I’ve decided to keep this blog on ibankcoin specific to trends. To keep this blog on topic I made a post at stocktradinginvestments.com titled Kelly Criterion Shows Decreased Correlation Increase Return. The short version is the picture worth a thousand words.
Reducing correlation (and thus increasing your independence of your bets) is important because you can reduce your draw-down, or increase leverage in multiple uncorrelated names and keep the same draw-down with higher long term returns. If you lose 20% you need 25% gain to make up for it, but if you are invested in uncorrelated assets, a 20% loss will be much smaller as your overall portfolio, even if you have multiple uncorrelated bets with leverage. That is the idea.
What’s this all have to do with trend following?
As great as it would be to go “all in” in the best possible area and get every single call right, that isn’t realistic.
This is why I propose you set minimum holdings for risk on assets (stocks,natural resources&commodities,etc) and minimum for risk off assets (currencies&cash, bonds,). But also consider other lowly correlated opportunities. Depending on the trend, you would adjust your weightings, but not necessarily neglect opportunities if it keeps your portfolio’s correlation low.
When stocks go down when you expect them to go up, if you are 100% invested in stocks you not only are down in your position, but you also lose in opportunity to rebalance at lower prices, and in some extremes even change your allocation to be more aggressive. There is a fine balance between trend following and value investing. Value investing principals would suggest that if you are bullish if a stock is at $100 you should be more bullish if a stock is at $90. Trend following is often, but not always, in conflict with this, especially in individual names vs indices. This means you have to be positioned within a trend both to take advantage of the directional move, and also to take advantage of fluctuations in prices away from the trend (contra-trend moves), and to position more heavily if the signals are stronger. But unless you are 100% certain or the move severely outweighs the downside of it going against you, you do not want to be 100% in any asset class. Additionally because daily and weekly volatility (noise) exists within a monthly trend, it still may be right to have some funds you can transfer, despite also being “right” about trend direction since we still may have opportunities to add stocks lower in a monthly uptrend, or add to TLT or “risk off” trade at a lower price in a monthly downtrend (downtrend in equities, that is). For this reason we set parameters.
So we set parameters of maybe 75% maximum and 25% minimum for both risk off (bonds) and risk on (stocks). (You could certainly go with less or more depending on how you want to push your risk, and maybe make an exception or two). We also want to keep what we learned from the linked to post in mind and make sure an area of low correlation has it’s place.) Having this much is a bit more for longer term traders and contrarians looking to preserve enough cash in the event of a big plunge. If you are more nimble and more accurate go ahead and change this, but the rare times you get caught long in a big decline or vise versa, you will often make up for all the opportunity you missed out prior to the big run. Another solution would be to find more pair trades and hedged positions.
Overall though, you have to not only keep track of the trends in stocks, but in the alternative investments.
To keep things relatively simple, I came up with a general guideline to follow for stocks. I started with defining what type of trend we are in . We can be in 4 trending conditions:
Monthly trend up, weekly trend up
Monthly trend up, weekly trend down
Monthly trend down, weekly trend up
Monthly trend down, weekly trend down
Then I threw in overbought and oversold conditions. Within each of those trending conditions there are 4 possibilities. Either no extremes, weekly extremes, monthly extremes, or both weekly and monthly extremes. This gives us 16 potential scenarios to account for. (In reality there are more because 3/4ths of the trend signals for example can signal an uptrend) If you want to use The PPT OB and OS signals there are 32 potential scenarios.
The simple way is rather than make 16 more adjustments, to just note the 16 conditions first then as a rule of thumb subtract 10% from stocks and add 10% to bonds when PPT OB and -1% from stocks and +1% to bonds every additional 0.1 OB points it gets. And for PPT OS to add 10% to stocks and subtract 10% from bonds and add +1% to stocks -1% to bonds every additional 0.1 OS it gets. A more complicated solution would more aggressively sell the overbought signals and more cautiously buy the oversold signals when weekly trend is down (but not oversold), and more aggressively buy the overbought and more cautiously sell the oversold when weekly trend is up (but not overbought).
Then I went through each condition and came up with a potential allocation. To keep it less complicated I just chose “Arbitrage” as the low correlation play mixed in with “treasury bonds” and “stocks”. In reality, “gold” “natural resources” should be considered for “risk on” plays as well. And “currency”should be added in addition to “bonds” for “risk off” plays. Adding in MORE lowly correlated assets and using leverage when appropriate will increase return without at the expense of volatility and long term growth.
In some conditions, leverage is allowed to be added depending upon the asset class.
Since originally writing this article, I decided to keep an eye on these as a guideline, but to change the individual assets. So the principals remains in tact of what percent is “risk off” asset and what percent is “risk on” and what percentage is “arbitrage” or “minimal correlation” to the rest of the portfolio. But the actual percentages changes based on trend.
As you saw in my most recent post the trend trader, I came up with a sort of “model portfolio” to follow in the current conditions. In reality, I may shift a lot more heavily to arbitrage if the deal is right and I may leverage it if the deal itself does not seem to require leverage. For example, if Apple or Google bought something smaller, they would probably have enough cash on their balance sheets and the concern of the deal going through would not depend on availability of credit. If the economy turns south in a hurry as it is vulnerable to do in a monthly downtrend and weekly downtrend, or monthly downtrend with a weekly overbought condition, deals can fall through, so avoiding leverage, keeping that percentage of your portfolio towards arbitrage small, and being cautious makes a lot of sense. There are those I know who just trade pre earnings both long and short certain names, This would be a pretty low correlation type of trade so “arbitrage” when market isn’t vulnerable to sudden credit contraction and rising LIBOR rates isn’t the only way to have a near 0 correlation, it’s just the one I am going with. Earnings has larger moves in a short period of time and may require greater number of trades at a smaller position size to reduce potential for a large downside swing in portfolio size. What I am trying to communicate here are the PRINCIPALS though…
You can use the trends, or use value weighting or whatever signal you want for adding lower and selling higher via rebalancing, or more aggressively repositioning your allocations. But A very often overlooked goal is how your overall return on risk within a portfolio comes out. And to do that, it requires multiple assets with low correlation weighted towards which ones have a higher probability of equal upside/downside or greater overall edge, and a focus on low correlation. Once you can accomplish that, you can determine your return based upon leverage and how aggressively you position one way or another.
I have another post I will work on that further illustrates this difference in leveraging up your returns vs no leverage given everything else is roughly the same.If you enjoy the content at iBankCoin, please follow us on Twitter