Managing Risk

The markets are now very highly correlated which is a condition we seek to avoid in choosing positions for our portfolio from a risk management perspective. In the past that would mean not buying GLD and a Goldminer or multiple stocks in the same sector unless they are treated as one position. However since the Fed has kept short term interest rates at record lows for an extended period of time, money is now taken at the very low rate of interest and invested in risk assets that have generated higher yields and why not? The CRB (commodities) Index has gone virtually straight up. The Fed's Permanent Open Market Operations (POMO) seemingly have a quid-pro-quo with the Primary Dealers that buy treasuries at auction and flip them to the Fed sometimes only two weeks later at a significant premium that puts billions of dollars at their disposal with virtually no risk. When this happens and the submitted:accepted ratio is favorable, the Primary Dealers drive the market higher which has been going on for a long time. Make no mistake, it is Federal Reserve initiated and sponsored market manipulation.

There's really very little perceived risk, thus all asset classes have moved up making the market of investible instruments highly correlated. While this can not and will not persist forever, it creates a danger that any down turn in any of the risk assets will affect nearly all risk assets similarly, especially as traders and hedge funds hit multi-year high levels of margin debt-again showing very little respect for risk which in the recent past has led to some of the legendary Wall Street firms going belly up. This also creates a very unstable condition in the market, especially when the market drops. The fact that the consistent melt-up in the market has created a scenario where there are very few shorts sellers in the market to provide a bid (when they cover to take profits in a falling market) when the market falls has created even more danger. As you can see in my recent videos on market risk, High Frequency Trading Firms of all types have undercut the role of the traditional market maker or specialist and have left the market in a situation where there is very little liquidity, especially in stocks. So imagine a black swan event when the market falls and you want to close out losing positions, it will be harder and take longer to find a bidder to relieve you of the losing position. Just today it was announced that the SEC is underfunded and can not (nor have they shown a willingness in the past) to rectify the structural problems inherent and increasing in the markets.

Thus being long risk assets, almost any kind, creates the same effect, they all rise and fall together which is exactly what we don't want in diversifying a portfolio. The fact that we may be at a market turn makes this problem of utmost concern now.

I'm not sure what you can invest in that is not highly correlated already, so my personal attempt to limit risk includes the following:

Reduce leverage, this can be done by getting off margin and taking on fewer shares of long positions. I would also raise my cash levels, each trader/investor will have to decide what is appropriate for themselves. I would have short positions in stocks that are trending lower that make sense as an investment anyway, but not too big of a position, not a majority portfolio position until the market confirms the downside reversal through price action. I would also have a heavier bias in real short positions rather then inverse ETFs, although I would hold inverse ETFs. The fact is you have advantages in a real short position that inverse ETFs (which is the equivalent of being long) do not have. Please see my article at Trade-Guild.net titled, “Making more then 100% in a short” and you will understand the mechanism. Any inverse ETFs should be probing positions until they breakout and start trending higher. ETFs are meant to approximate one day's gains not a month's. So when they are trading laterally, the leverage inherent in them creates compounding that is magnified by the leverage and in many cases that compounding can be dangerous. Thus I'd keep these positions as “toes in the water” and only add to them when they trend and consider using them as swing positions, meaning try to get out of them when they pullback.

This is a risk management problem that I have not had to face before and I don't think there are any great ways to deal with it, but it is still imperative that losing positions do not cause you to lose more then 1-2% maximum of portfolio and that's aggressive. My article on risk management here at WOWS will help you understand how to properly position size a trade so that you will not (except for gaps we can not account for) take losses larger then 1-2 % of portfolio value at maximum. Personally, I'd go even more moderate as the article will also explain. 

If you have questions or ideas, please email me as this is the most important aspect of trading and ultimately will determine your success in the markets through consistent risk management. It only takes one trade to lose 50% and you have to make 100% just to get back to breakeven, thus it is infinitely easier to keep your money then it is to make it back.