Rules-based investing is the ultimate antidote to emotions. Lately, I’ve been fine-tuning my active trading rules to improve my decision-making. Today I want to share a few revelations I’ve come across.
Trade with the Trend
The concept of trading with the trend is simple. But the implementation can get complicated. When does an uptrend become a downtrend? Do you always flip bearish when the trend turns, or do you simply reduce exposure? These questions must be answered if you’re going to remove the subjectivity from your process.
Here’s what I’ve found helps.
First, identify the appropriate amount of delta exposure for your portfolio. I’ve discussed how to do so here and here. For today’s purposes, I have a portfolio where the following describes my SPY beta weighted delta for varying biases.
+3: 90 SPY Deltas
+2: 60 SPY Deltas
+1: 30 SPY Deltas
0: 0 SPY Deltas
-1: -30 SPY Deltas
-2: -60 SPY Deltas
-3: -90 SPY Deltas-3 to +3 Directional Bias Spectrum
Remember that -3 represents max bearish and+3 represents max bullish. Zero is neutral.
When we break resistance, I increase my bullish exposure. When we break support, I decrease it. Here’s how that would have played out using the SPY chart over the past few months.
Note that the numbering doesn’t automatically correspond with my directional bias spectrum. Instead, it shows each resistance level (green 1,2,3) and support level (red 1,2) broken.
Each time we broke resistance, I would have added exposure to my portfolio by shifting from +1 to +2 and then to +3. There are a million ways I could have accomplished this, but fundamentally, it’s a matter of entering new bull trades or exiting old bear trades. During the September sell-off when we broke support, I would have reduced exposure in some fashion. Some traders might have shifted from +3 to +1. Others might have more aggressively pivoted to -1 or -2. Regardless, the theme should have been one of respecting the support breaks by lowering exposure.
This is accomplished by entering new bear trades or exiting old bull trades. Often this happens automatically as your stops get hit on bull trades. In other words, even if you didn’t add any new positions, the mere fact that you were following your existing plans should have tilted your portfolio more bearish.
I’ve found that it’s relatively easy to shift a purely active portfolio with short-term swing trades from bull to bear. Hit your stops on the bull plays, add a bear trade or two, and voila! you’re now leaning negative delta.
When you’re carrying some legacy stock positions, it becomes much more challenging. Reducing risk is more a matter of moving from+3 to +1 than turning bearish.
Ultimately, it comes down to personal preference. If you want to over hedge by loading the boat with long puts when the market breaks support, you can get the delta negative. You’ll feel fantastic if the correction morphs to a big bear market like in March. But it’s incredibly annoying getting suckered into insurance only to see the market quickly recover. For that purpose, I tend to prefer keeping my portfolio leaning long deltas.
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