During the financial crisis, the portfolio value drops dramatically within short time. The use of leverage increases the rate of drop and thus shrinks the portfolio components. As a result, the recovery capability of portfolio is reduced if the market changes to favorable condition. Even worse, if the market condition is against the portfolio for extended period of time, the fulfilment for margin requirement with portfolio liquidation will quickly diminish the portfolio due to leverage.
If the market moves against an investment decision, some people may not admit the mistake and even bet more against the market. This scenario is commonly seen in casino gaming where the outcome of an event is random. In stock trading, such attitude coupled with the destructive power of leverage can easily wipe out the entire portfolio. Therefore it is most important that in a properly managed portfolio, the rules should be strictly followed to avoid this from happening.
For a small and aggressive portfolio, use of leverage is inevitable. Otherwise the commission fees will be significant drag on profitability. To reduce the risk of forced portfolio liquidation before recovery, reduce the use of leverage or use hedging to protect against unfavorable market movement. Since use of leverage is inevitable for a small portfolio, hedging would be the preferred means of risk control although it would reduce overall profitability.
Since it is speculative stock trading, the round-trip trade is typically accomplished within hours or days, at most weeks or months. The trading strategy is to make an investment decision and hedge at the same time. There are three possible outcomes for the trade.
1. Market goes into a stall.
2. Market moves in favorable direction.
3. Market moves in unfavorable direction.
If the market goes into a stall or drifts only a little amount, wait for new sign of movement trend. If market moves in favorable direction, wait for the momentum to exhaust or sign of reversal and then liquidate the investment. The portfolio will increase in value. If the market moves in unfavorable direction, the scenario is more complicated because of margin requirement and hedging operation.
If the investment is fully hedged, there is usually a premium for the hedge. Therefore, the maximum loss is confined. On the other hand, the expense of premium means that investment transactions have to be made with higher percentage of right decision in order to make profit. Random decisions with 50/50 chance of profit will result in overall loss to certain extent.
If the investment is only partially or indirectly hedged, the premium may be less or even none. There is still the overhead of commission fees but it is relatively small amount in comparison. In this case, the portfolio value will decline as the market moves further away resulting in larger loss. The portfolio can wait for market reversal or the bad investment can be liquidated if there is no sign of recovery. If the unfavorable market movement extends and the portfolio drops below margin maintenance requirement, There are possibilities of liquidating the investment, hedging, or both in partially or completely.
The objective of setting the rules for a trade with loss is to limit the impact on the portfolio value when a wrong investment decision is made. Above is general guidelines. Specific details depend on the leverage multiple and hedging tools.
The investment decision is critical to the portfolio growth. Each correct decision and timing will boost the portfolio value while each wrong decision and timing will shrink the portfolio value. The more accurate the stock movement estimate and investment decision, the more profitability and hence portfolio growth.
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