Certain Uncertainty - Control what you can Control and Moving into Cash - Part 5 of 6

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As often happens when I work through these big ‘Blog Series’ things, I tend to bash out a Draft and slowly over time I go over it and over it and refine and tweak and invariably they get longer rather than shorter. I am sure the idea of Proof-Reading and refining is to summarise and condense more but I am clearly pretty hopeless at that !!

I guess my logic is that I tend to need to clarify points so adding yet more text achieves this in the best way. As a result of this tweaking I have decided that it would be more appropriate to split what remains of the Blogs into two so we now have 6 Parts in total - but this one perhaps needs Readers to turn their Brains on and think about what I am scribbling, especially in the first section on Probability stuff, so maybe it is for the best that it is shorter. The Final Part will be in essence a Conclusion but there is actually quite a lot in it.
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Probabilistic Decision Making
I mentioned back in Part 4 of this Blog Series what kinds of Drops in the Markets were typical and of course it is impossible to know precisely before an expected Market Sell-off just how heavy it is going to be. Having said that, it might be doable to come up with some simple Possibilities and then to assign Probabilities to these Possible Drops - it could work something like this - first off I will list the Possible Drops (for this example I have used the FTSE100 but you could put in any sensible Index such as the S&P500 - and of course you could use similar Probabilistic Methods for individual Stocks etc.):

• 5% Drop in the FTSE100
• 10% Drop in the FTSE100
• 15% Drop in the FTSE100
• 20% Drop in the FTSE100
• 25% Drop in the FTSE100
• 30% Drop in the FTSE100.

We could then use our best judgement to assign Probabilities to these Possible Drops as follows (obviously the Probabilities must add up to 100%):

• 5% Drop in the FTSE100 - 10% Probability
• 10% Drop in the FTSE100 - 40% Probability
• 15% Drop in the FTSE100 - 30% Probability
• 20% Drop in the FTSE100 - 10% Probability
• 25% Drop in the FTSE100 - 5% Probability
• 30% Drop in the FTSE100 - 5% Probability

These Judgements could change according to the circumstances. For example, with a Major Event like Brexit coming along, you might decide that a Big Drop is likely so you would assign higher Probability Percentages to the Bigger Drops than if it was just a fairly ‘normal’ Pullback in a healthy Bull Market like we often get in the Autumn (and in such a case you might only go down to a Drop of 20% at the most or even less - you don‘t always need 6 Possible Outcomes - you can have the number you want but obviously it is best to not have too many and get too granular - or to have too few for that matter).

You can then do some clever Maths as follows and convert the % Probability into Numbers (I learnt this in a Book on Probabilities !! In essence a 100% Likelihood can be expressed as a Probability of 1.0):

• 5% Drop in the FTSE100 - 10% Probability = 5% times 0.1
• 10% Drop in the FTSE100 - 40% Probability = 10% times 0.4
• 15% Drop in the FTSE100 - 30% Probability = 15% times 0.3
• 20% Drop in the FTSE100 - 10% Probability = 20% times 0.1
• 25% Drop in the FTSE100 - 5% Probability = 25% times 0.05
• 30% Drop in the FTSE100 - 5% Probability = 30% times 0.05

We then get:

• 5% Drop in the FTSE100 - 10% Probability = 5% times 0.1 = 0.5
• 10% Drop in the FTSE100 - 40% Probability = 10% times 0.4 = 4
• 15% Drop in the FTSE100 - 30% Probability = 15% times 0.3 = 4.5
• 20% Drop in the FTSE100 - 10% Probability = 20% times 0.1 = 2
• 25% Drop in the FTSE100 - 5% Probability = 25% times 0.05 = 1.25
• 30% Drop in the FTSE100 - 5% Probability = 30% times 0.05 = 1.5

You then add all those Numbers together which gives 0.5 + 4 + 4.5 + 2 + 1.25 + 1.5 = 13.75

I might have totally cocked this up but I think it is right and it means that on the basis of the Possible Outcomes you have identified for a forthcoming Drop, and with the Probabilities you have assigned to them, you get an Expected Drop of 13.75% (in the terms you would see in a Probability Book this is called the ‘Expected Value’).

Doing some Probabilistic Modelling like this might enable you to take a view of the likely extent of a Drop that you expect to come along and this could help you decide how much of your Portfolio to Move into Cash and whether or not it is worth doing or whether you would be better off just Hedging in a particular case as I will talk about next. Of course there is no guarantee that the Drop will be 13.75% but you would be surprised how close this kind of mathematical modelling can get in reality.

As a general thing, whenever you have a List of several Possible Outcomes for something (not just Stockmarket stuff, but anything really) you can use this Method to assign Probabilities and come up with an Expected Value which represents the most likely Outcome. For example, I remember years ago when I was looking at a Mining Stock that was very likely to be a Takeover Target that I could use a similar kind of Modelling to work out what kind of Expected Price the Shares would be taken out at - in that case the most likely Takeover Price was for example 200p and I used Possible Outcomes of perhaps 160p, 180p, 200p, 220p, 240p, and then assigned a Probability % to each of those like I did above. That helped me make the decision whether to invest or not, depending on the Price at the time and my Expected Gain if the Takeover had gone ahead.

Hedging
As I mentioned earlier in this Blog Series, my own preferred approach is to use Hedging to offset some of the Losses on my Long Portfolio of Stocks when there is trouble in the Markets. At the end of this Blog Series I will lob in a Link to stuff I have written about Hedging in the past - if you cannot wait, then go to the Educational Blogs Page and click on the ‘Category’ ‘Hedging’ and you should find a collection of related Blogs. Alternatively on the WD2 Website there is a beastie called the ‘Blog Index List’ which is a huge list of all the Blogs I have foisted on the Public and they are all fully Linked up now for the Educational ones.

In essence Hedging means using Spreadbets or CFDs (Contracts for Difference) or specialist ETFs (Exchange Traded Funds) to Short an Index so that when the Markets fall, you will gain on the Short Positions to offset some or all of the Losses on your Share Portfolio (you could use Options as well but I don‘t really understand anything about those). It is in effect just like moving into Cash but it is quicker and easier. In theory you could also Hedge using something like Gold although I am not convinced that works all that well in practice - it might do for Recession-related Sell-offs but for ‘normal’ Pullbacks in the Markets I don’t think it is all that great. The beauty of using Indexes is that although they are never a perfect match for your Long Portfolio of Stocks, there is usually a fairly high degree of ‘Inverse Correlation’ which is exactly what you need.

In theory you could use Short Positions on Individual Stocks to give you an element of Hedging - I suspect this could work well because there often seem to be Stocks that have really gotten ahead of themselves and are on bonkers Valuations etc. The trouble with this approach though is that it is much much Riskier and something you need to really be careful about is if there is a chance of a Takeover - getting ‘caught Short’ on a Stock that gets a Takeover bid is likely to be horrific and you might even be forced to buy the Stock back at higher than the Takeover Price - I have seen this happen so be warned (a Guaranteed Stoploss with your Broker might be wise on such Trades - as would brown trousers and incontinence pads). 

A disadvantage of Shorting individual Stocks is that you can feel quite guilty doing it and you can easily upset people who are long on the same Stock - Shorting via Indexes dodges this problem.

Another Advantage of Hedging that I want to stress is how I think it can probably reduce some of the Timing Issues which I talked about earlier in this Blog Series. If you have to Sell and Buy many Lines of Stock from your Portfolio that takes time to do and it is highly unlikely that you will be Selling all that near to the Peak and likewise you will be most likely be Buying quite a while after the Trough. With Hedging it is very fast and chances are you can get Hedged after a small drop off the Top and once things Bottom out, you can quickly go Long on an Index if you want to.

Other Advantages of using Hedging are:

• The Transaction Costs are very low - this is a huge advantage I think when compared to selling lots of your Shares as I discussed earlier in the Blog Series and of course you have the Costs of Buying Shares back as well once the Sell-off has ended and Markets are perkier again.
• It can be used like an ‘On/Off’ Switch and this means you can quickly and cheaply Protect your Portfolio against Market Downside Risk and when the tide changes, you can just as quickly remove that Protection so you benefit from as much of the Rebound as possible. Doing this by Selling and then Buying individual Stocks is expensive and time consuming and you can miss a lot of the Downmove and the Upmove on the Bounce.
• Keeps your Portfolio intact - A Portfolio of great Companies that you have spent time and effort to create is left intact while the Markets go through their wobbly period. Without doubt one of the most important aspects of successful Investing is to let your Winners run and to let the Power of Momentum do its thing. Selling on worries around a Pullback can shake you out of something superb and ‘chop off the legs’ of a great Investment.
• An element of ‘Self-funding’ if done well - In a similar way to my Examples earlier in the Blog Series where by Selling and Moving into Cash at the Top of the Market gave you firepower to Buy at the Bottom, the Gains you make on the Short Hedges can then be used to Reverse the Trade at the Bottom and go Long so you catch a Gain on the Bounce. Of course a big advantage of using Spreadbets and CFDs is that they are Leveraged so you can Hedge your Portfolio using a fraction of the Exposure you have to Stocks - although sadly since the ESMA Rule Changes the Margin requirements have gone up a lot.
• Better able to deal with both the ‘speed’ of the Drop and the speed of the Rebound - I talk about this more in the ‘Conclusion’ which will be Part 6 of this Blog Series but in essence the ‘On/Off’ nature of Hedges mean that if the Markets fall fast you can quickly whack on a Hedge whereas trying to Sell a load of Share Positions is quite difficult to do quickly. The same applies on the Rebound when the speed of Closing a Short you have on and switching to a Long Index Trade can be done a lot more effectively than if you were trying to Buy loads of Shares.
• Psychologically helpful - I find that having Shorts on tends to make me a lot more relaxed and unstressed when Markets are nasty and falling big and fast. Obviously simply from making you feel a lot happier this is a good thing but probably more importantly it means that you can remain calm and rational and think things through carefully when it comes to dealing with your Portfolio. I am sure we all know that getting scared and jumpy and stressed out is not a good Mental State to be in when trying to make complex Trading/Investing Decisions. Anything you can do that helps avoid you becoming a Panic Merchant in the bad times is very useful.

Disadvantages of Hedging:

• It is not easy to do - that is such an understatement !! - in practice it is extremely difficult to do although I would argue that it is pretty much exactly the same as Selling your Shares before an expected Drop in the Markets and then timing your Buys once things are better. None of this is easy. However, if you can do one you can do the other but discipline is essential.
• Needs strict Risk Control disciplines like careful Position Sizing and use of Stoplosses at appropriate Levels. Building Positions up over a period of time tends to be the best way as well I find. See the Link at the bottom of this Blog to the Blog Series I wrote on my ‘New Improved Index Trading System’.
• Margin Requirements with Spreadbetting and CFD Companies have recently got a lot larger so you need a fair chunk of Cash lying around - which is of course inefficient.
• If you use ETFs like XUKS to Short the FTSE100, you must have the Cash available to be able to buy the ETF in the first place. Some ETFs like SUK2 for the FTSE100 are Leveraged and they are superb if the Markets fall in a straight drop down but if the Market wiggles a lot over a period of Days then they do not give you anything like the Return you would expect if you just measure the Drop from the Top to the Bottom. For example, the Market might fall 20% over a period but if it wiggled around a lot you might only get a Return of 12% on the Leveraged ETF and the more Leverage you have the worse they are. I would recommend you use XUKS first off and don’t use the Leveraged ones unless you understand their limitations - they are best for perhaps Day Trades or a few Days at the most.
• It’s very complicated - well, actually it is isn’t !! I think many People get scared off Hedging because they think it is too difficult etc. In reality it is very easy and simple and it is well worth getting your head around it and try it first in very small size and practice until you fully understand how it works. Let me be clear though - the mechanisms you use for Hedging are dead simple but the timing you need and the Trade Discipline are the hard bits. 

That’s it for this Part - one more to go which should come out soon and I will put Links in that one to all the other Parts. If you want to read those again or if you have only just discovered my Blogs and Website, then you can find them on my Educational Blogs Page if you just scroll down a bit.

Regards, WD.


Related Blogs
Here is a Link to the Blog Series I wrote on Hedging (be warned, it is extremely comprehensive but as you may guess from the paragraph at the start, I got bored when working on it !!):

http://wheeliedealer.weebly.com/educational-blogs/topiary-time-aka-all-you-ever-wanted-to-know-about-hedging-but-were-afraid-to-ask


There is also this one which you might like:

http://wheeliedealer.weebly.com/educational-blogs/thinking-about-downside-risk

And try this one (please note the numbering of the Parts went a bit screwy and as a result it is a bit confusing - however, I think the Link below has Links to all the Parts at the bottom - there are 4 Parts):

http://wheeliedealer.weebly.com/educational-blogs/wheelies-new-improved-index-trading-system-part-3-of-44826674