Thursday, April 30, 2015

Being too cautious with stocks can cost you money

As you may know, investor’s fear and greed are main reasons for market anomalies to persist, and it creates an opportunity for a systematic trader to build successful strategies. Usual examples of those emotional effects are situations around market booms and crashes, but little is said about calm markets between volatility surges.

Meanwhile human nature shows itself even on calm markets, the difference is investors take fear for caution here. Instead of panic sell-offs this fear emerges as excessively low-risk positions, abusing of expensive hedging strategies and premature exit to cash.

“Leverage effect”, existing on stock markets, states that calm, low-volatility markets grow faster. The matter is, consecutive historical high renewals, sometimes for a long time without serious correction, give rise to a huge wave of publications about “this high is definitely the last one”. Susceptible investors read this, get frightened and become excessively cautious. They start hedging their positions against the inevitable market crash.

Most of popular hedging strategies against market downsides are like broken watches, they are correct only two times a day. The problem is that rest of the time they cost serious money.

Most obvious hedging is cutting down the positions, cashing out, and waiting for the market crash to appear. These strategies are expensive because you lose your potential profits, sitting in cash through most successful market periods (remember the “leverage effect”). As you may know, most of market timers lag stock indexes – this is the payment for this kind of hedging strategies.

Then there are more complicated things, like buying index puts, buying volatility, selling volatility calls and even more intricate constructions, all of them equally overbought almost all the time and for this reason highly not recommended for “just in case” long-term holding.

When volatility is low, there is only one justified position – long the market. Cutting down is justified only when volatility emerges and you chose to correct your risk exposure. Not before that, not because “long time no correction”.

Of course, even calm markets do not grow infinitely. But before they turn south, markets become restless first.

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