In the last edition of the Trading Tutors Newsletter I wrote an article about picking strong or weak sectors and choosing long or short trading opportunities within those sectors. The main focus of such a top down trading methodology is quite simple, however, it still requires some directional analysis when opening positions – be it Elliott Wave/ breakout trading or using technical indicators. In times of extreme volatility the flaw with any directional trading methodology can be found in the risk mitigation strategy; namely the use and positioning of stop losses.
For most traders, the typical daily ranges we have experienced over the last weeks and months will have made position sizing and stop loss positioning particularly difficult, often the case may be that your analysis is correct, but the position is stopped before there is a chance to make a profit.
There are some trading strategies that you can adopt in these times in order to reduce the level of risk and that can also benefit from the results of your sector analysis. In financial mathematics, trading risk is subdivided into two broad categories: systemic and non-systemic risk. Systemic risk represents that which can affect all securities in the same class and cannot be eliminated by the process of diversification. Non-systemic risk is all other risk, but in reality is made up predominantly by the risk for the individual security. A simplified example could be found in gold miners. The systemic risk is that the price of gold might fall drastically overnight (effecting the earnings of all gold miners), whereas the non-systemic risk might be that one particular gold mining company could have a cease in operations due to mine collapse (effecting that company alone).
With this knowledge it becomes easy to ‘hedge’ out the overall market risk whilst still maintaining an element of potential gains. For any CFD trader, this is a style of “pairs trading”. First, find a sector that is outperforming (or underperforming) its peers and the overall market by using the relative comparison tool in your ProfitSource.
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The RSC tool makes recognising the outperformance obvious and is confirmed alternatively represented by the split screen charts below.
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Next, take a long or short position in the sector (long the XEJ in this example) and an inverse long or short position in the overall market index (short the XJO in the example). Now, if the market drops 600 points overnight you are hedged against this risk and (should the sector you have chosen continue to out/underperform) you still benefit from your analysis.
The position sizes should be as close to cash neutral as possible in order to make the hedge effective. With some further analysis and practice it becomes a good way of reducing your exposure to volatility in the market place – why would you care if the market drops 10% overnight if you are both long and short at the same time?!
Of course there remains the risk that the sector falls and the index rises, but in this instance you have placed your stops based upon a dollar loss amount, rather than technically positioned on the charts.