This is all about trying to lower Downside Risk - in essence there are 2 types of such Risk - ‘Stock specific’ which can be diversified away by holding a number of Positions and by such things as Sizing to Volatility, diversity of Strategies, diversity of Sectors, diversity of Stock Types (Income, Defensive, Growth, Value, etc.). The other Risk is ‘Market specific’ - this can only be practically reduced or largely mitigated by the use of Index Shorts - which is what this Blog is about.
It is very much my belief that one of the biggest errors I continually made in the past was to sell great Stocks far too early. This was partly because I was selling Stocks when I thought the Markets in general were going to fall and therefore by Shorting an Index (in practice it is nearly always the case that Major Indexes across the UK, Europe and US are all very closely correlated - so they all move together) it would have the same effect as Selling some Shares and going into Cash. If you sell some Shares in advance of a Market Drop, this has 2 benefits - it means you have less Long Exposure so you suffer less damage and it means you have a Cash Pile ready to buy more Stocks when the Market has bottomed. These same benefits can be gained by Shorting an Index on the way down and then using the Profit generated and some Leverage to go Long on the way back up again - and your Portfolio remains exactly the same.
Shorting this way has other advantages as well - it means your Portfolio is unchanged so you are still exposed to any Ex-Dividend Dates and this keeps the Dividends flowing in and, more importantly, it is far cheaper - if you sell several different Stocks before a Market Drop, then you could run up a lot of Dealing Costs and you will also get a load more Costs when you buy back in at the bottom. By just using one or two Index Shorts and one or two Index Longs on the bounce, you are incurring much less Cost. It is also practically very easy to undertake and just like ‘Flicking a Switch’.
The other problem with selling Stocks before a Drop is that you are unlikely to be able to get your Cash back into the Markets fast enough to be able to maximise the Gains off the bottom when the Markets bounce - the speed in terms of turning Hedging On and Off is a huge benefit. I guess this applies in the Selling stage as well - it takes time to trim your Stock holdings.
I had been trying to Short various Indexes for quite some time and with varying success but things really went badly wrong in 2016 when I timed my Shorting well but when things reversed I got caught with a very big Position which was pretty much counter balanced by the Long Portfolio and was, if you like, a ‘Perfect’ Hedge - but the trouble was that it was too perfect and I struggled to get the Short closed when clearly I needed to do this and I made the amateur error of letting the problem run (this was partly because I knew I was making Money on my Longs so the overall effect was fairly neutral) but to cut a long and painful story short, the end result was that by the Close of 2016 I had not made any Money because my Longs and Shorts had balanced each other out but the problem was that I had missed out on probably 6 or 7% of Gains - this was very expensive. If you go back through my Blog Archive of 2016 there is a lot about this as it happened and if you look at the ‘Scores on the Doors’ Blog for 2016 that will tell you more about the end result (I have included this Blog in the ‘Related Blogs‘ section at the bottom of this particular Blog).
After this disaster clearly something had to be done about it - there is no way I could accept a repeat of this and of course the easy thing to do would be to just give up and forget about trying to Hedge my Portfolio. However, that just seems a total cop out and there was no way I was going to do that until I had thought about what I was doing and figured out whether or not I could fix the problems. It struck me that the issue was not to do with my Market Timing - at a guess I would say that this is pretty good and I am probably right for a very high percentage of the time - it could be as high as 70% plus. So the problem had a lot more to do with how I was Executing my Trades and in particular there was clearly an issue with Discipline (or lack of it !!!). I will expand on these problems in a separate Section further down this Blog and also on the steps I have taken to address these.
So far I have really focused on the Hedging aspects from going Short on an Index but my ‘New Improved Index Trading System’ also works for Long Trades - and this is in effect a counterpart and addition to Short Trades because when we get a big Drop in the Indexes, it is very possible that you can close the Short Trade(s) and bank a Profit and then switch to a Long Trade on the same or other Index and make some more Profit on the powerful Bounce-back as the Markets come up off the bottom. Of course it is impossible to pick the exact and precise Bottom but you don’t need to - you can be quite ‘late’ in terms of getting a Trade on but it doesn’t matter, there is still a lot of Profit to be made very quickly. This is an important concept and applies to when you go Short just off the Top as well - you can never get the exact Top but there is no point worrying about it and you can do very well by going Short not far after the Top and letting your Trade run.
In fact, this is a key element of how my System ‘works’ - it is the Classic Trading Model whereby you execute many Trades over a period of time and it is the aggregate Gains/Losses of these Trades that make the System effective or not. The key is to have plenty of Losing Trades but to ensure that when they happen the Losses ‘banked’ are small whereas you also have loads of Winning Trades and when you win, you win big. Again, dropping back to ‘Classic’ Trading Theory, you could have 65% Losing Trades but if you make sure you only have small and controlled Losses, then overall your System will make Money. It is vital to understand this and to embrace cutting a Position when (or before) it hits your Stoploss and to see this as just part of executing the System - this is the key to ‘Discipline’.
Think about it like this. If you just had a 50/50 Win/Lose rate (and let’s face it, the Proverbial Monkey with a Pin can probably achieve such a rate), then if your Losses are cut very early but your Winners are allowed to run to big Profits, then overall you will make good money.
The Principles of how my Trading System works will really apply to any Traded Asset and in particular the same ideas should work really well on very liquid Stocks and certainly I would think FTSE350 Stocks would be ideal. However, with individual Stocks there are some specific Risks like the possibility of a Takeover if you are Short on a Stock which can be a killer and sudden Bad News like a Profit Warning can whack you hard if you are Long on a Stock. Part of the attraction of Trading Indexes is that you don’t have these kinds of problems and they have very low Deposit/Margin Requirements when using Leverage via Spreadbets and/or CFDs. You can also use ETFs (Exchange Traded Funds) to do such Index Trading (these are in effect Funds which you can buy and sell just like normal Shares).
I have not had much (if any) experience of using such a System for Stocks but it strikes me that a Stock with a high Price (for example AstraZeneca AZN at around 4788p) would be advantageous compared to a Stock with a lower Price like KCOM at 89p - this is simply because a given % move in AZN would provide more ‘Points’ for a Speadbet than for KCOM. For example, a 5% move in AZN is 239 points but on KCOM a 5% move is just 4.5 points (with Spreadbets you ‘bet’ a certain number of Pounds per Point - so the more Points the more Pounds can be made or lost).
Spreadbets also have a lovely advantage when trading Foreign Assets like for example US Stocks or US Indexes (which would be listed in $s) because you can bet ‘£s per Point’ so even though they are priced in $s you in effect carry no Forex Risk. Spreadbets are Tax Free also which is super sweet.
Problems apparent in my ‘Old’ Trading System
I have put a lot of thought into why I was failing with how I was doing things and the following Problems are where I put the blame:
- I was lacking Discipline when it came to Stoplosses - this was two-fold - Firstly I would often ignore the Stoploss and end up running my Losses and having to Close the Position with a much bigger Loss than I should have had, and secondly my Stoplosses tended to be too wide and these meant that even if I was disciplined, I still took a big Loss.
- My Position Sizes were far too large - I guess this could be seen as ‘Greed’ and I have learnt that reining in my Exposure has been hugely beneficial. The problem I found with huge Positions was that when a Trade moved against me and got near the Stoploss, I would be making big Losses that I had to then ‘lock-in’ by Closing the Positions - this put a lot of pressure on me psychologically and I often chickened out and let the Trade run past the Stoploss in the forlorn hope that it would reverse and go my way - and this just meant that I ended up losing even more. With smaller Position Sizes I can have Stoplosses where the Loss is perfectly acceptable and I am having no such problems with Discipline now I am using far smaller Positions. To add some colour here, I have pretty much just finished reading Robbie Burn’s latest Book ‘Trade like a Shark’ and I noticed that when he talks about doing Index Shorts, he actually says keep the Position Sizes sensible and don’t get greedy.
- Trading Techniques like ‘Scaling-in’ and ‘Scaling-out’ are a key part of my New Improved Trading System and they are worth taking full advantage of - this is particularly important when Entering the Trades and I am much better at this now. This also means that if a Stoploss gets hit the Loss is smaller because the Initial Position Size is relatively smaller.
Solutions to the Problems I had with the Old System
When outlining the Problems above I touched on the Solutions but this Section covers them in more depth:
- Position Sizing - I am now using a Starting Position when I open an Index Trade which is worth around 10 to 15% of my Long Portfolio Value. The way I am determining this is to use my Charts to firstly identify where the Trade is likely to be Opened and then to decide where my Stoploss should be placed. Once I have worked this out, I know how many Points I am going to lose if the Trade goes against me and I can then work back from the amount of Money I am prepared to lose. For example, if I am prepared to lose say £500 on a Trade, then if the particular Trade I am calculating would mean a Loss of 60 Points if the Stoploss gets triggered (the distance from the Opening Level to where my Stoploss will be placed), then I would bet about £8 a Point because this is a round number when you divide £500 by 60 Points (60 x £8 is £480). So my Position Size is determined by the Potential Loss on the Trade and the Amount of Money I am prepared to Lose if the Stoploss is triggered. Doing it this way makes the Position Sizing a lot easier and more scientific in fact - I used to agonise about how large my Positions should be and now that is largely out of my hands. In terms of Portfolio Value, at the moment I tend to go for a Stoploss that is equivalent to about 0.2%-0.3% of my Total Portfolio Value (however, that might change in the future).
- Scaling-in - After doing the stuff I mentioned in the Position Sizing bit above, I place the Trade with my Spreadbet Broker (I use igIndex and they are superb) and then it becomes a case of Monitoring it. I tend to work on Full Day Candlesticks and Technical Analysis information that is generated at the End of Day (EOD) - working in this way keeps things ‘cleaner’ and less Noisy and also means that I am looking at my Charts in the evening when the Markets are shut and moves that are taking place in real-time on the Markets are not affecting my Emotions and leading me to inaccurate conclusions - I find this a huge help. So every Night I am monitoring the Trade and if it starts to go my way and it gives further Buy Signals, then I will think about adding to the Trade which can often mean doubling up on the Position Size. However, again I need to think about the Stoploss and size the Extra Position accordingly - sometimes this means moving the Stoploss on the Existing Position as well but I am fairly flexible on this aspect. If I do not get a further clear Buy Signal, then I will not add to the Existing Trade. Quite often I will double my Existing Position with an Additional Trade but of course this is largely determined by where the Stoploss is going to be.
- Very tight Stoplosses - with my usual Investing activities I have a strong dislike of Stoplosses and I see them as a hindrance rather than a help. It is also mystifying to me why People use such wide Stoplosses - I see many people using perhaps 15% or 20% Stoplosses on Stocks and this seems daft - if a Stock has fallen 15% you should be thinking about Buying it not Selling it !! So when it comes to my Index Trades, I want to be out very fast if the Trade is going wrong. This tends to work really well if I combine an extremely good Entry with a Tight Stoploss - for example, let’s say I want to Short an Index just after an Inverted Hammer Candle when the Index has had a strong and sustained run up, then such a Candle is a very good Reversal Signal and I would go Short with a Stoploss which is placed just above the Top or ‘Wick’ or ‘Tail’ of the Inverted Hammer Candle and this means I am Entering the Trade with a high likelihood of being right but if it goes against me, then I am out fast and I can reassess the situation and look to Short in perhaps a day or twos time. Note that Robbie ‘Naked Trader’ Burns is a big fan of Stoplosses but in recent years he has started using much tighter Stoplosses and getting out early. Having said all that, I think Tight Stoplosses can only really work well if you have pretty good timing on your Entry into Trades and the Candlesticks and things like Breakouts can really help with such Entries. Of course you don’t always have to let the Trade go against you to the Stoploss - you can close it earlier if you think it is not going to work. In a later Part of this Blog Series I will look at 4 particular Trade Set-ups where I like to put on Long and Short Index Trades with a high expectation of them working as well as the ability to use pretty tight Stoplosses.
- Trailing Stoploss - if a Trade or pair of Trades go my way, then I can move the Stoploss up behind it to make sure that I at least lock some Profit in if things turn quickly. However, in practice I tend to find that I Close my Positions before they hit a Trailing Stoploss because I am very focused on a Trade once it is running and they usually seem to run for only a few days.
- End of Day (EOD) Close Stoplosses with a Manual Trigger - because I work off Daily Candlesticks to a large extent, and also because I don’t want my Trades to get ‘Spiked out’ (this is when you have a firm Stoploss Order with your Spreadbet broker and then during the Day there is a ‘Spike’ and your Trade gets Closed out, only for the Price to move back to where it was and by the Day’s Close, it is still away from your Stoploss Level), I do my Stoplosses on an ‘End of Day’ Close basis and I trigger them myself if they get hit. This avoids Spikes intraday but it means that I need to be extremely well disciplined and I have to except that sometimes there is a bit of ‘Slippage’ (this is where the Price hits my Stoploss Level but by the time I get to Close it, the Price has carried on moving and done more damage) - in practice I find this tends not to be too much of a problem. Perhaps I am worrying about nothing and I should use firm Stoplosses with my Broker - I might try it sometime.
- Use Daily Funded Bets (DFBs) - I have used the Quarterly Funded Bets a few times but because these include the Daily Interest Charges for the remaining Days/Weeks in the Contract, if you Close the Position after just a few Days then you have paid for lots of Interest that you did not need. In practice I find my Index Trades are only on for maybe 10 Days at the most so using the DFBs is probably the best idea (on these you pay a Daily Interest Charge for every Day that you have the Bet open - they are pretty good value really).
OK, that’s it for Part 1. In the next Part I talk about those 4 particular Trade Setups that I really like and my intention for Part 3 is to produce some Examples with real Chart Pictures in them to demonstrate the actual Trades - I have not started this yet so it might turn out to be a right Dog’s Brekkie !!
If you look at my ‘Trades’ page then you should be able to see loads of examples where I have been doing these Index Trades - it was really at the tail end of 2017 where I finally got this Approach settled in the WheelieBrain and I have been following it since then. Every Weekend, usually very late on a Sunday Night, I produce a ‘Charts Blog’ and I tend to talk a lot about Index Technical Analysis in these and there are loads of Charts and I usually show any Index Trades I have running on those Charts.
Here is that Scores on the Doors one which shows exactly how not to do it !! (it is really in the Section on ‘Spreadbetting Account’ where the gory details are laid out):