The GoC challenge: how would you trade this market setup?

[Specterx]

Quote from Ghost of Cutten:

Let's say you identify an early stage bull market. Your analysis and past experience indicates that the market will go up at least 300% in the next 5-10 years, maybe 500%+. However, it will almost certainly have 2 or 3 corrections and short (3-9 month) bear markets of 20-40% during this period, and will eventually end with a huge blowoff top and then fall 75%+ like the nasdaq in 2000-2002. Assume that you will be able to identify the ultimate top roughly when it happens - i.e. you won't be able to sell the exact top, but will know that it's getting very risky. And assume that you will only have a 50% hit rate on identifying the smaller bear markets/corrections - both when they start and end.

Overall, you think you have an 80% chance of being correct about the huge move. And you have a clear stop, which will get triggered if you are wrong. If you are wrong, you anticipating losing about 30% from the current market price, before your stop is triggered.

So, you will win 80% of the time, and when you are right you make 300%+, when wrong you lose 30%.

How would you trade it? Firstly, how much would you risk losing on this trade, as a % of your total net worth? Second, what strategy would you use to trade it?

Would you just buy, sit on it for 3, 5, 7, 10 years, then sell everything once you see the warning signs of the ultimate top, and simply ride out the 20-40% corrections and bear markets? Or would you try and time the corrections and mini-bears, even though you might not be able to do so reliably, and might risk missing a big chunk of the move by getting out too soon, or exiting at a good time but failing to get back in? Maybe you'd put some money in as a "buy and hold", and then have another chunk where you add some size into the 20-40% corrections to juice your returns? If so, how much would you allocate to each?

What would be your approach?

Percent of total net worth is a tricky one, let's say that you have a pot of speculative capital that you use for such things, segregated from other money that is long-term invested in a diversified way (i.e. you don't plan to trade or speculate with it).

If we're talking stocks or RE, something that throws off income, and assuming I had no other remotely good ideas, I'd put 100% of the money in (no leverage). I wouldn't reduce the position in anticipation of corrections, but if we assume I had more spec capital becoming available over time (non-reinvested dividends or interest, money from job or other investments, etc.) I would try to boost my position during the bears, or even take on a modest amount of leverage (110%-120% position). If deploying leverage, stops would be used here to minimize the risk to my initial capital. Sell everything into the blowoff.

If it's something like gold, oil, or similar investments with no cashflow or intrinsic return, I'd probably put 70% in initially and average up during the bears.

 

[Specterx]

Quote from Ghost of Cutten:

Well, putting on the position and sitting is definitely one approach. I've avoided that so far because if I see a 15-30% correction coming, I dislike the idea of staying long during it. What usually happens is I spot the correction and sell a bit early or a bit late, the market goes down about another 10-15% from my sale point, and then that is the bottom. The market makes no obvious "buy signal", and either fucks around for a year slowly creeping back up without me going long, or rapidly rebounds, looking overbought the whole way back up, and I end up buying a smaller position back at higher prices, or missing my re-entry entirely (got better at avoiding that though).

It depends on a lot of things. If we had some way to know in advance the stats you gave in the first post, and assuming you cover the opportunity cost (e.g. other trade ideas you might have), it seems obvious that you should put 100% of your risk capital on. Making 10x-20x your risk with an 80% win rate is a fantastic play, corrections and bear markets in the middle are just noise if you're confident in the stats.

The problem of course is that we don't necessarily know the numbers in advance, so in practice you'd probably want to risk less of your spec capital and none of your other savings, certainly not all of your net worth. Purely technical plays are different from something with a fundamental story, assets like stocks, bonds and RE that throw off some cashflow and are subject to external valuation constraints are different from grains or gold or tulips. With certain investments (I'd say at least energy, currencies, and third-world markets) you're exposed to unpredictable risks - violent supply/demand shocks, political or policy risk - that argue for greater prudence than buying U.S. stocks or real estate at a valuation low.

Given the scenario you set out it seems best to avoid trying to trade the corrections at all, unless you have a robust method for doing so, or you're willing to pay up a bit in missed opportunity to bank some profits and keep your mind at ease.

 

[Ghost of Cutten]

Quote from Daal:


So in my view the way to go is to have as default 100% of the position except when you have STRONG evidence that something is going to happen, if it's just a 'worry' or 'feeling' its not enough, if one is not good enough of a short-term trader than you keep the full position(and decrease to the level where the vol doesn't hurt your sleep). You might decrease the position in the other scenario I mentioned(you keep making money and decrease because the bull market is playing out and expectation is getting worse, you dont want to be an JSDU ex-millionarie)

Ok that's a good approach. Another way I've heard it described is "don't sell out unless you would sell short". I think that is probably the best overall way to trade these kind of moves. Split it into part "buy & hold" without any timing, on small size; and another part where you stay long except when you think it's a short sale in the near-term. Also, there's nothing wrong with partial decisions, it doesn't have to be 100% long or sell out everything.

I think this is probably what I'll aim towards, there are some good ideas from people in this thread.

 

[Ghost of Cutten]

Quote from sprstpd:

Note: this will come off as bragging and since I never post about my results on this forum, may be hard for people to believe. However, its funny this thread found me just when I was thinking about/fighting with the same issue.

I make my living by daytrading. But I do read people like Fleckenstein and Kuppy for longer term investment ideas. And because of them I took a large position (for me) in gold, silver and other commodities when gold was around $700. I exited all these positions at the open on November 9th, 2010 because I just couldn't take it anymore. The large gaps in all commodities that morning on top of their previous monster moves just made me sell everything (not to mention Rearden Metal's silver call the previous evening). I really didn't want to sell those positions and I hope to build up my gold and silver positions again (I have nibbled a bit here and there on this move down). I.e., I feel naked without some exposure to gold and silver and I feel we are not at the ultimate top in the precious metals.

So I am attempting to time a short term correction in this market and so far it is going okay. My position currently is about 1/10 of what it was going into November 9th so I have certainly dodged a bullet. However, who is to say gold and silver don't take off without me? I don't know the answer to that. I would hope that I would have the balls to get back in these positions if they were to power higher. Maybe set a buy-stop if certain prices in gold and silver get violated and I do not have my full position on? I.e., if I am incorrect, my stop will guarantee that I will get back in the position (but maybe at higher prices). However, I certainly have no stops in currently - I am just hoping for lower prices to reload.

I guess to summarize, here is what I think might be a decent "method":

1. Buy a core position
2. Never sell until the opportunity seems so ripe for a correction that you physically get ill thinking about it
3. Attempt to reload at lower prices but always have a buy stop for reentry
4. Wait for the ultimate blow-off top to unload for good

This thread was inspired by exactly the same thing. I am long-term bullish but thought things were getting overdone. I took some profits (not as well-timed an exit as you) and am sitting on a core position, waiting for an opportunity to reload. In the past, sometimes this has worked well, other times it hasn't.

I agree you need a "buy back stop". Otherwise, you risk the market running back up and you missing the move, or having to buy back way higher. IMO the best approach to this is to treat the temporary exit not as profit-taking, but as a separate outright short sale.

If you think about it, the criteria for a short entry are much stricter than for conventional profit taking - and the criteria for covering a short are much looser. You only short when you are very confident it's going down - and you cover your short as soon as the market gets rather oversold, or you no longer see a clear downside bias from current prices. Whereas with profit-taking on a long position, you exit once things get unclear, and buy back only when things look clearly bullish.

The thing with major bull markets is they tend to go up more than normal, and the corrections often end suddenly with little warning...or just fizzle out, then the market creeps up 10-15% over a month or two without any clear buy signal. So normal profit-taking and re-entry methods don't work very well. Whereas normal short-sale and cover methods work well i.e. be very selective 'shorting', and be quick to cover as soon as the downside bias is no longer there.

IMO that might be the way to try and time these kind of moves, if you think you have the timing skill to do it.

 

[Ghost of Cutten]

Quote from Specterx:

It depends on a lot of things. If we had some way to know in advance the stats you gave in the first post, and assuming you cover the opportunity cost (e.g. other trade ideas you might have), it seems obvious that you should put 100% of your risk capital on. Making 10x-20x your risk with an 80% win rate is a fantastic play, corrections and bear markets in the middle are just noise if you're confident in the stats.

The problem of course is that we don't necessarily know the numbers in advance, so in practice you'd probably want to risk less of your spec capital and none of your other savings, certainly not all of your net worth. Purely technical plays are different from something with a fundamental story, assets like stocks, bonds and RE that throw off some cashflow and are subject to external valuation constraints are different from grains or gold or tulips. With certain investments (I'd say at least energy, currencies, and third-world markets) you're exposed to unpredictable risks - violent supply/demand shocks, political or policy risk - that argue for greater prudence than buying U.S. stocks or real estate at a valuation low.

Given the scenario you set out it seems best to avoid trying to trade the corrections at all, unless you have a robust method for doing so, or you're willing to pay up a bit in missed opportunity to bank some profits and keep your mind at ease.

Yeah - so being more "robust" about forward-looking stats (i.e. future performance is usually worse than past...and you have to anticipate a grey/black swan on occasion), we would probably end up at similar numbers. I agree that things with some yield value (so long as you are confident on the fundamental analysis) and fundamental valuation appeal can support bigger positions. And pure technicals alone is somewhat riskier than technicals along with cheapness or great fundamental headwinds.

Also we need to distinguish between how much capital you put in to the idea, and how much you risk. If you invest 40% into the S&P 500, then you are not risking 40%. Even in a 1932 scenario, there is an underlying value there. If your entry was timed remotely well, then even in a 2008-style crash your real risk is probably a 30% drawdown. So if you invest 40%, your most likely max loss is around 12% of capital, which is painful but not critical.

Regarding the corrections, from other posts here I am leaning towards the idea of at least scaling back or buying puts, but only if you would view it as an outright short (i.e. if you had no view on the long-term appeal, you would short it today purely as a timing play because the setup is so clear for prices heading lower). If your timing is at all competent, which it should be as a trader, your worst case should be that you take a small loss on the short. So if your long-term play goes up 300%, maybe you make 270% because your options expired worthless, or you kept getting stopped out of your timing "short sales". Given that it can protect you from 25-35% drawdowns, maybe halving their severity, that can not only improve your profits, but also improve your ability to stay with the position and add to it. It's much harder to hold on to something that just dropped 30%, let alone add to it, if you had a full position on the whole way down. If you cashed out partially or hedged, then it's far easier to reload or even size up into the dip.

 

[Ghost of Cutten]

Here's another thought - what if some ultimate tops are not so obvious? Ok, something like early 2000 was a blindingly obvious high risk situation for internet & tech stocks. Most aware speculators realised that housing was very bubblicious before it finally crashed. But what about commodities in 2008? You didn't have the crazed retail participation that bubbles normally have, this was very much a "professionals" blowoff top, and arguably wasn't even a bubble (many commodities are now above those prices), yet there was a giant crash.

So, the "sell if it is a near-term short" technique would seriously save your ass in this situation. A "hedge with OTM puts when the market goes parabolic" would also save you from the worst. Whereas the "hold on until the ultimate blowoff top" would not. The latter approach relies on you being nearly 100% accurate in being able to stop "the top", and if you get blindsided when some other factor comes along to turn a normal correction into something very bearish, you're there sitting fully long saying "ok this looks bearish and will probably be a 30% correction, but I'm staying long because ultimately it's going higher" as oil goes from 147 to 36. Like Jim Rogers did.

Ultimately we can't overlook the risk part of the equation, especially if punting with big size.

 

[jack hershey]

Quote from Ghost of Cutten:

Let's say you identify an early stage bull market. Your analysis and past experience indicates that the market will go up at least 300% in the next 5-10 years, maybe 500%+. However, it will almost certainly have 2 or 3 corrections and short (3-9 month) bear markets of 20-40% during this period, and will eventually end so, how much would you allocate to each?

Snip.....

What would be your approach?

You started an interesting thread.

The Bull/Bear time horizons are always in effect.

And money is there to be made on most faster time horizons.

Fortunately, as it turns out those who let you trade will allow you to use a multiple strategy as long as it exceeds their time horizon in part.

So this opportunity allows you to apply a multiple of your total capital to at least two opportunies that are concurrent.

sprstd outlined one of them, sort of.

You "invest" 100% of your capital in a long term situation to make the 3 to 500%. For as long as I have known some traders (many years), they have done such.

Now, to deal with the other 100% available. You can use the first 100% as collateral to trade shorter term in three ways, all leveraged:

1. Intraday,

2. Position trading, and

3. Sector rotation.

A nice set of 4 examples are:

For investing, gold and lithium either as metals or concentrated ore.

For trading:

1. There are about 80 exchanges for high velocity income using margined indexes. Go for a multiple of the ATR daily. The capital limit here is 5 times the market capacity using partial fill trading. Sweep weekly into 2.

2. Position trading stocks @ 10 % a turn where 40 to 100 turns a year are the norm. 12 streams at 100,000 share stream capacity is good. Use block entry and exit where 20 blocks get you in and 30 blocks get you out. Sweep weekly into 3.

3. Here you have performance @ 250% a year and a selection 15 to 25 stocks that parallel your investment grade for the collateral 100%. The list is returns at this level for at least three years out.

If you go to metal claims instead of concentrated stored ore, you can collateralize it twice. One way was cited above. The additional use is to collateralize performance bonds on large federal military construction projects. Projects are multiyear and they do not fail because the military will not allow that.

Gold is Bull/Bear contrarian but as you see there is a great deal of "lag" in the market/bulliion relationship.

Boliva IS the major lithium site of concentration. An additional positive factor is the control of the resourse. It is political and therefore, not incentivize in the ordinary sense. Immenent shortages will be recognized too late and that will be a cool kicker. Also the extraction science is misdirected.

You may want to deal in water rights if you are sophisitcated. Lake Mead is just being noticed as a western water supply failure. It is back to the first fill level in 1937 as of this week. Frequent western fliers have seen Lake Mead divide into two smaller reserviors already. Check out the Colorado River Tribal Council; their water rights are as nations under treaty.

For the very sophisticated, acquiring contemporary negative resouces is the most promising as a rolling 100% form of collateral. You acquire, reverse the negativity, roll capital and profits into the next negative resourse. This is called problem solving.

 

[Ghost of Cutten]

Quote from promagma:

In the GLD example, you lose $1.50 per year to time decay, but gain some advantages -

- Fixed risk in case of catastrophic drawdown
- No stop loss - in case of catastrophic drawdown you won't get shaken out if it recovers within 1 year
- Compound your profits

Definitely a roller coaster ride but IMO it may be worth it.

I like this idea as a way to add size after the corrections, whilst limiting risk in the case that you're wrong and it's actually the end of the run and now turned into a proper bear market.

For example, if you were already long gold in late 2008, it may have been unrealistic to expect you'd be willing to double down on outright long positions during that carnage. But risking a fixed amount in LEAPS on GLD or gold miners would have been perfectly acceptable, as you can tone down the risk as much as you want.

 

[Ghost of Cutten]

Quote from Daal:

I did had better evidence on the fed futures, there I just knew Dec 2011 selling at a 5 bps discount to the fronts was a huge joke that had to be sold.

This could actually be a great independent strategy - simply wait for any market price that becomes "a huge joke that has to be sold", then fade it

 

[Daal]

Quote from Ghost of Cutten:

Here's another thought - what if some ultimate tops are not so obvious? Ok, something like early 2000 was a blindingly obvious high risk situation for internet & tech stocks. Most aware speculators realised that housing was very bubblicious before it finally crashed. But what about commodities in 2008? You didn't have the crazed retail participation that bubbles normally have, this was very much a "professionals" blowoff top, and arguably wasn't even a bubble (many commodities are now above those prices), yet there was a giant crash.

So, the "sell if it is a near-term short" technique would seriously save your ass in this situation. A "hedge with OTM puts when the market goes parabolic" would also save you from the worst. Whereas the "hold on until the ultimate blowoff top" would not. The latter approach relies on you being nearly 100% accurate in being able to stop "the top", and if you get blindsided when some other factor comes along to turn a normal correction into something very bearish, you're there sitting fully long saying "ok this looks bearish and will probably be a 30% correction, but I'm staying long because ultimately it's going higher" as oil goes from 147 to 36. Like Jim Rogers did.

Ultimately we can't overlook the risk part of the equation, especially if punting with big size.

The thing with these changes is that while usually its hard to be a good short-term market timer it should be even harder if there is a bull market going on and you want to fade it, particularly when we are talking about assets with long-term risk premiums

If we consider the premium as a 'commission bid/ask spread' type cost, then almost no sane person would trade it. Which is why one needs a HUGE reason to get smaller, like it needs to be really obvious, otherwise it pays to stay on it and earn the premium