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Jeff Miller: Limiting Risk In A Volatile Market

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The Stock Exchange is all about trading. Each week we do the following:

  • Discuss an important issue for traders;
  • highlight several technical trading methods, including current ideas;
  • feature advice from top traders and writers; and,
  • provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some ideas, please join in!

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Our previous Stock Exchange pointed out signs of extreme market strength, and asked “what can it tell us?” We offered ideas about using a blended trading approach (i.e. momentum and dip-buying) to help mitigate risk exposures. Over the last week, the market has sold off significantly. A glance at your news feed will show that the key points of our previous Stock Exchange remain relevant.

This Week: Limiting Risk in a Volatile Market

After last week’s market wide sell-off, volatility has remained heightened this week, as measured by the VIX.

And many traders are left wondering how to limit their risk exposures while trading under these more volatile conditions. From our perspective, we’ve built multiple methods for limiting risk throughout our entire trading system. Specifically, we do not anticipate market turns, up or down, but we do react in a way that avoids the big losses. For example, our first signal is preliminary – sort of a “heads up.” This means that we pay more frequent attention to all of the indicators. We got that signal last Friday, so we have been closely monitoring the indicators.

The long-term market health remains solid, but the short-term trading conditions might be close to a change. We are at least a few days away from that, but it could happen next week. And when we get the bearish short-term signal we exit all positions in our models other than Holmes. In addition to this overall method, each model has a built-in exit signal for individual stocks. It works more effectively than traditional stops, because it does not depend solely on price.

Jake at EconomPicData offers some important behavioral perspective about trend-following during a market wide sell-off. He writes:

“Trend following has historically provided strong long-term returns with materially reduced drawdowns relative to a traditional buy and hold investment, but none of this matters if an investor cannot stick with the strategy through periods of relative underperformance.”

Our models are objective, and not prone to behavioral mistakes.

And for more perspective about exiting positions, here is a recent Q&A about entering/exiting positions from the highly regarded, Charles Kirk (if you can get on the waiting list for TheKirkReport, it’s highly recommended):

Q: I usually am all in or out – do you feel it is better to reduce the position in stages or trade 100% of the position? My goal is never to have a loss greater than -1% of my trading capital and I position the size of my trade based on that and the stop point.

A: I typically scale into positions in steps of three (1 at starter point, 2 at trigger, 3 at follow through) and I scale out in steps of two (1 at violation, 2 at follow through confirmation killing the play). At times, however, I will scale in only in two steps if I’m buying the initial positon at the trigger – the point where the play fires often in the breakout move if I’ve missed the starter entry. A good example in my the recent trade in the failed play of Jagged Energy (JAG). My starter position was added on the trigger when price broke out, but when there was a bull trap, I sold the position on the trap reversal. A one step in, and then one step out, with a reduced position size. Both the reduced position size and the quick stop kept the loss small, as my entry/exit strategy is designed to do when wrong and there is a play failure. I only increase position size on plays that prove themselves.

It’s always important to stay disciplined regarding risk controls, particularly in periods of heightened volatility.

Model Performance:

Per reader feedback, we’re continuing to share the performance of our trading models, and the following table shows this week’s update.

Important to note, we find that blending a trend-following / momentum model (Athena) with a mean reversion / dip-buying model (Holmes) provides two strategies, effective in their own right, that are not correlated with each other or with the overall market. By combining the two, we can get more diversity, lower risk, and a smoother string of returns.

And for these reasons, I am changing the “Trade with Jeff” offer at Seeking Alpha to include a 50-50 split between Holmes and Athena. Current participants have already agreed to this. Since our costs on Athena are lower, we have also lowered the fees for the combination.

If you have been thinking about giving it a try, click through at the bottom of this post for more information. Also, readers are invited to write to main at newarc dot com for our free, brief description of how we created the Stock Exchange models.

Expert Picks From The Models:

This week’s Stock Exchange is being edited by Blue Harbinger (Blue Harbinger is a source for independent investment ideas).

Road Runner: This week I bought Amazon (AMZN) on Monday. I’m sure you have an opinion, Blue Harbinger.

Blue Harbinger: I’m impressed by a company that can go from an online bookstore, to a $650 billion market cap company that is beating Microsoft in cloud and displacing struggling “brick and mortar” retailers of many types. I take it you’re not bothered by Amazon’s thin profit margins relative to its incredibly growing revenues?

RR: My typical holding period is about 4 weeks, so it’s less about fundamentals and more about proprietary technical indicators. As you know, I like to buy stocks that are at the bottom of a rising channel. And based on the following chart, you can see why I like Amazon.

BH: Interesting, Road Runner. Are you at all worried about the continuing market wide sell-off? Amazon is down since you bought it.

RR: I’m a model, not a human, so no I am not “worried.” Besides, I have risk controls in place. For example, I have a built-in exit signal for Amazon (and for all the stocks I buy). It works more effectively than traditional stops, because it does not depend solely on price.

BH: Any other risk controls, during your typical 4-week holding period?

RR: Yes, we monitor for short-term bearish signals, and I’ll exit all positions if we get one.

BH: Well in case you’re curious, Amazon announced earnings after the close on February 1st, the company beat market expectations for earnings and revenues, and the shares were actually up the following day, which also happens to be the day the rest of the market started selling off. Here is a look at Amazon’s Fast Graph.

RR: Thanks for that information. How about you, Felix—what have you got this week?

Felix: I bought Westlake Chemical (WLK) on Monday. What do you know about this company?

BH: They manufacture and market basic chemicals, vinyls, polymers and building products. The company’s products are used in flexible and rigid packaging, automotive products, coatings, water treatment, refrigerants, residential and commercial construction, as well as other durable and non-durable goods. Why do you like it?

Felix: I am a momentum trader, and this stock is still above its 50-day and 200-day moving averages, even after last week’s sell-off.

BH: Interesting pick, Felix. This company’s EPS has been perking back up lately. Here is a look at the Fast Graph.

Felix: Thanks. I typically keep my positions open for about 66-weeks—longer than the other models, and long enough for the fundamentals to be more of a factor.

BH: Anything else?

Felix: Yes, I also ran the Dow Jones through my model, and the top 20 results are shown in the following list:

BH: Thanks for sharing. Personally, I like Microsoft (#5 on your list). Microsoft Azure is no Amazon Web Services, but the company has established itself as the clear number two in “cloud” thanks to Microsoft’s forward-looking CEO, Satya Nadella. Plus its Windows and Office add to the company’s wide moat.

Athena: This week I bought Abercrombie & Fitch (ANF) on Monday. What do you think about that?

BH: Honestly, I am surprised you like ANF. The company is a specialty retailer (they make fashionable clothes for kids and young adults) that still has a significant amount of “brick and mortar” stores. Aren’t you afraid they’re going to get “Amazon-ed?”

Athena: ANF has some good momentum. As you can see in the chart below, it’s above its 50-day and 200-day moving averages.

BH: Yes, but as you can see in the following Fast Graph, earnings is only a fraction of what it once was. Are you waiting for Abercrombie & Fitch to come back in style, or are you trying to re-live your glory years, Athena?

Athena: Neither. I’m a computer. I like momentum. ANF is attractive, and I typically hold my positions for about 17 weeks.

BH: Okay. I’ll check back with you in about 17-weeks. How about you Oscar, what have you got this week?

Oscar: This week I’m sharing my top 20 rankings from our high volume ETF universe.

BH: Interesting, thank you. By the way, I seem to recall last week the inverse volatility ETF (XIV) was at the top of your comprehensiv ETF universe list. It’s been a horrific week for that ETF, as its price went from about $130 to $6.

(image source: One of the Greatest Short Squeezes of All Time).

Oscar: I don’t buy everything on the list each week. And we have risk controls in place, as discussed  earlier in this article. For example, my sell triggers work more effectively than traditional stops, because they don’t depend solely on price.

BH: Thanks, Oscar. I know you are a momentum trader, your typical holding period is about six weeks, and when you exit you usually rotate into another sector.


Trading in a highly volatile market requires discipline. One of the advantages of our models is they are objective and not emotional. This removes some of the psychological and behavior risks that many traders are prone to (e.g. selling out of fear). With regards to our current open trades, we are just monitoring. Losses in the current range are nasty (especially when coming so quickly) but normal. We are watching closely over the next few days.

Background On The Stock Exchange:

Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check out Background on the Stock Exchange for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Stock Exchange Character Guide:

Character Universe Style Average Holding Period Exit Method Risk Control
Felix NewArc Stocks Momentum 66 weeks Price target Macro and stops
Oscar “Empirical” Sectors Momentum Six weeks Rotation Stops
Athena NewArc Stocks Momentum 17 weeks Price target Stops
Holmes NewArc Stocks Dip-buying Mean reversion Six weeks Price target Macro and stops
RoadRunner NewArc Stocks Stocks at bottom of rising range Four weeks Time Time
Jeff Everything Value Long term Risk signals Recession risk, financial stress, Macro

Getting Updates:

Readers are welcome to suggest individual stocks and/or ETFs to be added to our model lists. We keep a running list of all securities our readers recommend, and we share the results within this weekly “Stock Exchange” series when feasible. Send your ideas to “etf at newarc dot com.” Also, we will share additional information about the models, including test data, with those interested in investing. Suggestions and comments about this weekly “Stock Exchange” report are welcome.

Disclosure: I am/we are long AMZN, WLK, ANF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Article by Mark D. Hines, Dash Of Insight

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