VHF News

Google Trends: Recession

2011-08-09T09:01:00.003-04:00

Just for fun, search using the keyword "Recession" on Google Trends and you'll see results above. FWIW, folks aren't searching for a recession as much today as they were in 2008.

CME Price Limit Guide

2011-08-04T11:10:00.004-04:00

On days like these, it's nice to review the price limits for equities and futures. You can find information on the CME Price limits at this URL:

http://www.cmegroup.com/trading/equity-index/price-limit-guide.html

The limits are (generally) 10%, 20% and 30%. According the the CME, here's how the 10% limit works:

The 10 percent limit is initiated if the lead month futures contract is limit offered. Once this has occurred, the limit is in effect for 10 minutes. This means you cannot trade below the limit, but it doesallow you to trade at or above it. Once the 10 minutes has expired one of two things can happen. If the lead month futures contract is not limit offered after 10 minutes, trading will continue with the 20 percent limit in effect. If the lead month futures contract is limit offered after 10 minutes, trading will halt for two minutes. Once the two minutes has expired, trading will resume with the 20 percent limit in effect.

Under NYSE Rule 80B, the 10 percent price limit is not in effect after 2:30 p.m. ET (1:30 p.m. Chicago time). Therefore, after 1:30 p.m. Chicago time, the 10 percent limit is removed and the 20 percent limit would be in effect. For example, if E-mini S&P 500 futures were down 5 percent at 1:30 p.m. ET, the 10 percent limit

See the CME Equity Index Price Limits FAQ (pdf) for more information.

As we age, should we 'cut back' on equities?

2011-07-15T09:04:00.007-04:00

We've long maintained that the investor should tilt their asset allocation away from stocks as they grow older. Professor, Jeremy Siegel in his book "Stocks for the Long Run"argues a contrasting view. However, a recent article by University of Chicago's Lubos Pastor and University of Pennyslvania's Robert F. Stambaugh in The Journal of Finance, "Are Stocks Really Less Volatile in the Long Run?" suggests that we rethink the use of stocks in our retirement planning, even for distant time horizons. Here's the abstract:

According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties reduce desired stock allocations of long-horizon investors contemplating target-date funds.

View Full Article (pdf).

Mark Thoma looks at Fed's exit strategy

2011-07-14T20:21:00.001-04:00

Comparing American and Japanese Economics

2011-07-08T13:24:00.002-04:00

Michael Schuman at The Curious Capitalist asks, "Is America facing a Japanese future?" and Clive Crook at The Financial Times examines the American flirtation with a Japanese fate.

The global recovery may backslide

2011-07-01T14:14:00.001-04:00

In a Project Syndicate commentary, Stephen Roach writes:

The global economy is in the midst of its second growth scare in less than two years. Get used to it. In a post-crisis world, these are the footprints of a failed recovery.

The reason is simple. The typical business cycle has a natural cushioning mechanism that wards off unexpected blows. The deeper the downturn, the more powerful the snapback, and the greater the cumulative forces of self-sustaining revival. Vigorous V-shaped rebounds have a built-in resilience that allows them to shrug off shocks relatively easily.

But a post-crisis recovery is a very different animal...

Brad Delong and Jim Grant talk about QE3

2011-06-16T13:00:00.001-04:00

Using Google Finance to visually back-test portfolio performance

2011-06-09T09:22:00.007-04:00

We've recently discovered that one of the under-appreciated features of Google Finance is it's ability to graph the results of your custom portfolio -- AND compare (graphically/visually) the performance of your portfolio to other indices, etfs, stocks, etc.

Here's how:

First you must create a portfolio on Google Finance. According to Google's instructions, to create a Google Finance portfolio you first need to create a Google Account. Once you have a Google Account, creating a portfolio is easy:

Click the Portfolio link in the left navigation bar of the Google Finance page.
Click Create a Portfolio on the right side of the page.
Name your portfolio, and click OK.

Now you're ready. For example, below is a sample portfolio that we quickly created using Google Stock Screener with criteria that we though would tilt a basket to give it extra oomph.

We then clicked on the "Compare to S&P500" check box to see how it looked over the past year relative to the index (not so good it turns out). However, we can get a quick and easy visual representation of it's relative volatility and performance.

The QE2 Effect: How far out of whack are interest rates?

2011-06-07T09:05:00.000-04:00

"QE2" may soon be ending. Unless you've been living under a rock for the past few months, you're probably aware that Quantitative easing is a monetary policy tool used by our central bank to stimulate the economy because conventional monetary policy has become ineffective. The central bank creates money by buying government bonds and other financial assets, in order to increase the money supply and the excess reserves of the banking system.[1] This action also raises the prices of the financial assets bought and simultaneously lowers their yield.

Many people are wondering what happens when QE2 ends? Will there be a QE3, QE4, ... QEn? And, what impact will the end have on interest rates?

For a hint, let's look at the historical relationship between short US rates and longer term US interest rates. Please remember that the slope of the yield curve and the spreads between short term and long term rates may (sometimes wildly) fluctuate in "stable" and "normal" times, so any insights that we glean from our graph are tentative at best. We're not sure where interest rates are heading, nor are we certain what the slope of the yield curve will resemble in the future. However -- from the graph above -- it appears that QE1 and QE2 may have impacted the short end of the curve much more than the longer end, which isn't news to anyone -- that was the intent of QE. Because the Fed had cut short term rates to the bone, they looked farther out on the yield curve to (attempt to) push rates lower. (Mark Thoma wrote a simply excellent overview back in 2010).

Our goal isn't too critique Fed policy. We're simply examining the rough relationship between long and short term interest rates in order to gauge what a reflux to normalcy might look like. The curve may stay the same for decades or it could invert next week: Some outcomes may be more probably than others, but we feel it is important to consider the historical relationships when we form our views concerning future contingent possibilities.

VHF Risk Tool

2011-06-01T12:22:00.003-04:00

We're working on a new tool to help individuals simply and easily analyse the risk that they have in their portfolio.

The beta version will soon be available at http://risk.virtualhedgefund.com

Burgers and Steak Indices

2007-05-29T22:34:00.001-04:00

Are burgers and steaks good economic predictors? Let's look at 2 indicators -- the Big Mac Index and "The Steakhouse Index".

The Big Mac index is an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. As stated in the Economist, it "seeks to make exchange-rate theory more digestible"... [the] index was introduced by The Economist in September 1986 as a humorous illustration and has been published by that paper annually since then. The index also gave rise to the word burgernomics. ~ wikipedia

The Steakhouse Index
If steak stocks are down. Should we worry about the rest of the economy?

"If you want to understand how high energy prices are impacting the economy, you could spend your days reading the Wall Street Journal or consulting with economists. Or you could go have a really expensive New York strip steak at the Palm or Morton's."

High-end steakhouses have expanded rapidly in recent years thanks to an economic expansion, the popularity of cholesterol-reducing statins such as Lipitor, and the low-carb/high-protein Atkins/South Beach diet crazes. You'll now find outposts of Morton's, Ruth's Chris, and several competitors in all the best suburban strip malls, edge-city shopping districts, and gentrified downtowns.

The financial results of these testosterone-filled cow palaces reveal much about several trends affecting the U.S. economy.

Read more at Slate

Correlation trade is extreme sport for hedge funds

2007-05-24T13:48:00.000-04:00

From Reuters,

To strip out the impact of the underlying index, dealers use the concept of correlation, a controversial measure of how the prices of individual components of a portfolio might move given various scenarios such as an individual default or bad news in a particular sector.
Five-year iTraxx correlation is currently around 17 percent, the highest level for 18 months but still below the 22 percent peak seen in April 2005, before the so-called correlation crises sparked by the downgrades of U.S. automakers Ford ... and General Motors...
Correlation is a measure of idiosyncratic risk over systemic risk, and there are no agreed method of measuring it. The general principle is that if correlation is higher, idiosyncratic risk is lower, because it is less likely that an individual company will default.

Continue reading Correlation trade is extreme sport for hedge funds

How Worrisome Is a Negative Saving Rate?

2007-05-23T13:57:00.002-04:00

Charles Steindel of the Federal Reserve Bank of New York writes,

"The U.S. personal saving rate’s negative turn in 2005 has raised concerns that Americans may have to curtail their spending and accept a lower standard of living as they pay off rising debts. However, a closer look at saving trends suggests that the risks to household well-being are overstated. The surge in energy costs may have temporarily dampened saving, while the accounting of household income from stock holdings may be skewing saving estimates. Moreover, broad measures of saving have remained positive, and household wealth is on the rise.

Personal saving has been negative since the second quarter of 2005. For 2005 as a whole, current data from the Bureau of Economic Analysis (BEA) show a personal saving rate of -0.4 percent—a figure that dropped to -1.1 percent in 2006. These readings are well below the 1999-2004 average of 2.2 percent, a good deal below the 1993-98 average of 4.6 percent, and considerably below the 1950-92 norms of 8.6 percent.

Negative saving would seem to point to growing indebtedness and, ultimately, a decline in living standards, as Americans tighten their belts to pay off debts. As Mr. Micawber noted in David Copperfield, “Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”

Concerns that negative saving could jeopardize U.S. household well-being suggest that a closer look at the recent saving trends and their sources is warranted. In this edition of Current Issues, we identify some of the forces depressing measured personal saving, examine how broader saving measures have fared, and assess the likelihood that low saving rates will constrain consumer spending and impede growth in the nation’s living standards in the near term."

Anticipating Fed Action with Binary Fed Funds Options

2006-07-31T10:20:00.000-04:00

The CBOT writes, "binary options have two possible outcomes, and final contract settlement is either a fixed dollar amount or nothing at all. When the options expire, “in the money” options pay $1,000 to option holders, while those that are “at the money” or “out of the money” pay zero. Strike prices for the new CBOT Binary options correspond to the Target Federal Funds rate using a formula of 100-minus the actual Target rate. For example, a Target Federal Funds Rate of 5.25 percent would be reflected as 94.75. Expiring options are cash-settled and based upon the most recent Target Federal Funds Rate level established by the FOMC. The options will expire on the last day of a regularly-scheduled FOMC meeting.

Binary options on the Target Federal Funds Rate trade from 6:00 p.m. to 4:00 p.m. CT Sunday through Friday. Trading in expiring options ends at 2:00 CT on the final trading day. The Exchange has contracted with two firms to provide two sided markets for the new contract during daytime hours."

For more information, visit the CBOT's Binary Options and also read Anticipating Fed Action.

Is it ephemeral-financial-media-buzz or is it real?

2006-07-25T23:10:00.000-04:00

Google Trends analyzes web searches to compute how many searches have been done on a particular topic and how frequently the topic has appeared in Google News stories. So, for example, if you're wondering if the topic of "stagflation" is appearing more frequently in the news and other media flabbergasts, you can check Google Trends to verify your inclination.

See also: Nouriel Roubini discusses the potential uses and caveats of 'Google Trends' as an economic barometer.

Tour de Investing

2006-07-25T08:18:00.000-04:00

In What I learned watching the Tour, the FinanceProfessor parallels the steps necessary to win the Tour de France and successful investing.

Are future fed rate cuts implied in the yield curve?

2006-07-25T08:05:00.000-04:00

Econobrowser makes a case (not necessarily one that we agree with) concerning the potential future course of fed rate actions by examining the shape of the yield curve.

Econobrowser writes,

If we were to trust the expectations hypothesis at the moment, what would it tell us? The initial sharp upward slope suggests that investors expect one more Fed rate hike to come soon, perhaps the next meeting. But the fact that the yield curve then begins to slope sharply down suggests that investors are betting on rate cuts later on-- otherwise, rolling over 6-month bills at 5.23% would beat any longer-maturity bets.

And what kind of scenario would have the Fed reversing course and starting to lower rates 6 months from now? Given recent inflation observations, it's hard for me to imagine the Fed lowering rates in the near future unless we get a significant slowdown in economic activity that makes it worry a lot more about the prospects of an economic recession. [more]

A Quick and Dirty look at TIPS

2005-04-25T10:40:00.000-04:00

As follows is a brief overview of an instrument we're examining as a somewhat aggressive surrogate for "cash".

VHF members should know when we talk about “cash” we examine not only overnight instruments, but the entire fixed income area, including Treasury Inflation Protected Securities (TIPS) or as they’re sometimes called - Treasury Inflation-Indexed Securities (TIIS). For the sake of brevity, we’ll identify the entire class as “TIPS”. If you are an individual investor, you have few choices your savings account or brokerage money market. If you have a margin account you have more choices like T- Bills, Notes, Bonds, or even 5 - 30 year TIPS. Because TIPS can theoretically trade at a discount to par prior to maturity, you may want to use TIPS only if you can hold them to maturity. The Commitment by the US Treasury
The Treasury is committed to developing the market for Treasury Inflation-Indexed Securities. These types of fixed income instruments offer investors a unique asset class that make a distinctive contribution to any diversified portfolio. TIPS also allow Treasury to broaden its investor base and diversify its funding risks. Benefits to Investors of a Unique Asset Class

1. Unique asset class (dollar-denominated, inflation-indexed, full faith and credit of the United States)

Virtually risk-free asset for investors focused on future real purchasing power of their savings.
Low volatility and attractive returns
Closer match to inflation than real estate, commodities, or other real assets

2. Market Big and Growing

Almost $150 billion TIPS outstanding, and about $350 billion inflation-indexed securities outstanding worldwide.
Liquidity in the TIPS market is improving, with daily trading volume having almost doubled in the past year ( to 2003).

As an integral part of Treasury's funding strategy, the expanded auction schedule for 10-year TIPS notes and increased issuance as follows:

10-year TIPS notes make up over a quarter of Treasury's 10-year note issuance.
Smaller investors should note that Treasury offers Series I inflation-indexed savings bonds.
Smaller investors should note that Treasury offers Series I inflation-indexed savings bonds.
The Investment Environment

In this environment, with the Fed Funds rate at 1.25 it is difficult for those with income or preservation of principal goals to keep up with the rate of inflation. Saving accounts and brokerage money market rates are currently paying 1.80% or lower not counting fees. But still a plus when compared to the equity market the last three years.

TIPS are designed to protect the buy buyer from inflation. TIPS are backed by the full faith and credit of the US Government. Like other US T-Bills, Notes, and Bonds, TIPS are a benchmark of the risk free rate. In an interest rate environment with Fed funds at 1.25%, 90 day T- Bills at 1.08%, 10-year T-Notes at 3.42%, 30-year Bonds at 4.41%, all at or near historical lows.

TIPS are issued in 5, 10, and 30-year maturities. VHF prefers the 10-year TIPS due to the liquidity and importance of the US 10-year Note. For example, mortgage rates trade off a spread over the 10-year. TIPS have an embedded option. In other words at maturity you are guaranteed par (100). What really makes them cool is the embedded call on inflation. As inflation tracks the Consumer Price Index (CPI), the notes principal increases by the rate of inflation. This is a great play for both conservative and aggressive investors in this low rate environment.

If auctioned on the same day at the same time and price what is the difference between the 10-year US T-note and the TIPS? Currently the yields are 3.42%, 1.75% respectively. Assuming the market is trading efficiently the change in yield 3.42 – 1.75 = 1.67 is the implied rate of inflation. Or you could look at 1.67 as the cost of the inflation call embedded in the TIPS.

Implied Option

Although we are currently in a highly deflationary environment, TIPS are a plus due to their protection against the future reemergence of inflation. Let’s test it by running a couple scenarios of long TIPS positions bought at original auction. If yields drop, the price rises on all notes and bonds, creating a trading opportunity to sell. Keep in mind, if rates go to zero, there is nowhere to reinvest your profits, assuming you want the identical risk free rate. Had you bought the 10-year TIPS (3% 7/15/2012) at last July’s auction at par, you would have received one coupon payment and be currently marked at 110-16 /32. As of 5/28/2003 a 10.5% gain in less than a year – SELL! Approximately, 12.6% annual return (10.5% * 12/10 = 12.6%). If you decide to hold, you have downside risk. Your “implied put option” has 100 strike at maturity. And you will be subject to tax on the gain on principal just like with zero coupon notes. If rates rise, your principal will be at risk to the extent the increase in the CPI is less than the increase in the nominal interest rate.

For those who buy and hold to maturity the Treasury Direct program is ideal. You can buy them through your broker for a small fee or open an account with the department of Treasury. It’s free for accounts less than 100,000 (I think). Then purchase TIPS at auction directly from the Treasury without commissions. If you’re thinking about trading the TIPS, buying via a broker or bank at the original auction (not a reopening) is recommended for custody reasons. Yes, you will pay a commission but the sale of the TIPS is effortless, a big plus. But if you trade TIPS make sure you really understand them. For exact security specifications and how to set up an account, please visit the Treasury website.

Helpful trading rules

2005-04-25T10:37:00.000-04:00

Know your information source. Brokers and many Financial Planners are sales people not traders and get their information indirectly though their organization. And you should question advice from your neighbor or fiend of a friend unless they’re in the business.
Transform information into an idea. If Georgia Pacific has asbestos liability, who else does? How does Microsoft affect other technology companies? This is where R&D and experience count.
Know how much risk you're taking. If you bet the ranch you can lose the ranch. This is key you must understand risk! In best-case scenario your risk reward ratio is limited risk and unlimited reward. The long-term investor outlook is if you buy a stock trading at 20 dollars. Risk is 20 dollars but the potential reward theoretically is unlimited. See VHF article on trading risk.
Always have a trading strategy before you trade. Always look ahead, have a plan.
Always have an exit strategy. Solution to “Murphy’s Law”.
Have courage. Without courage you have nothing. Have the courage to pull the trigger and follow your strategy with flawless execution.
Control your emotions. Insecurity makes you aware and open-minded. Feel comfortable about not knowing. When in this mode the tendency is to hurry-up or panic. Slowdown watch, observe and learn knowing you have an exit plan in place. The name of the game is execution, execution, execution.

Common Trading mistakes that can be avoided

2005-04-25T10:35:00.000-04:00

Flying by the seat of your pants. If you’re a perfectionist don’t trade. Everyone has losing trades but if you believe you can turn losers into winners it’s only a matter of time before you’re broke. Look at long-term capital and it’s two Nobel Prize winners. The difference between a good traders and a bad one is a good trader recognizes when he’s wrong and admits it by getting out. Resulting in smaller losses for his clients.
Averaging down on individual stocks have killed more traders than any other mistake, don’t do it. It’s OK to average down if you’re indexing due to automatic rebalancing balancing.
Don’t trade everyday. This is the biggest problem for professional traders. There are times when cash is king mean and green.
Trading in stocks with no liquidity. No volume has execution risk in fast markets, big volatility, zero research, and little if any institutional holders.
Use a benchmark like the S&P to rate your performance. Many individual investors are happy if they just don’t lose money. The problem here is you may be taking too much risk for the return you’re getting. A benchmark is a way to keep your money manger honest, think of it as a report card.
Ignoring systemic market risk. Does “ all boats rise is a high tide” sound familiar? Individual investors fail to see the risk and don’t sell in broad market down turns. Your stock may be a great stock but is falling due to its affiliation to a particular index. Systemic risk is real and is not ignored by professionals.
Don’t confuse risk (uncertainty) with danger. Understanding risk doesn’t shield you against potential losses. If you understand the risk but make a foolish move you will pay the price.

A casual discussion about Risk

2005-04-25T10:34:00.000-04:00

Risk is the most important concept for all traders and investors. Virtualhedge Fund defines risk as degrees of uncertainly. Risk is the variable between greed and fear, opportunity or the abyss. Determine the risk you are willing to take than practice risk management.

Risk for professionals is based on numbers, this is the world of the quants or eggheads if you prefer. You can read books from our recommended reading list on standard deviation, which is a measure of volatility of a security. Unless stated volatility is the annual standard deviation of the daily price change of an equity security. Quants also have to factor in beta (the relationship between a stock when compared to it’s index), interest rates, dividends, market impact, execution costs, and settlement dates. Traders plug these numbers into proprietary models to calculate risk reward, fair value, arbitrage trades, etc. This is an incomplete summary of how to calculate risk. Entire books have been written on volatility alone. Anyway you get the picture.
Mike one of our subscribers asked if we could give an easy to understand lesson on risk. To start you must find a risk free security. Risk less is defined by securities issued by the United States Treasury. Therefore, the three-month T-Bill is the risk free rate for a ninety-day duration trade. Why? Treasury securities issued by the United States Treasury, these are debt obligations guaranteed by the full faith and credit of the United States government. This means tax collections maybe used to pay the holders of U S Treasuries, making Treasury bills, notes, and bonds the safest investment vehicles in the world given the relative strength of the U S economy.

If Treasury bills, notes, and bonds are the definition of the risk free rate. Any return greater than that of the benchmark Treasury has a level of risk associated with it. The bigger the spread the greater the risk. Zero uncertainty equals zero risk. Let’s look at risk from a common sense point of view instead of by the numbers.

Let’s look at an equal mix and duration of Treasury securities, S&P index, and a basket of technology stocks. Focusing long-term on risk only; Treasury securities are risk-free; S&P rebalancing and large-capitalization components are manageable risk from a equity viewpoint; but as for your technology holdings is it rags (2000) or riches (1999). So you better be a trader. What is your risk? Calculate your expected rate of return for a given time period. If your Treasury duration averages 10 years, today’s rate would be around 4.90%. The average return for the S&P 500 for a 10-year period is roughly 10%. The average return for your technology basket for 10 years is 60%. As a rule of thumb comparing investments of identical durations the U S Treasury has no risk, S&P 500 has less risk than the technology basket based purely on their rates of return. It’s important to realize we compared apples to oranges. Less risk doesn’t equal optimization, which is the highest rate of return for the least amount of risk.
Think out side the box. Focus on duration. Think of risk in terms of time, the longer the duration the greater possibility more things can and will happen. Risk is uncertainty. Compare a thirty-year Treasury bond to a very volatile technology stock, which you plan to hold for 2 days, which has the most risk? Key here is certainty. Due to duration of the Treasury bond, the 2-day trade in a highly volatile technology stock has less risk. The assumption here is even a risky company will still be around two days from now. Maybe it will be gone in a year but we’ll be long gone by then. On the other hand Treasury securities are only risk free if you hold to maturity. Many have lost money on T-Bonds by having a liquidity problem that forced a sale before maturity. In thirty years you may have a medical emergency, buy a house, need cash, or change your investment allocation. No matter how small the probability there is no guarantee the U S will be the super power of the future. Rome didn’t last 1000 years, a limited nuclear war or the emergence of China as an Economic super power could change the standard of risk free securities (today’s Treasury securities). The further we look into the future the greater the uncertainty. We know what interest rates will be tomorrow but have no visibility where they will be ten years from now or beyond. Just remember September 11, 2001. Did you factor in the attack on America in your risk model? Virtualhedge fund has quant models that didn’t have a clue that anyone would attack the World Trade Towers. The most common event risks are merger and acquisition announcements. Event risks surprise everyone; so don’t feel bad if your risk analysis is wrong from time to time.

The important thing is you use your risk evaluation to manage risk. To evaluate you must know what you own. This allows you to “mark to market” (calculate your paper net worth everyday). Before you trade have a plan and exit strategy. The purpose here is to control your losses. See articles on “ VHF trading rules” and “VHF common trading mistakes”. If the trade is risky keep the position small, use stop-loss orders, and never average down. In the end it’s risk management that’s important. Understanding risk is great but if you don’t execute and pay attention to your investments you’re investment will control you. Bottom line you must trust us for ideas, strategies, and information but it’s important you be your own risk manager.

Remember we have no way of knowing exactly what you own.

What is Market Timing?

2005-04-25T10:32:00.000-04:00

Everyone practices market timing in some form whether they realize it or not. Some do it as part of a strategic plan to preserve capital or out perform the market. While others time the market without realizing it. The latter group’s timing is dictated by chance, convenience and other random events that impact their lives.

“Random Timers” sincerely believe that they are not market timers. They may claim to be long-term investors who are well diversified. But the fact is, normally, you don’t receive one lump sum of money at, say, age twenty, to invest and forget. Much of your investment timing is determined by outside influences. This de-facto timing-of-sorts is based upon when you receive income or funds. For example, you may invest biweekly (randomly) due to pay periods to your 401k plans (24 data points a year) or your “timing” may be determined by a rich relative who passes their estate along to you to be invested. You may get fired from your job and temporary postpone investments all together. You could receive an unexpected tax refund, win the lottery, get a year-end bonus, have a family emergency, have a legal windfall or penalty, etc. Asset reallocation is a form of timing the market (one asset class to another) in a macro sense.

Or perhaps you don’t time the market -- you let your financial professional do it for you. They determine your market exposure and “time” when you are more or less heavily invested in stocks.

If timing is irrelevant, then what’s all the fuss?

According to many academic theories, in the long run, timing is irrelevant. Funds relying on vast diversification and duration should outperform market timers. Yet, today, news headlines are filled with reports of hedge fund operators reaping extraordinary profits from “market timing” mutual funds. How do we reconcile these two opposing views? Are excess profits earned from exploiting mutual fund fees; global arbitrage created by differences in settlements, taxes; or front running the mutual fund customer? There are many flaws in the current design of mutual funds. One glaring problem is that many are tradable (by most investors) only at one time during the day – 4:00! The flaw becomes especially problematic – and was apparently exploited by some hedge funds -- when the assets underlying the Mutual Fund or news that affects underlying asset values differ from the daily 4:00 price of the mutual fund.

Many solutions exist – Exchange Traded Funds (ETF’s) that benchmark index performance over a period of years and closed end funds that are tradable throughout the day, not only at 4:00, are two simple solutions. Would investors be aware of these nuances if they read the fund prospectus? But that’s another issue concerning doing the right thing and personal responsibility.

Varying degrees of Market Timing

Professionals have always timed the market. The stop-loss order and many technical analyst methods are forms of market timing. If you really think about it and you are indexed or diversified across all sectors to capture the general trend of all the markets. Financial news and company fundamentals mean nothing. You are all ready fully invested and you plan has already taken into account some investments will fail. You are on autopilot until your plan has come to conclusion or you deem it has failed.

One key to successful market timing is flexibility. The recognition that you’ve made a mistake and can change your investment plan is an essential ingredient. The goal of market timing is to limit losses. In the long run the real key to wealth building is a percentage gain of a very large number not a small one. There are different levels of market timing based on types and subtypes of invest vehicles but many confuse market timing with larger than normal returns -- a risk management subject.

An individual’s asset allocation will change during their lifetime. Factors such as age, economic, income level, situational factors and other risk determinants will affect asset allocation. Asset allocation isn’t static -- the process is continually changing. At some stage, the execution of the plan becomes a timing issue. The micro level, the level at which the strategic plan is implemented, entails market timing, almost by definition.

Framing the discussion

Discussions surrounding the topic of Market Timing seem to depend, in large part, on the advocate’s or adversary’s point-of-view. The technical analyst may indicate that Market Timing is a critical part of portfolio strategy whereas the fundamental analyst and academician will discount its importance. Current headline writers may attempt to sensationalize the term and expand it’s meaning.

So … what is market timing?

At the rudimentary level it’s nothing more than the point in time at which we buy or sell stocks. There are many factors -- technical, fundamental, managing risk, portfolio models, investor utility, market or price levels, and more -- that impact this point in time. Regardless of whether you want to acknowledge the fact or not, if you’re involved in the equities markets, you’re involved in some form of market timing.

A discussion about "Stops"

2005-04-25T10:31:00.000-04:00

At the request of one of our subscription members we wrote this article on stop orders (also know as "stop loss orders) in order to make your exits closer to VHF’s. Our client Mike, asked, "what’s a stop order?" and said it would be helpful if we listed our exact exit points (stop levels) instead of telling members to "set your stops" or "set your stops tight". As I explained to Mike, VHF runs a book. This means we actually run money for wealthy individuals and no professional manager will tell the street their buy or sell points, knowing the competition will use this information to bury us alive! The advantage is similar to front running only legal. For example if you know I’m buying a couple of million shares of MSFT (Microsoft Corporation) at 57.75. Wouldn’t you be buying MSFT at 58? Why not buy at 58 you have unlimited up side while you are protected on the downside ( 58-57.75 = .25) as long as you know that the buy order is still there. I hope now you understand why we do not list specific stop prices, we do it to protect all of us since your stops would be identical with VHF’s. By keeping the competition guessing they cannot quantify their risk.

What is a “Stop Order”, for purpose of execution just shadow us and let your broker do the rest. Educationally speaking stop orders are used primarily to control losses. Here is a simple example we buy 100 shares of MSFT at the above price of $58.00. So now we are long 100 shares of MSFT at 58. Since we always have an exit strategy, as soon as we get confirmation we enter in an order to “sell 100 shares of MSFT @ 57.75stop” some brokers will ask if this is a stop-loss it’s the same thing. Don’t get confused by the fact a sell stop is placed below the market (current market price) while a buy stop is placed above the market. It’s extremely important your broker knows this is a stop order! If not in this example you end up selling immediately and your broker is proud to give you a fill better than you stop in this case 57.75. A sell-stop at 57.75 does not guarantee you will be filled at 57.75. It does guarantee you will be filled if MSFT trades at or below 57.75 but it does not guarantee price in any case. Stop orders become market orders once the stock starts trading 57.75, therefore, the price may vary like any market order. Our stops are part of an exit strategy, price is secondary if the original plan is failing, for this reason we do not use stop-limit orders.

We enter all our stop orders on a “day only” basis rather than a “GTC” (good until cancelled) basis due to lack of liquidity in the pre and after market trading. I could be wrong but I believe the average retail investor has no choice and must enter stops as “day only” when placing stops. Anyway unless you say GTC it’s a day order.

As we explained to Mike earlier we have to keep the competition guessing on where we are placing stops. The most accurate method is to continue to check our web-site in the members “trades and ideas” section this will give you the exact price of VHF’s execution. But as a rule of thumb if we say set your stop tight, hint, less-than two points. On stocks $2.00 or less there is no stop but the trade will be rated very risky or a “day trade”. Hint trades like this should be a very small part of your holdings assume there is real possibility you will lose your investment, think why is this a $2 dollar stock? On stocks trading between $2 to $15 dollars, set your stops at 30% to 50% of the purchase price. Remember this is disaster protection and stops will seldom be the actual exit price. Hint lower priced stocks will carry the 50% stop. All stocks $15 and higher will have stops set between 5% to 25%, again the lower priced stocks carrying the 25% stop level.

I hope this helps you in defining stops placements. Again the best way is check our web-site to confirm our exact exit point. VHF makes money by limiting our losses and letting our profits run or by stacking. And though on low priced high risk trades we a willing to lose 50%, our profit goal on these types of trades exceed 100% annualized return. You as an investor must realize when we talk of low priced stocks $2.00; high rates of return 100% plus, and possible 50% losses. You should be thinking danger and either have nothing to do with this particular trade or have a very small position. Know the risks before you trade.

The United States Treasury defines VHF’s definition of risk. An investment vehicle that yields greater than the equivalent Treasury security with the same duration has risk. For example if you’re a long-term investor the current 10year US Treasury Note is the risk-free rate. Therefore, any investment that yields a return greater than the 10 year Treasury note has risk. The Current 10 Treasury Note yields 4.5%; therefore, any return greater than 4.5% with a 10-year duration has risk. The greater the return the greater the risk, as risk is measured as a spread over the risk-free rate. This is true for any investment vehicle stocks, bonds, housing or whatever. We used the 10year Treasury note as an example for the long-term investor. A short-term trader would use the US 90 day T-Bill as a risk benchmark.

The Stock Loan Department

2005-04-25T10:29:00.000-04:00

Who are players in this market? Many major broker/dealers, banks and large institutional investors have stock-loan departments. Entities that control or own large portfolios have the ability to run or out source a stock-loan department. Custodial banks, and Prime Brokers may help large clients establish lending programs for their portfolios. Brokers have the right to lend stock that is bought on margin (see the re-hypothecation clause in any standard margin agreement).

As stated in our article on short selling, the short seller must locate a stock borrow and obtain a locate identifier before entering the order. The stock loan department enters into the picture by securing the stock to be borrowed and providing the locate identifier to traders or investors who are selling short. Once you locate the stock to borrow it’s important you know your obligations before you actually short the stock. Obviously, if you don’t trade you have no liability but if you decide to short, know your rights and obligations. So let’s define the stock borrow. As with any other loan you are obligated to return it either at a specific time (term) or (open) at the request of the rightful owner. The key to understanding the stock-borrowing concept is to understand you do not own the stock! Therefore, you are not entitled to the stock dividends; in fact you are obligated to pay them. This includes dividends in the form of regular quarterly dividends, special cash dividends, stock dividends, or stubs are all due to the rightful owner of the stock. Anything the owner of the stock is entitled to he or she will receive it at he borrower’s expense. In short, as the borrower you do not have the rights of ownership, voting or otherwise.

Possible problems you must know before you short a stock.

A problem exists when you still have a need to borrow a stock while at the same time the rightful owner decides to reclaim his property. If your stock loan department can find an alternate borrower there is no problem but if no alternate can be found you will be forced to “buy in” the stock to satisfy the lender. This may require a unwinding of the trade before you would like, and in some cases will produce losses. A good example of this would either be a short squeeze or an arbitrage trade known as a reversal. Unless you have a term agreement that is still in effect you are required to return the borrowed stock at the request of the lender. Right? This is technically and legally true but we have all heard the story of the 800-pound gorilla. Ok, so like in every other aspect in life if you’re the small retail client you’re toast. Translation I don’t want to hear it, return the stock now! However, if you’re a player, or the 800 pound gorilla, there maybe an exception. Say broker/dealer ABC owes institution XYZ, which in turn owes bank MMM. If MMM demands a return of the borrowed stock, ABC fails to XYZ, XYZ fails to MMM creating a daisy chain of fails. Since MMM is the anchor in the chain they’re in control. In this case a professional courtesy would be extended if possible due to potential repercussion, as it’s only a matter of time before the roles will be reversed and MMM will need a favor from either of the other two counterparts. Besides until the stock is returned the monies or collateral is kept and continues to earn interest without payment of the rebate* due to the fail. And that’s how the 800 pound gorilla’s sleep were ever they want.

*Rebates are interest payments made to the party who borrows the stock and whose proceeds are used as collateral. Denial of (zero) or reduced rebate payments make borrowing more expensive for the small retail investor - an important calculation to made when considering a short sale. When trading desks borrow stocks they give the proceeds as collateral but also expect the collateral holder to pay interest on those funds. After all it’s not the collateral holder’s money- they are just holding the funds as collateral while lending their stock. Rebates to the short seller are usually credited once a month by most brokerage firms. The rate paid on a security is determined by its availability: the harder a stock is to find the less the lender will pay to the borrower. Unfortunately most retail players like yourselves will receive a zero rebate rate for your collateral. This is one way the stock loan departments of brokerage firms make money. And if you’re a bigger retail account and do receive rebate interest it is very doubtful you will receive a rate equal to or greater than the fed funds rate like institutional investors do. Check your brokerage firm’s policy!

Fails are the other source of income for a stock-loan department. Fails occur when borrowers fail to return the stock on time. The revenue is produced by the discontinued payment of rebate interest on a failed stock return. These are not a major concern for small retail borrowers due to the fact they will either be bought-in and or not paid a rebate in the first place. It may seem insignificant but the interest on 100 million dollars is $11.111.11 Per/day at 4% the current fed funds rate. It is not uncommon for repo desks to lend out billions of dollars on a daily basis. The fail is stock-loan departments fattest source of revenue putting a premium on a smooth and efficient wire room to minimize in house fails.

If you run a repo-desk on the street and tried to raise cash through securities lending, collateral would be 102, 105 or even as much as 110% of the cash and approved securities with rights of substitution and repriceings options. The difference in cash verses collateral is referred to as the rebate haircut. The only point here is to point out haircuts, repricings and rights of substitution act as risk management tools for stock-loan departments and their counter-parties.

Short Selling

2005-04-25T10:25:00.000-04:00

We wrote this article to educate our readers on short selling. Have you ever sold a stock short? If not, why not? Did your investment advisor decide on your behalf you are either unqualified or not sophisticated enough to understand short selling? Read this article and decide for yourself if short selling is a tool you. Shorting is just another tool - no more; no less - and those who impose steadfast rules against shorting may suffer in performance by taking a "long only" approach. Short selling stocks and other financial instruments is an important tool we intend to introduce to VHF subscribers.

What is short selling?

Short selling is selling a particular item you do not own because you believe it will decline in value. In the investment world professionals short sell stocks, bonds, options, and futures. Although VHF will short any financial product from time to time, we’ll focus on the U S equity market to illustrate short selling to our viewing audience. The definition of short selling a stock, is to sell a stock you do not presently own.

Why do the pros sell stocks Short?

There are a variety of reasons to short financial instruments: the belief it will decline in value cited above, to hedge a trading position, arbitrage trades, pairs trading, and momentum trades, etc. The point here is that if the big boys find it important to short why don’t you?
How to short stocks

First, you must have a margin account with a broker dealer and therefore, you must fulfill the due diligence requirements of the executing broker broker/dealer. Once the margin account is opened, determine the VHF strategy to be implemented and away you go. Let’s open with a simple institutional example, shorting 10,000 Cisco Systems (CSCO) at 37 in hopes CSCO trades lower. The goal of short selling is the same as from the long side buy low and sell high but the process is reversed: we sell high in the hopes of buying back at a lower price later. Following the example above, this is how to execute our strategy. Look at the CSCO market say 37 to 37.125 (1/8 = .125) with the last trade at 37. First call is to stock loan department where I must secure a “borrow” on the number of shares I wish to short and wait for what is called “ locator number”, this confirms that I have located a borrow for delivery to the buyer. Next place the order with a market maker, or ECN, since CSCO is a NASDAQ stock. Sell short 10,000 CSCO at 37, the ticket at this point must be marked as a short sell and time stamped. If the next trade in CSCO is 37 or greater I should receive a fill or partial fill on my CSCO order. Note the print of 37 or 37 plus is important for I need a plus tick or zero plus tick to execute the short. Let’s now assume the stock trades at the appropriate level to execute our entire order. I’m short 10,000 shares of CSCO at 37 assuming the zero plus tick was 37.

Retail (individuals) short selling seems simpler but still has to follow the some rules. The retail investor simply obtains a market either from an online quote machine or broker and enters the order either online or verbally to a broker. In this case sell short 1000 CSCO at 37, just like before. In the retail example the broker is responsible for borrowing the stock for delivery, time stamping, marking the ticket as a short sell, and observing the up tick rule for execution. The retail investor has to sit and wait for his online trading system or broker confirms the fill.
Uptick Rule Most stocks require that a stock can only be sold short on an uptick. However futures, options and some hybrids, such as the NASDAQ 100 QQQs can be short sold at any time. Most individuals are one dimensional, meaning they buy and hold and forget about selling until they either need the money or market conditions dictate their sleeping habits. This has worked well for those with good professional money managers but recent markets illustrates good professionals are hard to find and are worth their weight in gold. But many money managers do not perform in the real world; money mangers move, retire and charge handsome fees. VHF is here to give you ideas and strategies for optimal results. This article explains the concepts and mechanics of shorting, to be used when the market or strategy dictate a short sale. VHF will not sell the sophisticated small investor short when it comes to presenting opportunity to our clients. After all who cares more about your money than you? Approved Investors who never consider short selling must be willing to ride out the bad times or be adept at converting their holdings to cash before downturns. These two strategies are not easily accomplished in reality particularly if there is an extended downturn as in the 1970’s.

Some dangers of selling short

Caught in a short squeeze and forced return of the borrowed stock.
Short sellers are responsible for all dividends due the rightful owner.
Change in rebate rate for the institutional trader could be costly.
Failure to implement risk management procedures will lead to losses since a short has a limited profit potential (from price we short at to zero) and unlimited loss potential (from price we short at to as high as stock goes).

We believe today’s individual investor is not only intelligent but has the resources and electronic support to utilize trading tools which improve investment performance. We feel strongly shorting for the reasons listed in this article are worth consideration when combined with good ideas and trading strategies. Is shorting for everyone certainly not but neither is Virtual Hedgefund Inc. VHF is a leading edge group providing ideas and strategies used by professional proprietary trading desks.