Managing Risk With The Machine

Over the first 2 weeks in August, the market has lost over 13% and the Dow has lost over 1,600 points. Did anyone see this coming? In fact, the market was extremely overbought in mid-July and looked like it had the potential to turn into a runaway bull move just as it did beginning in September 2010. The biggest fear everyone has is selling or shorting into a runaway market. Too many traders and investors have been steam-rolled doing this since the early 1980’s.

But the unexpected occurred. In this case it was the not-so-pretty sight of our elected officials grand-standing for television as our political process turned into a public spectacle. This started the market meltdown. Then on Friday night, August 5, 2010, the rating agency of Standard & Poors blindsided the government by lowering the credit rating of the U.S. This was completely unprecedented.

No one saw this coming.

We can’t change the past. But we can better control the future, especially when it comes to controlling risk in our trading and investment portfolios.

The Machine gives you 5 ways to manage and control your risk.

• Trade balanced portfolios with multiple, diversified strategies.
• Trade with proper position sizing such that you spread out your account equity among as many different stocks and ETFs as possible. This ensures that you do not risk too much of your account in one specific stock or ETF.
• The Machine also allows you to incorporate protective stops into your portfolio.
• Use Dynamic Hedging in order to create a market neutral portfolio. This significantly reduces your over-night and market risk.
• Utilize statistics to help to identify “Black Swan” events and times to potentially suspend or reduce your trading.

All Machine users are familiar with the first option of building a balanced portfolio. In future issues of the newsletter, there will be a 3-part series showing traders the power of building a balanced portfolio and taking advantage of all of the strategy groups that The Machine offers.

In a previous edition of the Monthly newsletter, I wrote an article about proper position sizing.

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%.

Proper position sizing is one of the keys to building a balanced portfolio and to help manage the risk in your portfolio.

The third way that The Machine helps to control risk is through the use of protective stops.Protective stops are the risk management technique most often discussed by traders and authors. Stops are used primarily to reduce the corporate (stock specific) risk in your portfolio. Stops often can 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 news or a variety of other reasons. This will cause your stop to be triggered and often you will watch the stock climb all the way back to where it had come from. Using stops in cases like this does relatively little to protect your portfolio.

Nevertheless stops do help to minimize risk in cases where a specific stock gets hit by a news event and never recovers (for instance in the case of fraud or eleterious regulatory agency announcements).

The Machine also contains a number of unique strategies to hedge your portfolio. This is referred to as Dynamic Hedging. Dynamic Hedging is a risk management technique that can be used to reduce the inherent risk associated with holding stock and ETF positions overnight. Dynamic hedging minimizes the market risk and/or risks that portfolios are exposed to when the markets are closed (nights, weekends, and holidays).Dynamic Hedging looks at the daily net exposure (long exposure minus short exposure) of a portfolio and determines the number of shares of an index ETF or inverse index ETF required to bring the net exposure to zero (or you can choose to reduce your net exposure by 50%).

This involves rebalancing the amount of shares in a position over time, according to the market environment, to protect against the downside risk associated with exposure to a net long position or the upside risk associated with a net short position.

Traders have the choice of selecting an S&P hedge (SPY/SH) a Dow hedge (DIA/DOG) a Russell hedge (IWM/RWM) or a Nasdaq hedge (QQQ/PSQ). Depending on what type of market risk you would like to hedge, traders have the option of selecting a close-to-close hedge (to hedge against market risks), close-to-open hedge (to hedge against over-night risks), or a weekend and holiday hedge. Traders also will have the ability to decide if the hedge is a 100% complete market neutral hedge, or a 50% hedge to partially protect your portfolios.

Let’s say that you have a $100,000 account. You would like to incorporate a 100% close-to-close hedge. Near the close of trading, the portfolio is long $50,000 in positions and Short $25,000 in positions. The portfolios net exposure is long $25,000. To incorporate a 100% hedge a user would buy $25,000 worth of SH (the inverse of the S&P) in order to be 100% hedged. If you wanted partial protection you would simply purchase $12,500 worth of SH in order to implement a 50% hedge on the portfolio.

Dynamic hedging is to be viewed as purchasing insurance on your total portfolio. As everyone knows, there is no such thing as free insurance. In most cases the Dynamic Hedging lowered the test results. The cost in most cases was little as the portfolio gave up minimal CAGR. What does dramatically improve is the portfolios resistance to drawdowns, which is exactly what needs to happen. It also lessened the amount of days that the drawdown lasted. This is significant.

Here is just a chart showing the power of Dynamic Hedging on some sample portfolios built with The Machine, over the course of this most recent “Black Swan” event. Kevin Heller goes into more detail on Dynamic Hedging in a separate article within the newsletter.

The final way that The Machine allows you to control risk is through the Risk Histogram. This histogram allows traders to utilize statistics to potentially identify “Black Swan” events and times that you may want to suspend your trading.

Utilizing the Risk Metrics Histogram within The Machine will enable traders to see if the returns that a portfolio is experiencing are normal or not and if any changes need to be made. Rob Davenport has an article in this newsletter on how to properly utilize and implement the Risk Histogram into your trading.