Comments on: Hedgies hate volatility

By: Baruch

Baruch — Sat, 12 Apr 2008 08:47:20 +0000

I agree almost wholeheartedly. Stops suck most of the time. They compress your timeframes artificially, increase trading costs, shake you out of stuff, and stops tend to congregate around the same price levels on popular stocks, making them easier to raid or squeeze.

But every now and then they do save you from the fund-killing positions, the ones you fall in love with in big size and which then move against you.

These killler positions are more likely to be short positions, however, which if they move against you do indeed increase in size and deadly potential. Longs on the other hand SHRINK in size and risk as they fall, contra your assertion above.

Thus I would tend to have more aggressive stops on shorts, and give my longs more room.

And of course, for a long only benchmarked investor, stops should be slightly different. Incurring a stop should bring you back to a benchmark neutral position. As you say, going to zero on a big overweight position would be taking the opposite position, as big a bet as you are removing — when all you wanted to do was reduce your risk.

By: Walt French

Walt French — Sat, 12 Apr 2008 04:43:41 +0000

“Stops are an essential risk management tool … All hedge funds use them.”

I can’t dispute the second statement, but the first is bunkum.

Once a position has moved against you, you have a larger risk than before, whether it’s a simple short, a long, or a long vs a benchmark position. Your regularly-scheduled updates to your beliefs about the future may continue to have the same target price, in which case you have a higher potential win, but your risk has grown a bit faster than the win. If the first position was optimal, it’s now a bit too big, and should be pared back if your review didn’t find an even stronger opportunity.

But paring back a position to its previous risk/reward profile is far different from taking it off the table entirely; for a long equity investor who cares about say, the S&P 500 benchmark, closing it completely would put on a negative bet… why would you do that, just because some new info appeared that probably didn’t contradict your earlier insight?

The whole idea suggests lousy framing of the trading or investment process problem. How do you make any money if you drive spending most of your time looking in the rear view mirror?

By: Cassandra

Cassandra — Thu, 10 Apr 2008 14:16:44 +0000

Dear EP,

I am sympathetic to your skepticism over practical limitations of CAPM, which as you point out, is akin to clipping one’s nails with hack-saw and mitre-box.

Forgive my ignorance of your business and associated practices, but what is the point of mincing risk-model hairs when one is gearing 24x upon a veneer of OPM? It seems about as futile as reinforcing the roof of one’s Carribbean corrugated iron shack with twine in preparation for a Hurricane.

By: baruch

baruch — Thu, 10 Apr 2008 12:16:26 +0000

Send photo. You must be comfortable with polygamy.

By: Equity Private

Equity Private — Thu, 10 Apr 2008 01:45:30 +0000

“I hate multiple analysis and think it lazy. I am a DCF jockey. As such I am probably more acquainted with stock beta in the real world than the average bear, as it were, because beta figures so heavily in my “application” of the Capital Asset Pricing Model. I promise you, were I to use actual beta as defined by CAPM I would get nowhere, my DCF results would be meaningless and I would be groping around in the dark no better than the poor souls in Plato’s Cave, and the majority of my peers. Far from using beta as a measure of a stock’s correlation with the stock market to find its cost of equity, the beta in my models is an entirely subjective measure of the underlying business risk, or in other words, the riskiness of the fundamentals relative to the average listed company (it tends to center around 1.2 for most of my tech stocks, in case you are interested).”

Will you marry me?