Final Word on my Hedging Fiasco (hopefully) - Some New Rules

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I am pretty bored with this Hedging Disaster which befell me for most of 2016 and I am sure Readers will be equally deflated at the tedious prospect of yet more words from me on the subject; but I feel a pressing need to punch the keys and just give the whole sorry business some ‘closure’.

Regular Readers / Twitter Followers / Podcast Sufferers etc. will be fully aware that I have made some poorly executed Hedging Trades against the FTSE100 and Nasdaq 100 Indexes which have dogged my Portfolio Performance throughout 2016 and how I finally Closed Out most of them just before Trump got elected - taking advantage of a slight dip in the Markets. For a bit of clarity on this, if you look at the ‘Trades’ page on this Website and find the entries for early November 2016 regarding the FTSE100, Nasdaq 100 and XUKS (ETF), there is a reasonable explanation of the pain which caused me to bite hard on a chunk of wood to mollify. There are also copious Blogs I have written about Hedging and if you click on the appropriate ‘Category’ in the column on the Right Hand Side of the Blog Page, you should find plenty on the subject. You can also use the Search Box on the Homepage to track them down.

And because I am so nice to you, there are links to the key ones at the bottom of this Blog.

What happened?
In summary, I opened some Short Positions on the FTSE100 (and latterly the Nasdaq 100) to hedge my Long Portfolio of Stocks through some turbulent periods like the Brexit Vote and the US Presidential Election etc., but for various reasons, the FTSE100 Index in particular continued to Rally and I racked up big losses on the Short Positions which were only just offset by the Long Positions I hold as Stocks. In effect this meant I missed out on a very strong Rally for most of the Summer and this has hit my Portfolio Performance hard - and caused an immense amount of annoyance, angst, psychological stress and irritation.

In one sense the Hedging worked and did exactly what it “says on the Tin” - I had a look back through my Portfolio Numbers for the last 6 months or so and for most of that time my Portfolio went absolutely nowhere - in other words in periods when the Markets rose the Gains on my Long Portfolio of Stocks offset the Losses on Shorts and in periods of Markets dropping back (which were sadly very rare) the Losses on my Stocks were offset by Gains on the Shorts.

This is the fundamental point of Hedging. In the past I used to Sell many Stock Holdings or TopChop them or something when I thought Markets were getting Toppy or perhaps when an impending thing like an Election was about to cause a huge amount of ‘Event Risk’ in the Markets. I particularly used to do this as we headed into Summer as this is regularly the weakest period for Markets. However, I am much more aware these days of the need to “Run your Winners” and I know one of the biggest errors I used to make (I am much better at this now) was selling great Stocks too early - so now I would rather reduce Downside Risk caused by Market gyrations by using Index Shorts to hedge my Portfolio - in effect it is like I am moving a part of my Portfolio into Cash.

However, for obvious reasons I am not satisfied to just totally ‘Hedge out’ all Risk - this is the situation I have been in for most of 2016 but it is unacceptable because by removing Downside Risk, I am also removing Upside Risk - and the latter I do want !! My hope is that with adoption of a refined Method, I can make sure I get exposure to most of the Upside Risk that Markets have and cut out the Majority of the Downside.

Where did it all go wrong?
I have used Hedging for years and normally employ the FTSE100 Index to Short with - but this Year the correlations and behaviour I was used to utterly broke down (this is a problem with relying on correlations - it is ok for many repeated Trades which can lull you into a false sense of security and suddenly break down and kick you in the Private Bits. It was exactly this kind of breakdown that caused Long Term Capital Management LTCM to blow up).

In the past, Indexes around the World have been remarkably closely correlated - all the Major Indexes in the US and Europe would fall at the same time and rise at the same time; and even smaller Indexes like the FTSE250 and FTSE Small Cap and AIM were pretty closely correlated in the sense that if they rose it was always as a group and if they fell it was as a group. This broke apart nastily this year in several ways:

• FTSE100 Weightings - Right at the start of 2016 the FTSE100 had a massive collapse and got really low - maybe down to around 5500 or something I think. With hindsight, this was obviously driven by the Big Oil Stocks and Mining Stocks etc. falling in the FTSE100. The Index is skewed massively these days by having very unequal Weightings between Stocks - it is not an Equally Weighted Index - in practical terms, this means that LLOY and RDSB are the 2 biggest Stocks and if they fall, it can have an effect on the Index even though they are only 2 Stocks. Once you throw in other heavyweights like HSBA, GSK, AZN, BP. Etc., the movements of the FTSE100 become more like movements of perhaps as few as 8 or 10 Stocks - it is a really unrepresentative Index. For many years, because I hold a mix of Stocks across the Market Cap spectrum (from small AIM Stocks through to FTSE100 Megacaps) I found that the value of my Portfolio would rise and fall with the FTSE100 - but this year that totally broke down.
• Poor timing - This Weighting problem then exacerbated my problems because I Shorted far too late in the Falls (it is important to Short just before a Drop in the Indexes or just after it starts - once we are deep in the Drop, it is too late) and the FTSE100 rallied very fast and very strong off the Lows - so I very quickly was running up Paper Losses on my Short Positions. Luckily I had fairly small Shorts at this stage, so the situation was recoverable, but I failed to play it well and part of the reason for this Blog is to clarify my thinking and help me from repeating this grave error.
• Caught out by Rally after Brexit Vote - Once the Markets had rallied through the Summer and we approached the Brexit Vote around June, I Shorted the FTSE100 more and this was much higher up - so in theory I was quite well set to ‘Average Up’ and get myself out of a sticking situation. As it happens I played it a treat and when the Markets collapsed on the shock Brexit Result, my Shorts recovered nearly all of the Paper Losses and I then Closed out about half of the Shorts because I wanted to keep some running in case there was more turmoil in the Weeks after the Brexit Vote Result. With hindsight this was probably an error (although I am not totally sure it was avoidable - but I will address this later in the Blog) as I had a great opportunity to Close out all the Shorts and I would have taken a very small Loss (maybe 2% of my Portfolio maximum - not a bad hit considering the Risk the Shorts were saving me from with Markets tanking). With the hindsight benefit, it was clear that I should have Closed out all of the Shorts and if the Markets then dropped again after an attempt to rally, I could have quickly put another load of Shorts on - this is a big benefit of Hedging via Index Shorts - it is very fast and should be cheap if done properly.
• Don’t try to get even with the Market - I then went on to make another criminal error - I “tried to get even” with the Markets. As the FTSE100 rallied strongly after the Brexit Vote (driven by a combination of a flight to the perceived ‘safety’ of Megacaps, a hunt for Divvy Yields and the weak Pound making UK Megacaps very good value for Overseas Buyers and Companies earning in Dollars being seen as getting a boost to their Earnings) I was getting hit 2 ways - I was losing on the FTSE100 Shorts and I was also losing on my Long Portfolio of Stocks because they tended to have Costs in Dollars not Revenues in Dollars - so this was quite painful. As a result, I tried to ‘Average Up’ like I did before with a mistaken belief (too much emotion !!) that Markets would tank again at some point - possibly around the US Presidential Election. With this thinking in mind, I let the Short Positions get massive and this was an attempt to reduce my Paper Losses quickly if the Markets tanked - sadly they did not drop much and when I finally decided that “Enough is Enough” and gritted my teeth and Closed the Shorts, I ended up crystallising some huge Losses - probably around 6% or more of my Portfolio Value which was a disaster really.

So, what am I going to do about it?
I have put a lot of thought into this in the Days/Weeks since this happened, and I reckon I have got an approach that should save me from repeating such a major screw-up. I am still highly committed to the Hedging Principle and I am adamant it is not the Theory / Concept that is in the wrong but my p*ss poor application of it. To be able to make Money when Markets are generally on the way up and to be able to make Money when the Markets are on the way down (or at least to hold the Value of my Portfolio level during Markets falls) is without doubt the Holy Grail of my Investing Methods. I just need to make it work in a far more consistent manner, as these ‘principles’ should help me do:

• Stoplosses - I need to use Stoplosses on all my Index Short Trades without exception. This will take practice and patience to apply, but it is critical that I do this. IT IS WITHOUT DOUBT THE SINGLE ACTION WHICH WILL HAVE MOST IMPACT ON MY HEDGING RESULTS AND WOULD HAVE SAVED ME FROM THE PROBLEMS I HAVE SUFFERED DURING 2016. I have thought long and hard about this and it is in many ways contrary to my approach for investing in Stocks but I see no other way of giving a sensible balance between damage control and being able to capitalise on Gains via Shorts when Markets drop. It will take patience and application and timing but I need to practice this and make it work. If I put on a Position and I get ‘Stopped Out’ then I must accept the small hit and just look for an Opportunity to put a Short on again at a better Entry Point or even totally rethink whether or not going Short is the right direction. I think Entries are critical and I will try to put considerable focus into timing these well, using the normal Chart Signals like ‘Inverted Hammers’ and ‘Dark Cloud Cover’ and high RSI readings and stuff like that. The fact is that had I used Stoplosses on my Shorts this year then I would have quickly been Stopped Out and I would have benefited from the Rally over the Summer Months and I would have been able to put new Shorts on just before the US Presidential Election. I will start with a Maximum Stoploss of 1% of my Total Portfolio Value on each Short Hedge Trade - I may need to tweak this with practice/experience.
• Size of Shorts - Another big error I made was letting my Short Positions become too big. This was partly because I was trying to get even with the Market but also because I was being Greedy and trying to Hedge 100% of my Long Portfolio - I realise now it would be better to perhaps try to just Hedge 50% (or less) of the Portfolio for general Market Falls - this would have been much more manageable and with Stoplosses as well it should work much better. I will let the Exposure size be determined with regard to the 1% Maximum Loss rule on the Stoploss.
• No half measures - all in or all out - As I mentioned earlier, when I am given a good Opportunity and clear signals by the Market to Close my Shorts (like I did extremely well on the Monday Night just after the Brexit Vote on the Thursday - you see, I do get some things right !!), I should close ALL my Shorts because I can always open them again later very quickly and easily. The same applies when I am given a Signal to put Shorts on - I should Short in decent Size and use a Stoploss placed nicely above the Signal to get me out in case the Markets decide to keep on Rallying - they have done some crazy things this year and it is silly (and expensive) to fight a crazy Market.
• Choice of Index - I need to consider my choice of Market to Short very carefully; the way correlations have broken-down this year has meant that the Indexes used to Short with can give surprisingly different results. It is clear the FTSE100 is not ideal by any means and perhaps the S&P500 or even the FTSE250 would be better for me - the catch here is that the FTSE250 has much higher Margin Requirements for Spreadbets than the larger Indexes - but I am certain it would ‘balance’ more closely with my Long Portfolio of Stocks.

Conclusion
I like the idea that using Stoplosses will remove my own Decision Making from the action to Close a Short Hedge (buy it back). With these Macro things it is very easy to take a Bearish View on things and how I think the Markets will behave, but in reality they can be remarkably irrational - for instance, when the Markets rallied hard on the Day of the Trump Victory it caught nearly everyone out. Perhaps a useful side effect of this will be that when I get Stopped Out, I need to adopt a mindset of thinking about where and how I have judged the situation wrong (both Technically and Fundamentally) and it could well be that I should be adding to Long Positions rather than trying to go Short; this is quite sophisticated and in practice may be hard to apply for mainly psychological reasons.

I have no doubt that Shorting via Indexes to ‘Hedge’ my Portfolio is an entirely valid and vital technique - one big advantage is that it helps my psychological and emotional responses during Market Sell-offs - whereas other people might be terrified and shocked into inaction, my calmer mindset enables me to be detached and rational in planning my next moves (which is usually to go Long in closing the Shorts and buying more Stocks or Topups). By adopting my refined Approach using Stoplosses it should mean I am well equipped to take on the Markets in coming years and unlike during this year where my Portfolio has flat-lined for much of the time, this new Approach will let me take part in the Rallies in between any Sell-offs.

I am sure the Sharpest Readers out there will have noticed a glaring inconsistency with my approach to Shorts and Longs - in other words, if I use Stoplosses on Shorts then why don’t I use Stoplosses on Longs? Great question !! I am so impressed you thought of that !!; anyway, my answer is that I see my Short Index Hedges as Short Term Trades to protect my Long Portfolio during periods of Market duress which are more often than not experienced around one-off Political Events like Elections as we have recently seen. When it comes to my Long Portfolio of Stocks I am very much a Long Term Investor - NOT a Trader. If a Stock falls 20% I don’t want to be selling it; I am running the Slide Rule over it and seeing if I should be buying more - I want to buy things cheaply and the lower they are the lower my Risk is.

I will just add here that I think anyone doing any form of Short Term Trading really must use Stoplosses as part of a Systematic Approach - if you are not doing this, you will fail I am pretty sure.

OK, Wheelie, that sort of nearly makes sense, so why haven’t you used Stoplosses on your Short Hedges before? There are a variety of reasons - in the past I got lucky and I was able to use the trick of ‘Averaging Up’ to get myself out of situations where Trades went against me at the start. Another factor is that Correlations broke down this year - this meant that trying to Average Up actually made the situation worse. In the past I have Shorted in smaller Sizes - this is something I need to do again as my recent Shorts were far too big.

Anyway, that’s got it off my Chest and hopefully will help Readers understand the complexities of Hedging and how easily it can kick you in the butt without clear Rules to help avoid trouble. Sorry to put everyone through that pain again !!

Thanks for the therapy,

Cheers, WD.

Related Blogs on Hedging:
This one explains how I have struggled this year due to the Shorts:

http://wheeliedealer.weebly.com/blog/the-price-of-caution

This one is a discussion on the 2 types of Downside Risk that concern me - Stock specific and General to the Market:

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

This is an absolute epic I wrote about the subject of Hedging - if you are new to the idea, then this is probably well worth a read:

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