I'm scared.

W

wutangfinancial

My market-neutral strategy failed today. I almost never give up a significant amount during a down day, as my shorts generate enough alpha to more than compensate 90% of the time. Today, I'm down as much as the broader indexes.

My global stagflation strategy, with a near zero beta, is breaking down. I wonder if this might be early indication that were moving towards full on global recession, with a likely hood of interest rate increases to cool overheated emerging markets. Much has been written about the possibility of Japanese style deflation moving to China, in particular, as sudden capital flight takes hold. There is certainly more FDI than actual investment opportunity in the BRICs at the moment.
 
Have you considered maybe it's due to a holiday week? Does your system work the same for summer time trading and a holiday week as other times?
 
How many distinct positions do you hold at one time? The only perfectly market-neutral strategy is to have no possessions. The fewer positions, the more noise and good/bad luck.
 
^I hold between 30-40 positions, long and short included. However, this was not a case of idiosyncratic risk acting up. All of my long EEM positions were down MORE than my shorts, which were still down, just not nearly as much. I've never seen a spread of this magnitude. Generally, I churn out daily returns of +.5-1% regardless of market direction, thus resulting in a super smooth equity curve. A day like today makes me look bad.

There was a kind of reverse in momentum, across all my longs and shorts. There's been overall deceleration in the drop of my shorts, and a serious break in the upward momentum of my longs. I ignore changes that result from idiosyncratic risk, i.e. one company missing earnings, etc. so as not to over trade. But there's clearly a fundamental shift here not resulting from general market noise.

I believe we may be in a real transition phase in terms of global macro conditions, as the market always looks ahead. If exporters are hurting, and the companies that import raw materials are hurting, there's a different theme taking hold-the only thing that could explain a decrease in the share price of both is the return back to positive real interest rates.
 
One thing I've learned over the years is that a high VIX signals much higher correlation between trades. Everything eventually becomes a punt on the S&P. Risky stuff gets hammered, safe haven stuff rallies.
 
^yeah, that's actually a really, really good insight.
My longs and shorts, taken individually, have above market betas and even higher individual risk factors (in the long term, I'm a very strong believer in this strategy, as you profit off of others loss aversion and reap an asymmetric payoff).

Basically, you're right though, Cutten. I should really get long volatility as a hedge, and I've been thinking about it for a while. I'm not an options guy, but I think buying out of the money straddles on the broader indexes would be key for the robustness of my strategy. Also, if Taleb is ignored, he will proven right again-we should have some 5 sigma events in the next few years, and those same premium sellers will get hammered.
 
Quote from wutangfinancial:



My global stagflation strategy, with a near zero beta, is breaking down.
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As does everyone eventually, who tries to guess what will happen. Trade what you see, don't try to become psychic
 
I run a long/short portfolio with part of my capital. I've noticed it always gets hit hardest during nasty corrections, usually in the last week or two before the low. I am usually long the most resilient stocks, which tend to be the narrow momentum favourites late in the day - they do really well except in the later parts of a selloff, then they get absolutely creamed. Meanwhile the prior short favourites often bottom prior to the market, since they are so oversold.

Bottoms often have sector rotation, which is another killer for long/short portfolios that are based on prior trends.

IMO the reason for this is the margin calls and risk aversion during a panic. Obviously other smart managers know the same "hot" stocks as you do, the ones that were on the 52 week high list for the last 6 months. Ditto the other way for their shorts. In a panic, the more aggressive ones have to liquidate and so you get a two-way squeeze.

Speculative favourites usually have 1-2 weeks of getting absolutely hammered in the tail end of a market selloff. It's gotta be due to deleveraging. If you look at commodities in Jan and March, that happened. Every decent hedge fund was long them, and in the week or so prior to both panics, commodities cratered. I got caught by it the first time (but added once I realised what had happened), the second time I liquidated once it started, and actually shorted for a small short-term trade, before re-entering after.

So IMO this is the source of your problem. Julian Robertson experienced the same with his long/short portfolio whenever there was a market panic. But being more an analyst than trader, he never really figured out a way around it.
 
Quote from wutangfinancial:

^yeah, that's actually a really, really good insight.
My longs and shorts, taken individually, have above market betas and even higher individual risk factors (in the long term, I'm a very strong believer in this strategy, as you profit off of others loss aversion and reap an asymmetric payoff).

Basically, you're right though, Cutten. I should really get long volatility as a hedge, and I've been thinking about it for a while. I'm not an options guy, but I think buying out of the money straddles on the broader indexes would be key for the robustness of my strategy. Also, if Taleb is ignored, he will proven right again-we should have some 5 sigma events in the next few years, and those same premium sellers will get hammered.
More...

You can either go to cash, or buy lots of cheap OTM front month puts, when you see the risk-trade starting to make your portfolio all negatively correlated to a spiking VIX. Usually these periods only last a few weeks, so the time value is not too much of an issue.

Going cash is very tricky, since the decision to re-enter is so hard to get right. And it's easy to get false alarms and liquidate just before your longs soar (high beta stuff sure rallies fast at the first sign of safety lol). So I prefer the front 1-2 months OTM puts. Reducing size can also be good.

I think solid backtesting plus some "forward-testing" real world experience should give a good idea how effective options/long gamma is as a trade. One alternative to long S&P puts is to buy bond and eurodollar calls, for a flight to quality. This time thought, inflation means bonds aren't rallying as hard as they normally would. TIPS are better but no futures contract. I would suggest gold calls as an alternative. Or maybe go long 10-30% gold, it's in a secular bull market anyway.

I certainly haven't mastered this myself, but I've seen it enough to realise the issues with just sitting tight. You either need brass balls and deep pockets, or a decent long gamma hedge.
 
^yep. You got it. This might very well be a market micro structure thing, not an economic one. Still, I think these guys are operating on the same global fears as me, and trying to get out early. So yeah, big deleveraging leading to a two way squeeze.

I'm gonna re balance, but not close my positions.

I DO NOT believe in market timing. At all. I never, ever go to cash...I have too much humility in this regard.

As far as bonds-I'm betting on global interest rate increases in the near future. I hold positions for months, so long bonds doesn't work for me. I thought about gold...but I think the run is up. Maybe interest rate futures is the way to go-I gotta run some regressions to figure out the best strategy.
 
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