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Re-Launch of the Income Trader – A Strategy for a Market with Compressed Extreme Moves

Posted on the 07 November 2011 by Phil's Stock World @philstockworld

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The word ‘RISK’ is a simple four- letter word; yet, the management of risk is critical in any investment or income generating strategy. When historical norms no longer hold, and markets can make moves within a span of days, or just a few weeks what used to take a whole year or years to make, it becomes critical for trading and investment practitioners to rethink old models and adjust given new information or market realities. Whilst increased volatility increases market risk as a whole, it also provides tremendous opportunities to make an abnormal return if you are on the right side of the market trend. For market participants, the question is – are you prepared to assume the increased risk that can provide the environment to make huge returns, and at the same time, if your thinking is wrong, assume huge losses. Or, is it wise in a period of high volatility to disengage and get back in  when sanity returns to the financial markets? This is a critical question that market participants have to answer and honestly face up to the conclusions they come up with. For most people detached from the market and not involved in any trade, there is always the false assumption with the knowledge of hindsight that they are prone to being risk takers. And given the choice, they will definitely take more risk rather than less and that somehow they harbor the wrongful notion that they would have been on the right side of the trade. Taking calculated and limited risk where the risk reward structure is favorable is always preferable to assuming tremendous amounts of risk in the hope of being right. In  an era of investment where crisis, whether real or imagined hit the market with such frequency, and cause extreme market moves within a compressed timeframe, what should one do? Should we totally disengage, call it quits and look for new avenues? Or, should we take cognizance of such realities and design our investment strategy for such markets? The market, it seems is so structured in a way that now a tsunami or an earthquake or a plane crash is no longer a real event that occurs every 100 years or so, but one where it has become the norm. If catastrophe is no longer a real event but occurs with frequency, it stands to reason then, that any market participant should at least always hedge their strategy with some sort of a catastrophic insurance. This  acts as a risk mitigator for when the tsunamis hits. The question then becomes, what is the cost of such a catastrophic insurance, and does it make sense given the strategy the investor or trader is pursuing? For market participants with limited capital, such insurance becomes a challenge since it can or may constitute a large percentage of their overall capital. For those with a reasonable capital base, it becomes a mute point since it will constitute a small portion of their overall investable or trading capital and can view such insurance as the cost of doing business. For participants with limited capital, where catastrophic insurance seems out of the question, it becomes imperative to put in place a strategy that only engages when volatility is down and markets are normal and disengage totally when volatility rises. It is critical to note that portfolio or trading insurance is put in place not to make you money, but to provide protection.  The fact that the insurance makes money, if the situation so presents itself is just an added bonus. From the perspective of the Income Trader strategy, catastrophic insurance becomes critical and should now be a vital part of the strategy. Income trading strategy is seeking to generate consistent income on a monthly basis. The strategy is not looking to hit a home run, and as such does not have the luxury of getting hit by a catastrophe, especially when they are now a frequent occurrence. If for instance, we are looking to generate approximately $4000 a month from a $50 to $100k portfolio, we cannot afford to lose more than $4000 a month in a bad month, and our strategy and thinking should revolve around not losing more in a month than we can make in that month. Critical also to the strategy, is to make the critical decisions in certain months of extreme uncertainty and volatility to totally disengage. The financial markets it seems is the only arena where nobody forces you to make a trade. An individual or an investor or a trader can choose when to participant.  This is a critical advantage that most investors and traders ignore, and it is an advantage that makes a world of a difference if pursued. Most market participants have been programmed to believe that they should at all times be in the markets, and if they are not, they are missing out, It is worth noting that, nothing can be further from the truth. Making money in the market requires skill, patience and the discipline to plan the trades and also be out of the markets if the dynamics of the markets no longer favors your strategy. Given the high velocity with which prices of indexes and other financial instruments move, a trader should be well advised to have a high reaction time faster than the high frequency trading computers or be hedged at all times to enable losses to be manageable and neutralize the high speed of price changes. For the team at Income Trader, as we re-launch our product, we intend to follow the key fundamentals aforementioned above and implement a strategic investment view that incorporates the following principles. ·   Incorporation of catastrophic insurance into our investment strategy.·   The discipline of engaging and disengaging in the markets given prevailing market conditions.·   Managing our positions at all times within acceptable risk parameters and making sure that for our Iron Condor positions, the delta of the overall    position is acceptable within + 0r – 50, and to manage such as the deltas are always within this range or the position is closed.·   Ensuring within reason and to the extent that we can control, to keep the overall losses within the parameters of our average income per month.·   Diversification in the instruments we trade to include the SPX, SPY, IWM and to include other instruments as we see fit. Finally, in a market ruled by computers with a high velocity of price changes and void of fundamentals, it seems the old rules of trading have changed and we have to adapt as such or perish.

 


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