Q&A WITH KEVIN
WHAT’S NEW IN THE MACHINE
- The Returns Distribution Histogram allows users to see what the simulated historical returns look like for their portfolios over various periods from 1 day to 1 year.
- ETF Limit 2 is the second new short-term long-only ETF strategy that utilizes limit entries.
- ETF Extreme & ETF Leveraged are two new ETF strategy that attempt to identify ETFs that have been over-sold in the market.
- We have added a new scale-in type, “No Scale-in,” that allows for a full entry position to be taken as the initial entry.
- April 2011 simulated statistics are now available.