The past few weeks we have been highlighting the similarities between 2011 and 2015 and those that have followed my column will be aware that with a slice of good luck (or do you make your own luck?) our predictions have been on the money.
This week I will open up our proprietary trading book to give readers a sneak peek into the instruments we traded and the structure of these trades to give some insight into ways to maximise profits and do so with limited risk. After all, its one thing to be correct on a market view and another to profit from it. At an even deeper level how much you profit from these type of market moves is also crucial in determining whether you are an exceptional investor/trader that produces consistently high returns or mediocre one with the a history of average market returns at best.
Again just to recap, from my 2011 analysis I indicated that equity markets would remain weak into the start of October where like in 2011 a very aggressive short covering rally would emerge taking indices back to levels virtually where the whole sell off began – particularly for the S&P 500. This analysis led us to formulate an effective and precise trading strategy or plan to maximise profits in a period when most market commentators and traders are still trying to understand what is actually going on.
We remained with our bearish short positions into the end of September given more weakness was to come and then we would close these out, reverse and go long.
Our short positions were very much broader market based. We did not have significant short positions within individual stocks for several reasons and they do generally apply in most market corrections. Firstly, when markets decline correlations increase and the ability to pick stocks that will outperform on the downside (fall more than others) is generally more difficult than picking winners in a bull market. Therefore, there is little advantage in our view to short specific stocks versus sectors or major indices.
This leads to the second reason of avoiding specific stocks (aside form a specific circumstance) for building and holding large short positions – liquidity. Short covering rallies can be very rapid and can occur without warning and when scrambling to cover shorts quickly you need volume if your position is large. Major market indices have that, specific stocks often do not. When all the selling has dried up, there is little sellers from which you can buy to cover your short. For the potential of possibly earning a few extra percentage points of return the risk of not being able to cover when you want to is too great for our prop desk so we skew much of our short positions in those markets with the deepest liquidity. Furthermore, with futures markets open virtually 24 hours a day you can cover whenever you want, stocks not so. A massive overnight rally can leave you with a local short position that has reversed into a loss at the next day’s open after showing a tidy profit at the prior day’s close.
So our short positions consisted of long S&P 500 put options, short ASX 200 call options, long ASX 200 put options and short SPI futures. We had also been short the High Yield Bond ETF (HYG) as discussed previously, taking advantage of the flight out of high risk debt and into US Treasuries.
Given that we were expecting to see a huge short covering rally begin in early October after indices retested their August lows, we covered these short positions and began to put on trades and build positions that would take advantage of a rapid market bounce.
The key though was to first limit our risk. Knowing that the all-important US employment number was to be released on Friday October 2nd, this was likely to be a major market mover and the trigger for a short covering rally. The aim is to establish a few loss-defined options positions beforehand and then add to them as confirmation of a rally has begun. The key was not to be too aggressive too early. From our analysis and research we had already determined that the S&P 500 could rally back to 2040 – almost 200 points – we don’t need to be too over exposed. Once the rally begins there will be plenty of gains to capture without overly risking our capital before receiving confirmation.
With any sustained market rally one of the first things that is crunched is volatility. With volatility already high and unlikely to experience another substantial move higher, shorting very expensive put options was one of the first trades. If the market only fell gradually, traded sideways or rallied these puts would decline in value (at varying speeds), producing a profit in a wider array of circumstances. With some protection in place via put spreads and calendar spreads we were also able to quantify the risk as well. So while not producing the biggest return (you only earn the premium you sold) the number of market outcomes where you actually do profit is wider. We did this on both the SP 500 and the ASX 200. For the ASX 200 we managed to sell put options as low as 4000!
Next, we bought some out of the money calls. With expectations of a strong aggressive rally in a short period of time we focused on calls with a short dated expiry – specifically October. We don’t want to pay for extra time premium into November or December when effectively we don’t need it. With call options we are aiming to add a lot of cream to our profit if our exact prediction or even a stronger rally results.
With volatility likely to drop quickly we also shorted one of our favourite ETFs – the Short Term Volatility ETF for the S&P 500 (code VXX). ETFs, with all other things being equal, will lose value over time due to their management fees and holding costs. So being short ETFs is better than being long an ETF for the same underlying asset. With inverse ETFs there are many different ways of playing the same outcome for the same asset class. Below we show the VXX and it can be seen that the volatility spike with the equity market correction created a short selling opportunity. We shorted this ETF at levels above $26 which has resulted in a great short term trade but when you look at a long-term chart of this ETF below you begin to realise how value decaying this particular ETF is being long short-term volatility. Rallies on this ETF are always shorting opportunities and over time is the best short in the market.
VXX – past 2 years
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VXX – Past 10 years spent decaying
Finally we began to accumulate positions in specific stocks. Now, what stocks are bought will make for a significant difference in returns. Recalling we specifically highlighted the point that this would be a short covering rally only with no change in the underlying fundamentals. As a result those stocks which have underperformed the greatest would be most likely to rebound the strongest. Again those stocks with the largest short positions would be very vulnerable and thus a primary candidate for being stocks we want to build positions in. Stocks which outperformed during the market slide are not going to rally strongly as they have already experienced their solid buying interest, hence their outperformance and stability over the August and September months.
As we sifted through the most heavily shorted stocks resources, mining services and some retail stocks stood out as vulnerable to short covering rallies. We bought oil producers like Drillsearch (DLS), Santos (STO) and Beach Petroleum (BPT). Resource companies like BHP, Newcrest Mining (NCM), Independence Group (IGO) along with several mining services companies. We added NAB and CBA to our portfolio however, their performance has been disappointing reflecting my comments above, the short positions here are not substantial enough to create a huge wave of buying.
Finally we bought outright index futures on the S&P 500, ASX 200 and the Italian MIB 30, once the reversal began following the US employment release. Notice we took no positions in bonds, currencies or commodities. While an equity rally would create flow on effects in these asset classes their reactions would be tame in comparison to equities where short positions were at a historic level. As I say to the hedge funds i consult to and the traders in the office – always trade the instrument you have a view on. If its equities, trade equities not trading the reaction bonds will have to your expected equity move. Its like a photocopy of a photocopy of a photocopy. The further you move away from your original the less crisp and perfect the result.
Trading too many markets at once is a distraction and its important to maximise your returns when such market moves like we have seen – the best week for the S&P 500 in 2015 – occur. As George Soros was famous for saying, "when you’re right be a pig, go for the jugular". Maximise your profits and maximise the opportunity.
So we are very close to hitting our nominated targets for the S&P 500 of 2040 with the index closing at 2015 on Friday. We have already started to reduce much of our positions in the US as we approach these targets which will prove very difficult to surpass. With the S&P 500 approaching these levels we have also begun to reduce some local ASX 200 exposure as well, even though the local index is a little further from our targets 5350/5400 than we would have expected. Blame a lackluster performance from the banks for that.
All in all, the past few weeks I hope to have shown you a glimpse of the type of analysis, research and trade structuring that is required to not only be on the right side of the market but to maximise profits as well. It’s not just about identifying a chart pattern or waiting for a level to break. That doesn’t give you an edge over the professionals. It’s about identifying what is occurring behind the scenes with trader positions, understanding how the herd operates at times of market panic and importantly, being quick to act when the time is right.
Hopefully there have been readers out there who used the analysis and trading strategies I highlighted in this column over the past month to generate some great profits. As is always the case, I only discuss trades and strategies we actually adopt on the proprietary trading desk. It’s nice when it works and you don’t get stopped out.
