(part 1, part 2, part 3, part 4)
Last time we determined that beta neutral spreads are the perfect instrument to use in our speculative portfolio. Now we need to decide which spreads. Sadly, that’s as open ended a question as “Which stock should I buy?”. What I’m going to share with you here is a technique I’ve developed that seems to give good returns on relatively low risk. Continue reading
Before continuing, you need to have a solid grasp of alpha and beta – otherwise the rest of this article will make no sense.
Back in part three, we developed a method for trading the S&P 500 for use in the long term speculative account. In other words, we’ve figured out how to trade beta. That’s good, but one of the goals of this speculation method is to limit beta exposure to +- 20% of the account value. The purpose of this limit is to mitigate account damage in unexpected crash situations (when long) or boom situations (when short). Since I’ve allocated 20% of the portfolio to beta trend following (which could thus produce betas between +-20%), ideally everything else in the portfolio should have a beta of zero. That’s a difficult requirement for stocks, however, because they essentially all have a positive beta, and in most cases that beta constitutes at least half of the stock’s movement. What we need is something that acts like a stock, but with no beta component. Continue reading
An arbitrage is a trade that produces near risk-free and near guaranteed profits. In general, independent and retail traders are not successful as arbitrageurs. We’ll get into the reasons why in a bit. But it’s still important to understand how arbitrages work, because they’re a fundamental part of the structure of the market. Each arbitrage defines an equation, for lack of a better word, of how the prices of various instruments should be related to each other and to interest rates. Some of these relationships are trivial to understand, but others are far from obvious. Continue reading
Before we continue with the speculative alternatives to investment series, I need to introduce some mathematical concepts. Yeah, yeah. You’ve got a hangover and barely eked out a C- in calculus. But stick with me.
Two key tools of quantitative finance are:
It’s pretty easy to understand how you combine instruments – the easiest way is to make an index. You take a bunch of instruments (say, stocks) that are somehow similar and average their price. Typically you weight the average by a size metric like market cap. Voila – an index. This is a big data approach to understanding the movement of the market.
It’s a little less clear how you take one instrument and slice it up. Turns out there’s slightly beefier math involved – Pearson correlation, linear models and linear regression in this particular case. It’s OK if you skipped that class – there are plenty of tools to help us get through the math. Continue reading
Here’s a tidbit to think about: broad market reactions are not symmetrical. The market doesn’t move down the same way it moves up. Downward moves are generally much larger, faster, and shorter in duration. Upwards moves are slower and more sustained. Continue reading
You don’t have to spend too much time around the stock market to discover that there’s something fishy about many stocks’ initial public offerings, (IPOs). The standing joke is that IPO really stands for “It’s Probably Overpriced”. While that may or may not be true in any given case, there are a large number of pitfalls awaiting the would-be IPO trader or investor. It’s a case of caveat emptor, and in order to be suitably wary you need to understand how an IPO works and how it can be manipulated to your disadvantage. Continue reading
Stocks are the most widely held and discussed securities in the United States. Of all the security types, they are the only one that has penetrated popular culture and become a topic of kitchen table discussion. When Joe Sixpack refers to “the market” he’s talking about stocks, not bonds or commodities or derivatives. This is seen as myopia by most financial professionals – while stocks matter, they really only matter at an economic level in the aggregate. Any individual stock is small in terms of capitalization when compared to the T-bond market, mortgage bond market etc. In terms of size, bonds and index futures rule the roost and individual stocks are a backwater.
This pro-bond/anti-stock bias is apt in the context of very large funds and bank trading desks trying to move huge volume. If you want to put billions of dollars of capital into play, you’re limited to a small number of markets – a few bond markets, index futures, oil, foreign exchange. Individual stocks just don’t play. But for the individual trader with a small amount of capital, stocks have some intriguing characteristics. Continue reading