After establishing the objective for speculative trading strategy, following will be to specify the conditions for profitable speculation in the equity market with stocks and derivatives. It derives the unique strategic rules from the initial two-choice situations in a given environment with complex structure involving arbitrage in iterative plays for speculative profits.
Since the initiative for the development of trading strategy is inspired from the collapse of investment portfolio during the financial crisis, the creation of rules will be more emphasized on actual experience than theoretical approach. The former is exploited mostly to minimize risk to the portfolio when the market movement is unfavorable to the investment objective. The latter, as well as speculative intuition, is used to analyze the market movement trend and to arrive at an investment decision.
This approach will render the actual transaction a highly subjective process which in turn means that the result is highly unpredictable if the underlying event is more or less random in nature. The market environment and sentiment can infer an investment mistake from emotion. Therefore it is important that before an investment decision is made, the market condition has to be thoroughly analyzed for short term movement trend estimate. After an investment decision is made, if the market movement is favorable then the next decision is when to liquidate the investment to take profit. If the market movement is unfavorable, the impact on the next decision is more complicated due to leverage and hedging consideration.
There may exist theories to analyze market and construct a portfolio for speculative profit. But for the average retail investor, there is neither the knowledge nor the financial resources to execute those plans. However, an individual with correct estimate of market movement for over half of the transactions and adequate risk control should be able to make appreciable profit.
Rules in managing the portfolio is to control the risk and avoid emotional mistake. Therefore it is important that they are strictly followed. The investment portfolio for development and experiment of speculative trading strategy is remnant of the investment portfolio after the financial crisis. Although it is much smaller than initial value, it is real asset and the transactions will incur monetary gain or loss.
Since the speculative trading strategy is under development, the initial draft is mainly based on past experience and is subjected to modification upon review of actual performance. Nevertheless it is guideline for managing the portfolio and risk control in adverse market condition. As previously mentioned, the objective is highly speculative. The major component in the investment portfolio is leveraged ETFs. Other components include small, medium, and large capitalization stocks and derivatives.
As an initial guidance, the proportion in the portfolio value is 30% for small-cap stocks and 30% for mid-cap and large-cap stocks and 100% for leveraged ETFs. Derivatives such as stock options are for hedging purpose and constitute only a small portion of the portfolio. The leverage multiple will be about 1.6x which may not be achievable in realistic account because of FINRA restrictions in trading account margin requirement. Since higher leverage is desired, the major equity for speculative trading is leveraged ETFs and thus have a maximum portfolio value of 100%. The total percentage for equity stocks in the portfolio will be limited by account margin requirement.
Hedging has an important role in risk control. The meltdown of the investment portfolio during the financial crisis is mainly due to over leveraging without adequate hedging. Although similar strategy works well in the aftermath rally in favor of the investment, the seriously damaged portfolio cannot recover much of the previous loss. Therefore the process of asset allocation and portfolio hedging is critical in the investment decision.
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