Since my last post one week ago, markets have dropped somewhat. S&P is now at 3825, down from 3911.
General Markets
The corrective bounce ran out of steam, and the major equity markets dropped a few percent. There was a rebound in US yesterday, and S&P went up about 1%. However, I doubt the uptick can be sustained, as there has been a constant stream of bad economic news flow applying downward pressure on sentiment.
Earnings season in the US is starting in the 2nd week of July. This is another potential source of downward pressure on equities. There is a significant risk that earnings expectations have not come down enough. If earnings disappointment + negative economic news flow hit the markets together, it would be difficult to avoid another down leg.
Commodities
Commodities are still falling. Below is the chart for copper.
There has been no relief at all for commodities, even with China’s re-opening impulse. The pessimism from the global downturn seems to be overwhelming everything else.
Is there still room for further falls? Let’s take a look at a longer timeframe for copper.
Copper is still above pre-COVID levels. To me, it feels like there is still room for further falls. Of course, things rarely move in a straight line.
Trading Considerations
I am back to favoring shorting commodities, as negative economic news flow has been relentless. Except for China PMIs which have been ok, but their economic stimulus has been underwhelming so far. However, prices have dropped a lot, so a lot of agility is needed to avoid getting caught in any violent rebound.
As for the long side, I still like bonds. Bond yields have dropped somewhat, with 10-year Treasury yields dropping to multi-month lows. Recession fears are the culprit. Just be careful and do not bet huge on junk bonds for their high yields, as recession will still hit low-quality bonds badly.
This has been a good week for the markets. Economic news has actually been bad overall, but there is some hope that inflation is peaking. It is likely that markets rallied due to lowered expectations of rate hikes.
Markets are shifting their focus rather rapidly. Just recently, it was global slowdown fears. This week, it is peaking inflation hope. Next week, would there be a new focus? Perhaps. Earnings slowdown is a possible candidate. Or maybe slowdown fears will triumph again. Market dynamics are changing more quickly these days, making trading more challenging.
Commodities
Commodities have continued to fall despite verbal support for stronger Chinese stimulus. A lot has to with weakening economic data. Copper price is at 16-month lows.
Prices have literally fallen off a cliff after being in a trading range for some time It is possible for prices to continue falling, but the probability of at least a short-term bounce has increased. There are still folks believing in the power of future China stimulus.
Trading Considerations
In my previous update, my preferred short was commodities and long was bonds. Commodities have fallen a lot since, so I would not short it due to increased probability of a bounce. Bond prices have increased slightly, but I am retaining it as my preferred long. It seems likely that the economic slowdown will cap the increase in bond yields going forward.
Markets have extended their extremely bearish behavior last week. S&P posted its worst week since 2020. Bitcoin is crashing as I am writing this post, going below $18k at one time. Bond prices are buckling under severe pressure.
US economic data has deteriorated, contributing to the pessimism. Chinese economic data seems to be doing fine, but it is not enough to offset the prevailing negativity.
Stock prices are starting to look more reasonable, but negative drivers of the markets may not have peaked and turned around yet. Inflation expectations are still awful, and major economies are at risk of substantial slowdown.
Commodities have been rising steadily due to being touted as an inflation hedge, but lately have been hit because of economic recession worries. Shorting commodities may be viable if recession worries do not recede. This is my preferred tactical short bet if I am intending to short the markets, as there is still quite a lot of room for commodity stock prices to fall.
On the other hand, recession worries may actually benefit bonds. If economic data continues to deteriorate and/or inflation data goes lower, bonds would benefit significantly. I like this long bet as bond sentiment is extremely low, but I would be cautious about the timing of any bets as there are still several almost confirmed interest rate hikes coming up.
Anyway, hope you folks are doing ok. Do stay safe and sane, and be rational and keep away from impulsive behavior. Good luck!
Markets have dropped a lot in recent days. S&P 500 settled at 3930 yesterday (12 May), down a whopping 700 points from 29 March (4631) and more than 800 points from its all-time high of 4818. It is very close to entering a bear market (20% drop from the peak).
Is it time for a decent bounce? Probably, but news flow has been poor, very little fundamental change has occurred. This means that if there are no major news flow surprises, any bounce may be relatively small and short-lived. In such cases, agility is required to move in and out quickly.
If any positive headlines appear, there should be a stronger bounce. It is also entirely possible for the markets to just slowly drift downwards or sideways. It is a tricky situation to trade indices or stocks with high correlation to the general markets. None of the possible scenarios have an significantly stronger probability of occurring than the others. Hence there is no high-conviction outcome to bet on.
If you trade in any niche markets/stocks which are relatively disconnected from the general markets, this should not affect you so much. If you still would like to trade, please monitor news flow closely and get out quickly if any headlines pop out which are negative for your trade(s).
Volatility is back in a big way. Dow Jones has had a couple of 4-digit swings, and it has been a bloodbath in many markets. Uncertainty in overlapping major risk areas is fueling a brutal sell-down.
The risk areas include:
China slowdown due to COVID measures and property weakness
Central bank tightening due to persistent inflation
Commodity imbalances due to Russian invasion
In highly volatile situations, I find it useful to establish as much certainty as possible, because uncertainty fuels fear and leads to sub-optimum decisions being made. Reaffirming and reminding ourselves of the certainties make it easier for me to maintain rational decision-making.
Everyone has their own set of high-conviction ideas from which to establish these certainties. Some of my own are:
1. Considering the very long term picture, it is still possible for markets to fall significantly further
S&P 500 from 1990
Looking at the big picture, recent falls do not actually look very big. Markets have risen a lot, and recent falls are much less than recent rises. It is entirely possible for the S&P 500 to fall significantly below 4000.
2. No one can predict the markets with absolute certainty
Trust no one. Many will seem to know a lot and present compelling evidence, but it is impossible to be absolutely sure about the markets. Trust no one entirely.
3. Avoid crowded trades even if they seem logical and well-recommended
When a trade has become crowded, potential upside becomes limited and potential downside conversely grows a lot.
4. What goes up a lot has a higher probability of falling a lot
No matter how compelling a high-flying stock’s business case, it always has a higher chance of falling fast to the ground. Remember that fundamentals can change, and research reports are not perfect.
Conclusion
Reinforcing your own set of certainties will help anchor yourself in volatile times, and prevent decisions being made based on more emotion than logic. To develop your own set of high-conviction ideas, do read extensively and spend time to analyze markets deeply.
Retail investors are always seen as the perennial underdogs against institutional investors. Indeed, institutional investors have significant advantages over the average man in the street. However, retail investors can still be successful and perform well in the markets, given the right knowledge and frame of mind.
What are Retail Investors Up Against?
Institutional investors are people employed by companies/organizations to make trades in the markets. These organizations include banks, insurance companies, mutual funds and hedge funds. With their large budgets, economies of scale and corporate connections, they are able to:
Obtain faster, more in-depth info
fundamental research in companies, sectors, economic trends
price-moving events in real-time
alternative economic indicators (eg. satellite images, railway traffic)
Invest in the best hardware and software
Trade more cheaply
their large volumes allow them to command lower fees
Hire good traders/investors with proven track records
Provide expensive/specialized training
Why Retail Investors Still Can Compete
There are several reasons why retail investors should still be able to compete with institutional investors despite their huge advantages listed above:
Complexity of the Markets
Size and Variety of Markets
Constraints of Institutional Investors
Agility and Flexibility of Retail Investors
Complexity of Markets
The markets are made of many moving parts. Many variables affect the price of assets, some are difficult to quantify while others may not even have an obvious relation to an asset. This underscores the difficulty of predicting asset price movements.
Major financial institutions have many years in the industry, and also possess some of the best talents. And yet they get their target prices for stocks wrong more often than they get it right. Since no one can very accurately predict stock prices, no one can dominate, and hence everyone in the game still has a chance.
Size and Variety of Markets
There are many asset classes in many markets, spread across many sectors and occupying different niches in their locale. New assets are being created everyday, adding to the colour and diversity of the markets.
With such a huge number of possible assets to trade or invest in, there would always be some which are not traded by institutional investors yet. Also, retail investors may be able to explore and find a niche in which they are familiar with and have an edge.
Constraints of Institutional Investors
Institutional investors invest/trade in huge amounts. This means that companies with small market capitalizations and those with low liquidity are not appropriate candidates for them.
They are also often not able to buy or sell stocks at one go, as their orders may fill up the current price level and slip into the next price level(s). They may need to split up into several different orders, sometimes across different days.
There may be mandates from management preventing them from investing in the stocks they prefer, for example ESG mandates. They may also need to buy an asset which they may not particularly like, perhaps for maintaining fund composition requirements.
Agility and Flexibility of Retail Investors
Retail investors deal in small amounts. They are able to invest in small cap and illiquid stocks. Their orders can be filled easily within the current price level, thus they have no problems buying/selling quickly.
They also do not have any constraints on the type of investments to make (eg. ESG mandates, fund composition). Also, there is no need to force a trade/sale if there are no good options around, they can wait until an opportunity arises.
What Retail Investors Can Do To Compete With Institutional Investors
Retail investors should aim to minimize the advantages institutional investors have over them, and maximize their own advantages over them.
Research to reduce information gap
Explore freely to find areas you perform well in
Be patient and do not force trades
Be nimble and react to fundamental changes quickly
Research to Reduce information gap
With the advent of the Internet, retail investors can now access a lot of information for free. They can diligently research on the stocks and sectors of interest to keep themselves updated. It is also useful for getting near real-time updates for time-sensitive trades.
Free information sources can probably give you about 60 to 70 percent of the info that institutional investors receive. To gain more specialized information, retail investors can subscribe to dedicated financial sites. Sometimes, this is necessary in order to gain more knowledge in depth in certain areas, and increase your chances of developing a trading/investing edge.
Explore freely to find areas you perform well in
Retail investors are free to try out any trading techniques and strategies in any areas of the market, without needing to seek permission and report results. They should keep learning about new assets and instruments, and not be afraid to try them out.
Be patient and do not force trades
Being able to wait for a while for a good trade will guarantee a higher probability of success than being forced to make suboptimal trades. Retail investors have the luxury of not making trades for weeks, months or even sometimes years. They should take advantage of this privilege to make fewer but higher quality trades. This will lead to a higher percentage of winning investments.
Be nimble and react to fundamental changes quickly
Retail investors can enter and exit a position easily in just 1 or 2 trades most of the time. Institutional investors trade in large sizes, and have to enter or exit a position gradually over time. This is to ensure that their trades do not cause prices to shift and cause them to transact at unfavourable prices.
This means that retail investors are a lot more agile, and can establish or exit a position much quicker, most often on the same day. In contrast, an institutional investor owning perhaps 10% to 15% of the entire company has to take some time to entirely dispose of a position.
Retail investors should regularly monitor news flow, and react decisively on any fundamental-altering event once some research has been done to ratify its legitimacy and impact. For example, if a major coal-using country decides to ban coal imports and make a major push towards natural gas and renewables, it would be optimal to cut positions in coal miners as soon as possible.
Conclusion
As of current market conditions, retail investors still have a good chance of doing well in the markets against the institutional investors. They just need to choose their battles well and be willing to put in time and effort to hone their edge.
This may change in the future, depending on how the nature of the markets changes and how unequally technology advancements benefit retailers/institutions. However, no one can predict the future accurately, so there is no need for retail investors to worry about it at the moment. The sun is still bright for them, so they can focus on making hay while the sun shines.
A trading edge is an aspect/area of trading in which you are better than most others at, and which allows you to profit consistently from trading. It may not necessarily encompass merely a specific technique or fixed set of techniques, but may also include the approaches adopted to handle the technical, strategic and mental aspects of trading.
Most of this article is relevant to investing edge as well. There is a fine line between investing and trading, and sometimes the boundaries are blurred and overlapping.
Why do you need a Trading Edge
Without a trading edge, it would be difficult to make enough money from trading to make a difference in your life. This is because trading is a negative sum game – the players have a less than 50% chance of profits on average because of the fees imposed by the various middlemen (eg. transaction fees, holding fees, trading platforms, stock exchanges, financial institutions). Thus if you are an merely average player in this game, you have a less than 50% chance of making consistent profits.
Arguably, if you are trading/investing over the long term, the game becomes a positive sum game, where the average player has a more than 50% chance of profits. This is because of the effects of technological progress and efficiency gains in companies over time. However, you are unlikely to make life-changing amounts simply by banking on these effects.
How do you develop a trading edge?
There are 4 things you need to work on concurrently.
Understand what drives asset prices
Understand the methods to trade the markets
Experiment to find out what works for you
Work on honing your cognitive skills
1. Understand what drives asset prices
Understand how markets work and what makes stock/asset prices go up or down. A lot of information is already on mainstream media free, so a reasonable understanding can be obtained from websites and videos.
Do note that you would need to regularly measure a pulse of the markets by constant research, as market behavior changes constantly.
2. understand the methods to trade the markets
There are various instruments available to trade markets, for example regular stock purchasing, options, CFDs, Daily Leverage Certificates. And there are various ways to utilize them, either within themselves or in combination with each other. The characteristics of each method should be studied, for example one-time costs, holding costs, leverage, break-even point etc. In addition, it would also be good to know the expected pattern of results of each method (eg. buying options typically results in more losses of smaller amounts, but also wins of greater amounts).
An example of an analysis of trading methods can be found in my previous post here.
3. Experiment to find out what works for you
Basically, be like a mad scientist and try out many different ideas. Test out different instruments using different strategies across different asset classes. But please do it without bankrupting yourself in the process. Use demo accounts first, but if you find demo experience not useful at all, go with live accounts, but trade with small amounts first.
4. Work on honing your cognitive skills
Your cognitive skills are used to assimilate info, develop strategies, recognize patterns and trends, identify correlations and learn from experiences. With more honed cognitive abilities, you would have a higher chance finding an edge, and your edge would be sharper.
There are many ways to improve cognitive abilities. There is a good article on it here. Personally, I find that computer games involving problem-solving and monitoring/managing different data points are useful in this aspect.
How Long Will It Take To Develop A Trading Edge?
Like any other skill, it will take a lot of time and effort. You may have heard of the “10,000 hours rule” to master a skill. The truth is, there are a lot of variables affecting learning speed, and not everybody will take the same time to develop an edge. Some may take months, while others may take years.
Will I be able to Develop A Trading Edge By Copying A System/Approach Already Used By Other Traders?
It is unlikely for 2 reasons:
Your trading edge likely has to be customized for your own cognitive and personality traits
If a system/approach has been copied and used widely, it likely would lose its competitive advantage
It can still be useful to look at other successful systems/approaches. You can adapt parts of them to fit into your strategy.
How Long Will Your Trading Edge Last?
It really depends on how markets evolve and the nature of your trading edge. They can last for less than a year, or they can be effective even after many years. Markets do evolve, and it is unlikely that any trading edge can last forever. You can try to maintain its effectiveness over time by continually tweaking it to cater for changing market behavior. If tweaking does not work anymore, it would be wise to move on to find another trading edge.
Conclusion
Being able to develop and maintain trading edges is key to being a successful trader. It will definitely take a lot of work, but the end result will be worth it.
When you have developed your edge, it is important to stay humble and recognize that market dynamics can change anytime and render your edge useless. Conversely, if you have not yet developed your edge, just keep learning and trying different things, your breakthrough may yet come soon.
We all know that making a trade is not free – it costs money (transaction, holding costs) and time (research, analysis, trade execution). But less commonly mentioned is that trading/investing also incurs emotional costs. Stresses are incurred in almost every trade, and it is important to take this into account in order to maximize the probability of success for your trading/investing strategy.
The market has been in chaos during the past week (as of the time this article has been written). Equity and crypto markets have dropped sharply, with some assets down as much as 50%. This is most likely the most stressful period for traders and investors since the Covid crash of March/April 2020. It is periods like this that the emotional costs of trading/investing become most significant, and hence most important to manage.
What is Emotional Cost
Emotional cost of trading/investing is the collective set of negative emotions one experiences during trading/investing which causes psychological stress and may potentially lead to emotional exhaustion.
Why It Is Impossible To Avoid Incurring Emotional Costs During Trading
Emotional costs are incurred whenever a non-optimal trading/investment decision is made, as regrets are experienced for every buy or sell trade which did not result in the most money made or least money lost. It is nearly impossible to consistently make optimal decisions in trading, as trading is too complex. To make a trade in general, one has to decide on 3 things:
Direction of trade (Should I go long or short?)
Timing of trade (When should I make the trade?)
Quantity of trade (How much money should I put into the trade?)
It is literally impossible to consistently buy/sell at the absolute lowest/highest points using 100% of your buying/selling power. It is not necessary to do that in order to be profitable, but even when you have made a profitable trade, you would have some regrets over the decisions you could have made to make even greater profits. Indeed, there would be regrets in most trading situations.
For example, the regrets after a trade has been initiated are:
Price went down after trade initiation
Price went up after trade initiation
Shorted using 100% of selling power
No regrets
Should not have shorted
Shorted using < 100% of selling power
Should have increased position size
Should not have shorted
Didn’t initiate trade
Should have shorted
Should have longed
Bought using < 100% of buying power
Should not have bought
Should have increased position size
Bought using 100% of buying power
Should have bought
No regrets
Table of Regrets
In most situations, regrets would surface. And it is unfortunate but true that the negative emotions aroused by bad trades are stronger than the positive emotions evoked by good trades. Thus overall, an investor/trader would likely experience net negative emotions from trading/investing.
Impact of Excessive Emotional Costs
Firstly, it impacts your trading/investment performance. Staying disciplined and sticking to your trading strategy is difficult when you are facing massive losses. Huge losing positions may be liquidated, even if they should be held due to fundamental/technical reasons. And worse, subsequent risky trades may be undertaken to try to recover losses, even if the risk/reward ratios are not favourable.
Secondly, it affects your mental well-being and may blunt cognitive capabilities. This would lower success rates significantly.
Lastly, there may be detrimental effects on the non-trading/investing aspects of your life. Your personal and professional life may suffer, perhaps permanently and significantly.
How Should You Manage Emotional Costs
The best way to manage emotional costs of trading/investing is to simply take them into account when deciding to make a trade. This should be done at both the individual trade position and entire portfolio level.
individual position level
Max Loss
Determine the lowest price your stock/asset would go to (or highest price, if you are making a short trade)
Calculate the amount you would lose at the lowest point
Decide if you can take the loss for that trade/investment position
Daily Volatility
Estimate the daily fluctuations in value of the position you are considering to take
Decide if you can withstand the daily fluctuation in your position value
Portfolio Level
Max Loss
Estimate the losses your portfolio would take in the event of a worst-case market development
Add the max loss of the position you are considering to take to your estimated max portfolio loss
Decided if you can take the max loss for your entire portfolio
Daily Volatility
Estimate the daily fluctuations in value of the position you are considering to take
Add the estimated daily fluctuation in value of the position under consideration
Decide if you can withstand the daily fluctuation in value of your portfolio
Conclusion
The emotional aspect of trading/investing is generally under-appreciated in mainstream educational media. More coverage is placed on how to execute wining strategies and choose winning stocks. When positions are small, emotional costing may not be so significant, but it needs to be considered as soon as you start to increase position sizes. This would ensure that trading discipline can be maintained and cognitive performance is not degraded, and hence success rates can be maintained.
Bonds have traditionally acted as a bastion of stability in a portfolio. They are resilient to market fluctuations, and can provide a modest but reliable source of recurrent income. But given that interest rates are most likely going to rise in the next few years, bond prices are slated to fall. Do they still have a role to play in your portfolio?
Bonds act as anchors in tough times
What Are Bonds?
A bond is basically a loan made to companies or governments. They generally pay a fixed interest rate over a set period. It is effectively an IOU which can be transferred to different parties. When you buy a bond, you are taking over a loan made to the company. You will receive regular payments from the company until a date stipulated in the bond contract. If you would like to know more, Forbes has a nice write-up on it.
How Are They Valuable To You?
They are very valuable whenever there is a market downturn. When equity prices drop drastically, bond prices will tend to be stable, and continue to provide recurring income. This has immense psychological value and tactical value.
Psychological value
Your portfolio is a lot more stable than a 100% equity portfolio. Portfolio value fluctuates less, thus there is a lot less emotional cost. When stocks drop > 5% and your bond values barely changed, you would feel much less of a hit. You would be able to sleep better and make less impulsive decisions.
Tactical value
You have the option of selling away your bonds to take advantage of depressed equity prices. The recurring income is also more assured than the dividends from equities.
Why Are They Less Favorable During This Period?
Interest rates are projected to rise over the next few years. This would make bonds less attractive, as the interest rates they pay out (ie. yield) would be closer to general market rates. For example, a yield of 3% would seem very attractive compared to a 0.5% fixed deposit rate, but not so if compared to a 2.5% fixed deposit rate.
Are They Still Useful During This Period?
Yes – personally I feel they are still useful and relevant to any portfolio. Their psychological and tactical values are not totally nullified by the rising interest rate environment, and they are still extremely valuable during periods of heightened volatility. The key is to select bonds which are less affected.
Short duration bonds (bonds maturing in < 2 yrs)
Bonds with relatively high yield, perhaps > 4%, and having its yield adjusting to inflation
The key risk to consider is that rates increase faster and in greater magnitude than expected. This would put more downward pressure on bond prices. Balanced against that is the chance that inflation recedes, and interest rates remain low, which would improve the outlook for bonds.
If wholesale bonds in $250k denominations are not your cup of tea, you can consider bond funds/ETFs. As always, please do not invest 100% of your portfolio in a single asset/asset class, and select reasonably safe bonds from entities which are not in financial distress.
Shorting is a good skill to add to your trading skillset, as it allows you to take advantage of a wider array of market conditions, and also increases the variety of strategies you can employ. There are many methods of shorting the market. The most common are:
Buy put option
Sell call option
Sell via CFD
Buy Put Option
Description
Purchasing the option to sell an asset at a certain price by a certain date
Characteristics
Breakeven point is a moderate distance away, thus probability of a trade being profitable is significantly lower than 50%.
As downside is capped while upside is unlimited, the magnitude of wins are much larger than losses.
Typical win/loss pattern
Many small losses, few big wins
Preferred Market Conditions
Volatile environment where moves are relatively large, so that it is easier for you to reach breakeven point, and upside potential can be maximized
Pros
Highest profit potential, profits can be several multiples of capital invested. Losses for each trade are capped.
Cons
Highest risk, entire capital sunk in a trade can be lost. Value of option declines over time. May be difficult to accurately assess win rate and risk/reward ratios and balance them optimally, as calculations for options can be complex.
Sell Call Option
Description
Selling the option to others so that they can buy an asset at a certain price by a certain date
Characteristics
Breakeven point (for the person buying your option) is a moderate distance away, thus the probability of a trade being profitable is significantly higher than 50%.
As downside is unlimited while upside is capped, the magnitude of losses are much larger than wins.
Typical win/loss pattern
Many small wins, few big losses
Preferred Market Conditions
Stable environment where moves are relatively small, so that it is difficult for the person who bought your option to reach breakeven point, and the number of losses can be minimized
Pros
Option position will earn more money over time due to decay of option value for the person who bought your option.
Cons
A single loss can be huge and completely wipe off gains from many successful selling of call options. May be difficult to accurately assess win rate and risk/reward ratios and balance them optimally, as calculations for options can be complex.
Sell Via CFD
Description
Establishing an agreement to sell an asset at the current price, and buying it back at a future price
Characteristics
Breakeven point is a short distance away, thus the probability of a trade being profitable is slightly lower than 50%.
Upside and downside are balanced, unless stock price increases more than 100%. Downside is theoretically unlimited while upside is capped at 100%. Downside would breach 100% once the stock price increases more than 100%.
Typical win/loss pattern
Wins and losses are about equal in magnitude and frequency.
Preferred Market Conditions
Stable to moderately volatile environment, where stock price gains do not exceed 100%.
Pros
Relatively simple pricing mechanism makes it easier to accurately assess win rate and risk/reward ratios, and balance them optimally.
Cons
Holding CFD positions will incur financing charges, thus it may be expensive to hold them for too long.
Conclusion
In theory, different trading conditions would be best served by different shorting techniques. In practice however, many traders do not employ all the techniques. They usually stick with either options or CFDs. For beginners in shorting, I would recommend to try out both and find the one which fits your style better.
