Friday, August 27, 2010

Volatile and Risky Market

The equity stock market has a strong rebound today after a long decline. It is still unknown whether it will continue to drop again next week. The portfolio is holding a long position and the value fell to only two third of the year maximum yesterday.

Individual stocks in portfolio exhibit weakness relative to the broad market. The market finished with gain on Wednesday. It is hoped for an extended rebound after a long decline. With heavy borrowing from account purchasing power, a relatively large position in leveraged ETF is added to the portfolio. Unfortunately, the rebound cannot sustain in such market condition. This investment decision is a bet on the stock market. Although general sentiment is pessimistic, there is no significant selling pressure. Since there is hedging to reduce the loss, the position is held overnight for the play.

In the beginning of the trading session, the encouraging GDP figure moves up the market slightly but then suddenly it drops below yesterday's close. It seems to continue the downward trend in this month. But then it suddenly reverses and sharply moves up. In the last few days, the market is very volatile and moves violently. The market finally ends highest of the day. The portfolio holds the newly added ETF position and corresponding hedging until end of the day. If not for the hedging, the gain would be much higher. However hedging provides sense of protection in such volatile environment though at a cost. Without hedging, it may be scared not to hold the position overnight with such heavy borrowing. It would be devastating if the market moves against the portfolio as experienced during the financial crisis.

Although the bet in this investment returns a profit, it is a very risky decision with 50% chance of win or lose. The portfolio needs to be reorganised to better handle the market volatility and to grasp opportunity to make profit. It is now still exploring the trading strategy by means of trial and error. Since the portfolio has a core position for bull market, the overall portfolio value is declining recently. The downward trend in the equity market during the past few months shrinks the portfolio value. It is not known whether the trend will continue downward or already reach the bottom. The longer term holding positions in the portfolio will be reviewed for a smaller proportion of the portfolio. Holding an investment has a market risk although buy and hold strategy probably works in long term. Day trading or trades spanning across only a few days can minimize market risk but it is exposed to randomness.

As discussed in previous posts, investors (corporate and individual) are reluctant to enter the market at current level. They are waiting on the sideline for a low market entry point. The scenario is not the same as the economic depression starting in 1929. The advance in technology has created significant wealth compared with that time. Thus the impact of an economic cycle on the average person is less severe. However, there is a shift in the economic structure in the global environment. Due to the lower labor cost and improving competitiveness in developing countries, there is a growing trend for outsourcing of jobs from developed countries. Coupled with the trough of an economic cycle which is triggered by the financial crisis, the financial market collapses and hit the economy. The recession/depression will recover as usual in an economic cycle. However, the structural change in labor market has unprecedented impact on the society. The intertwined relationship of economic cycle and structural shift in labor causes the violent movement in financial market.

Many individual investors have not fully recovered the confidence since the financial crisis. While waiting, their wealth are moved towards bonds and treasuries which are providing a yield though relatively small. Some are moved towards commodities which do not provide yield but are considered safe relative to stock equity. Stocks can provide the best return but are considered risky at current level. Therefore capital does not flow into the equity market until it drops to an attractive entry point. On the other hand, the potential return of stock equity attracts some risk taker for short term profit as well as some bargain buyer for long term appreciation. Thus the trading volume is low and there is no panic selling or buying. But there is still volatility because market maker can easily move the market because there is less participants.

There is unlikely any panic sell-off to drive the market down significantly to a level that is attractive to the investors who allocate their wealth mainly to bonds and treasuries. The stock equity market will probably drift around and will continue to trade at low volume until a trigger for the enthusiasm of the investors waiting on the sideline. The wealth effect of equity appreciation will then drive the market to a level corresponding to risk and return.

Although current stock equity appears attractive based on valuation, there is not much driving force for upward price movement. Therefore the trading strategy will still be optimistic but will be aware of potential downfall due to market news or rumors.

Wednesday, August 18, 2010

Strategy For Current Market Dynamics

Stocks are being traded at low volume level recently, regardless of movement direction. Market participants are constantly shifting their investment criteria according to market environment. The low trading volume in equity market is partly due to the increased proportion of bonds and treasuries in private funds. The lack of interest from retail investors is also a contributing factor.

Although the trading volume is low, it seems that many people, including stock analysts, fund managers, individual investors, etc. express pessimistic sentiment on the near-term market. Market makers have been successful to advance the stock after the bottom is reached in March 2009. However, few individual investors ride on the rally until near the end. Thus they do not profit much from the initial rally. From late 2009, the stock market seems to reach a level which is difficult to advance further.

Scared by the steep market decline during the financial crisis, many retail investors prefer to sit with cash on the sideline rather than to take risk on another dip in the market. However, the rally is missed and the low yield of CD is annoying. Therefore the more aggressive retail investors among them are looking for an entry point into the market. A large and extended dip in the market would make an opportunity. Although not fully invested in equity market, many still have some positions to a certain extent. They still enjoy the appreciation if the market moves up. But they are not ready to jump in until the previous bottom is reached or near.

On the other hand, there are some traders who see the equity market as undervalued. Due to the overall pessimistic sentiment and market risk, they are not holding the positions for long-term appreciation but short-term swing trade profit.

Market makers attempt to move the market with the pessimistic sentiment. However, the selling force cannot create a large enough downward spiral. Despite of liquidating the portfolio in a panic during the financial crisis, retail investors are now waiting to enter the market. At current market level with small decline, they are not going to take the risk to increase the portfolio holding. However, some day traders will jump in after a small decline. If the selling force is limited without panic selling, the market can find a support without significant decline.

In conclusion, the risk of significant market decline is relatively small in the present moment. Buy low and sell high in a bounded range should be an appropriate strategy. However, the behaviour of market participants may change abruptly and cause significant change in market movement. Therefore the speculative trading portfolio is monitored constantly and should have buffer to cope with unexpected market reversal.

Friday, August 13, 2010

Leveraging Amplifies Profit/Loss; Overleveraging Can Be Detrimental

The broad market index is falling during the whole week. As mentioned previously, the portfolio is long the market and therefore the value shrinks at the end of the week. The investment strategy developed for speculative stock trading is subject to the test of real market condition.

The leveraged ETFs in the portfolio slightly exceeds the limit outlined in the trading strategy. The equity stock in the portfolio exceeds the limit outlined in the trading strategy by a larger extent. As a result, there is no cash buffer in the portfolio. It appears that hedging is not enough for current market movement. Although the impact on core investment is confined up to this moment, further downward movement of market will damage the core investment due to margin maintenance requirement in the trading account.

It is not known whether the market is stable at current level or will decline further. Apparently, the portfolio is over invested without enough cash buffer to accommodate market reversal. This is the same mistake made during the financial crisis and should be avoided in the future by keeping with the investment limit outlined in the trading strategy.

The portfolio is under threat of significant loss if the market continues to drop. However, the probability of another big decline seems not high. Therefore the portfolio will wait to see if there is a rebound. After that some of the core investment needs to be liquidated to provide adequate cash buffer for the portfolio and rebuild the hedging tools.

In previous discussions, the trading strategy emphasizes on risk control. The importance of adequate cash buffer for a leveraged trading account is experienced during this week's market decline. Over investing is a major factor for the destruction of the investment portfolio during the financial crisis. If there is enough cash buffer in the account to survive a market dip and rebound, the portfolio can maintain its value. Otherwise the damage to the portfolio is permanent. Following is the scenario for a fully invested margin trading account with calculated figures.

Most stock brokers allow a margin borrowing of 30% to 50% for stocks. The percentage for penny stocks and leveraged ETFs may be higher, i.e. less borrowing. For simplicity of calculation, assume a margin percentage of 33⅓%, i.e. trader can borrow 66⅔% of collateral market value. Also, assume that the initial portfolio value is 100 and the stock drops 33⅓% first and then rises back to original value. For a cash trading account or margin trading account without borrowing, the portfolio remains intact after the dip and rebound.

The scenario for a fully invested margin trading account is different. The net value in the account is 100. With borrowing, the stock value in the account magnifies to 300 and the borrowing is 200. When the stock declines by 33⅓%, the stock value in the account becomes 200. The available borrowing from the collateral becomes 133⅓. Thus the trader is required to pay back the excess borrowing of 200 - 133⅓ = 66⅔. There are two possibilities to achieve this purpose. The first is to deposit additional fund into the account to reduce borrowing. The second, which is most of the case, is to liquidate the collateral. This requires selling of 100 worth of stock, ½ (100/200) of stock shares, at market price to reduce borrowing from 200 to 100. The account holding becomes 100 worth of stock and 100 of borrowing. The net value of the account is zero. Practically, the trader has lost all the principal. When the stock rebounds to original value, the stock value becomes 150 (300 x ½). Since the borrowing is 100, the net value is 50 (150 - 100). Thus the final portfolio value is only half of the original portfolio value.

The above example shows that over leveraging can destroy 50% of the portfolio value for a 33⅓% dip and rebound while a cash trading account or margin trading account without borrowing can preserve the portfolio value.

Since the portfolio is for speculative stock trading, the use of leveraging is considered adequate. However, the trading experience learned from this week's market movement is to maintain adequate cash buffer and hedging for core investment in the portfolio.