Anyone who has read some of my Blogs and Tweets and followed what I get up to with my Trades cannot have missed my obsession with trying to Hedge my Long Portfolio of Stocks using Short Spreadbet Positions on Major Indexes.
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.
I have been attempting to Short the Indexes for many Years and overall I have been pretty unsuccessful. My belief in the importance of this comes from some success I did have back in the Credit Crunch where I did well on a lot of Short Positions and as a result it made me realise that there was a lot of sense in keeping my Long Portfolio of Stocks intact rather than selling Stocks before a General Market fall, which was something I had done in the past. It is also a technique which Robbie Burns, the Naked Trader, uses and it is pretty obvious that it can help reduce the pain in terms of Losses when we have a big Market Drop and it also helps with the psychological aspects as I tend to find that having even a Small Short in place diverts my attention to that rather than my worries about the value of my Stock Portfolio tanking !!
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:
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:
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):
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