where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
At Profit effect we know that the only “secret” to successful investing is well-informed investors applying sound market strategies. That’s why the Profit effect mission is to teach you how to understand the market, the modern tools available for successful investing, and how to apply both for investment success.
This edition of Profit Talk we’re going to take a step back from the technique side of the investing and trading process to focus on the big picture philosophy which ultimately drives the trading decisions. At this juncture, I’d like to illustrate how all the pieces we’ve covered since the inception of Profit Talk in November of 2016, fit together to form a complete trading system or strategy. And, how a consistent, mechanical approach to implementing the techniques learned in this course can lead to sustainable profitability. In the end, it is not picking the right stock or stocks, but the consistent application of the trading philosophy that results in a positive outcome from your trading activity.
The big picture goal for my own trading and the Profit Effect style of trading is to derive consistent, stress free cash flow from the financial markets. This goal propels the primary trading objective which is to place as many non-correlated, high probability trades as possible while continually taking profits and managing risk. Let’s break down each of these four components.
Correlation is a natural relationship of two or more things. When it comes to the term correlation, there are many correlations involved when investing, but for now, we’ll focus on two main types, asset and strategy correlation. In both cases the goal for us is actually non-correlation.
Asset non-correlation is created by spreading the investments among various asset classes to avoid over exposure to one area of the market and the broad market as a whole. As covered previously, some markets move together in varying degrees, which is called positive correlation and other markets move opposite of each other in varying degrees, and this is called negative correlation.
The movement or volatility of a market can be measured against another market to compare the historical relationship or degree of correlation the markets experience over time.
This is done by using a measure called Beta. Beta is a measure of the volatility or systematic risk of a security or a portfolio against the market as a whole.
Most US investors use the S&P 500 composite as the “whole market” to measure against. This index can be traded just like a stock via the “SPDR ETF” ticker symbol SPY. It contains 500 of the largest companies traded in the US.
A stock that has perfect positive correlation has a beta of 1.0.
If the stock has positive correlation but moves in excess of the market, it would have a beta higher than 1.0. For example, if it is 20% more volatile than the market it’s being compared to, it will have a beta of 1.2.
On the other hand, if it generally moves in the opposite direction of the comparison market, it will have negative correlation. The beta number will be displayed as a negative number. Perfect negative correlation is -1.0.
Some example markets that carry negative or low correlation to the market, meaning, historically the price movement has no correlation or moves opposite of the market and therefore they have negative beta, are US Treasuries, like ticker symbol TLT and gold, ticker symbol GLD and on the extreme end of negative beta, you have the “Fear Indices” such as VXX or VIX. Long shares of negative beta markets historically rise when the market falls and fall when the broad market rises. Negative beta can also be acquired by selling short a positive beta market.
It’s important to point out, historically a market may display longer term negative correlation but experience near term periods of positive correlation. This is one such period. In the near Gold and Treasuries have had positive correlation. The purest negative correlation is the volatility or fear index VIX.
To find beta of a stock compared to the broad market using the Think Or Swim platform use the analyze or trade page. The Beta of the market is shown here (Figure 1)
There are two different goals when it comes to asset non-correlation. The first goal is to make sure the trade or investment does not overweight the portfolio in any one asset class or area of the market. For example, a person should not buy several different stocks such as Dicks Sporting Goods, Nordstroms, Home Depot and Best Buy and believe they are diversified. These stocks are all from the US Retail sector and will go up and down in relationship to one another.
To avoid this problem, create an asset allocation rule for the portfolio.
The 10 main sectors of the US market are represented by:
XLY - Consumer discretionary https://www.spdrs.com/product/fund.seam?ticker=XLY
XLP - Consumer staples https://www.spdrs.com/product/fund.seam?ticker=XLP
XLE - Energy sector https://www.spdrs.com/product/fund.seam?ticker=XLE
XLF - Financial sector https://www.spdrs.com/product/fund.seam?ticker=XLF
XLV - Healthcare sector https://www.spdrs.com/product/fund.seam?ticker=XLV
XLI - Industrials sector https://www.spdrs.com/product/fund.seam?ticker=XLI
XLB - Materials sector https://www.spdrs.com/product/fund.seam?ticker=XLB
XLK - Technology sector https://www.spdrs.com/product/fund.seam?ticker=XLK
XLU - Utilities sector https://us.spdrs.com/en/product/fund.seam?ticker=XLU
IYR - Real Estate sector https://www.ishares.com/us/products/239520/ishares-us-real-estate-etf
For example, say the allocation rule was to evenly divide the exposure among the ten main sectors of the US economy. That would mean an exposure of 10% to each sector. The beta of any perspective trades could then be measured against the current asset allocation of the portfolio to determine compatibility based on the 10% allocation rule for the portfolio. A great free tool for measuring correlations between various markets can be found here https://www.macroaxis.com/invest/marketCorrelation
That is the first and general goal of asset allocation. The Profit Effect philosophy adds a second level of thinking to the idea of asset non-correlation. In addition to avoiding a high amount of individual stock or sector correlation within the portfolio, high correlation with the broad market itself is to be considered. The amount of correlation the portfolio of holdings has to the broad market is determined by measuring the “Beta Weighted Deltas” of the portfolio. The beta weighted delta value determines how much correlation the portfolio has with the US broad market. (Figure 2a & 2b) The amount of correlation desired can be custom tailored per the investors preference. As I’ve mentioned in previous Profit Talk issues, the preference of many short option strategy traders is to maintain a correlation that is relatively neutral to the broad market. This means keeping delta levels as near to zero as possible.
That describes the two main styles of asset correlation that must be managed in your portfolio. The other type of correlation to consider is strategy non-correlation. This involves the type of strategies being used. In addition to diversifying exposure across the various asset classes, it’s vital that a portfolio carries a variety of option strategy types as well. Avoid the overuse of any one type of option strategy. For example, you may love trading Iron Condors and therefore feel compelled to fill your portfolio with Iron Condor positions. This would be a risky practice. The behavior of overloading a portfolio with any one type of strategy is just as dangerous as having too much exposure to one particular asset class or area of the market. Practice the habit of diversifying the type of option strategies used to create positions in order to maintain strategy non-correlation.
When it comes to high probability trades, you’ve learned that credit style option strategies offer the highest probability for making a profit.
The option chain is powered by proven math models. The probability for profit is displayed in this column and is set for the options seller. 75% - 80% of the Profit Effect style portfolio is made up of a variety of credit style option strategies. Including, short Strangles, Straddles, Puts & Calls, Vertical Spreads and Iron Condors. These credit based strategies have probability for profit rates between 65% to 80%. Given enough occurrences the numbers are proven to work out. More on number of occurrences in a moment.
The rest of the portfolio contains directional trades and/or debit based option strategies. According to the statistical probabilities as shown through the same math models, directional trades have about a 50/50 chance for success. The “at the money” options shown on the option chain tell the truth. (Figure 3)
This statistical probability for success when directional trading can be improved through the use of chart analysis combined with trade entry and exit strategies. Such as the CCI Reversal strategy discussed in the previous issue of Profit Talk. Or the trend trading setup covered in the December 31st, 2016 issue of Profit Talk called “Cash Flow Trading with ETFs”. Also, I shared details from lessons I learned through creating and backtesting trade setups in the February 6th issue of Profit Talk called “Directional Trading Philosophy”.
I will share more of the top strategies I’ve developed for directional trading in future Profit Talk editions. Using the strategies may improve the success rate for your directional trading. But, let’s put things in perspective. Even the best strategies carry a success rate of 65% to 70% maximum. The honest master chart technicians and strategy traders out there will admit that a success rate anywhere near 70% is considered the cream of the crop when it comes to strategy performance. On the other hand, the average short Iron Condor strategy carries a probability for profit of 68% and some of the credit strategies we teach and use carry probabilities for success of 80% and higher.
It is for this reason that, in the pursuit of high probability trades, the Profit Effect style of portfolio allocates 75% - 80% of the position to credit style option strategies. However, I enjoy directional trading and understand that big winners are possible when trading directionally so the remaining available funds are applied to directional trades using the handful of high quality setups covered in this course. Together, these practices help us apply as many high probability trades as possible.
The next component of our primary trading objective which again, is to place as many non-correlated, high probability trades as possible while continually taking profits and managing risk, is the practice of taking profit. The power of managing winners by harvesting profits at pre-planned points can not be overstated. The action helps increase your success for several reasons.
First, the success rate is actually increased when profit is taken at the 25% and 50% points. This is based on laws of probabilistic outcomes that put simply say, that once price has reached any point it has a 50/50 of moving in either direction. This means once you’ve reached each higher profit point, you have a 50/50 chance that price may reverse and destroy the profit. For this reason, the act of aggressively managing winners by taking profits at predetermined points increases the probability for success and long term profitability.
Another reason for taking profits has to do with the increase in the number of occurrences. That’s assuming the capital is redeployed quickly when a winning trade is closed, which is always our goal. Remember earlier I mentioned that the statistical probabilities for profit created by the option model is reliable “given enough occurrences”. This is true with any statistical probability. A large enough occurrences must play out for the true statistical probabilities to take shape. Think about flipping a coin. The coin has a 50/50 chance of landing on either side. If you flip a coin only 10 times, what are the chances it will land 5 times on one side and 5 times on the other side? The chance is pretty low. The coin could easily land on one side 7 times and the other side only 3 times. The probability is still 50/50 but with such a small number of occurrences it is very unlikely the probability will actually play out. The more times you flip the coin, that is the more occurrences you have, the higher the chance of achieving the mathematical probability. Each additional coin flip works to smooth out the number until finally reaching the true statistical probability of 50/50.
The action of removing winners earlier rather than later and redeploying the capital not only increase the probability for keeping the winners and therefore improves your probability for profit, but the behavior also increases the number of occurrences which increases your chance of reaching the positive probabilistic outcomes the strategies offer.
The final piece of the puzzle involves managing risk. I don’t want to say any one of the components contained in our primary trading objective is more important than another but, if I was forced to choose, I’d have to say risk management is number one. As outlined in the the February 6th issue of Profit Talk called “Directional Trading Philosophy”, even a trade success rate of less than 50% can produce profits if the risk is managed properly. In particular, the risk to reward ratio. This refers to ratio between the possible profit and risk associated with the trade. Controlling this key ratio is vital to long term success in the trading and investing business. However, there are many aspects to managing risk and this complex subject will be covered extensively and continuously throughout future Profit Talk issues. In this context, I’d like to cover a vital part of the risk management process that is not often covered. I’m referring to the risk management that occurs prior to entering the trade.
You’ll often hear people say that the financial markets are risky. Is this true? Are the markets risky? Actually, that is not an accurate statement. The markets themselves are neutral when it comes to risk. They are simply providing the opportunity for exchange and as long as there are plenty of individual, un-associated participants in the market and complete, real time transparency around the transactions taking place in the market, then no risk is contained in the market itself. The risk comes from the investor and the actions they take. The fact is that in any business or investment transaction of any kind, all the profit is made prior to entering the trade or investment.
We have complete control over the situation at this point and the decisions made leading up to and at the time of entry determine the eventual outcome. After an investment has been made our control is limited based on the decisions used to create the transaction. In other words, everything about the trade must be determined beforehand. Never after the fact.
The main factors which determine risk that must be determined prior to entry are:
Price at Entry
When it comes to risk, the first mistake most traders make, outside of not having any plan whatsoever, is that they trade too big. That is the position size is too large for their personal risk tolerance and/or account size. The problem comes from thinking we need to “swing for fences” on a trade….that is trying to hit that home run investment which always makes for a good story, or Hollywood movie.
The truth is that, real, long term successful investors never trade that way. The best way to achieve success is by applying lots of small, high probability, non-correlated trades. Proper trade size is a key component in our risk management process. There are many advantages for us as traders if we use a position size that is appropriate for us. These advantages are numerous, the most profound being the ability to emotionally withstand trades that go against us which allow us to stay in the trade long enough for our assumptions to play out.
The fact is that markets are cyclical and do tend to swing back and forth as they move. They rarely continue forever in one direction without experiencing some retracements. This phenomenon gives an advantage to premium sellers and directional traders alike. Awareness of this fact along with discipline around trade size, allows us to stay in a trade without overwhelming fear or a margin call which may force us to take an action contrary to our best interest.
Correct trade size will depend on our personal tolerances and the size of the account. As a general guideline, I want the risk exposure in any single position or specific underlying to remain in the ½% to 1% range of the account value. The percentage amount refers to the size of loss at risk in the trade and is not referring to the total notional value of the position.
The actual risk of loss can always be controlled by us in how we construct the position and in the actions we take based on price movement.
The risk can be set in numerous ways, such as distance between short and long strikes when using spreads. Or, by other actions we take to defend a losing position, which may include neutralization techniques through buying or selling shares as a hedge or rolling and/or removing or adding strikes as necessary to control our risk.
In addition, each individual trade size is compared with current holdings and the overall exposure to correlating markets, as discussed earlier, must be considered. The combined exposure when all the correlated positions are totaled is set by the asset allocation rule for that sector of the economy as discussed earlier.
The takeaways for us today on how to achieve our primary trading objective which is- to apply as many non-correlated, high probability trades as possible while continually taking profits and managing risk are:
First, consider correlations in both asset classes and strategy types, manage accordingly.
Second, use as many high probability trades as possible by using a heavy weighting of well managed credit strategies mixed with some directional trades using high probability setups.
Third, manage winners and losers.
The US broad markets continue to climb higher. They closed out the week at all time highs.
The opportunities in the general markets will come when they pull back to the trend trade buy zone or a demand area.
In addition, I’ve shared two scan filters to find trade prospects, the Trend Trade scan query lesson in the December 31st, 2016 issue of Profit Talk called “Cash Flow Trading with ETFs” and the CCI Reversal which was covered in last week’s edition February 20th, 2017 called “Directional Trading Essentials”. These scan queries can be used to look for candidates.
Look for strong companies only in well established uptrends with near term weakness from a passing news event or slight earning miss but otherwise are showing relative strength.
The high impact reports due out this week are:
Monday 2/27 - Core Durable Goods orders released this morning
Tuesday 2/28- Preliminary GDP (8:30 am eastern) , Consumer Confidence reports (10:00 am eastern), President Trump speaks (9:00 pm)
Wednesday 3/1 - ISM Manufacturing PMI (10:00 am eastern, Crude Oil Inventories (10:30 am)
Thursday 3/2 - Unemployment claims 8:30 am
Friday 3/3 ISM Non-manufacturing PMI (10:00 am) , Fed Chair Yellen speaks (1:00 pm eastern)
Opportunities may exist around these reports.
I hope this has been helpful for you. Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.