How To Trade Through The Fog Of War. Part 3: Stocks
Equities present more of a conundrum to trade during this initial period of war-induced uncertainty as opposed to crude oil and gold.
This is due to the fact that while stocks have been moving higher for the past 2 years, they have been selling off quite heavily recently.
How then should equity traders and investors position themselves?
As you can see from the chart below, the S&P 500 has been trading lower since making record highs at the start of 2022. The index broke below the bottom end of its bullish channel last week, a few days before Russia invaded Ukraine.
While last Friday’s massive bounce brought it back into the channel, it still remains in a short term bearish channel, and about 9% off its all time highs.
The NASDAQ Composite looks a lot more bearish, having broken below its bullish channel at about the same time the S&P was making new all time highs in Jan 2022. The tech index has only fallen further since then, and is now about 15.5% off its all time highs.
However, a quick glance at both charts will immediately tell you that the medium term trend is higher. This is more so for the SPX, which still looks capable of rallying back into its bullish channel.
As you can see, the situation for stocks isn’t as clear cut as it is for crude oil and gold. While oil and gold had both technical (trend), and fundamental (supply-demand imbalances) factors lining up for them in both the short and medium term time frames, equities do not.
This makes trading stocks a little more complicated than simply going long or short.
As such, what one does at this moment depends a lot on how they are currently positioned. For example, if you are currently long, with a medium to long term horizon, your best course of action would probably be to put on a short on the weakest index/indices as a hedge.
Taking out a hedge on the weakest indices at this point can serve a dual function. The first is obviously as a hedge to your existing portfolio, and the second as a way to potentially profit on the short side.
This can work simply because the indices trading most bearishly are the ones most likely to sell off more heavily. Which means that it is possible to cover intraday losses on your existing holdings with a little extra profit.
Hedging in this fashion is aggressive, and won’t appeal to all traders/investors. But, if it does, the NASDAQ Comp and Russell 2000 are better options than shorting the SPX, simply because they are trading in a more bearish fashion.
If you prefer a hedge that is more broad based, the SPX is a better option.
Naturally, all of this depends on what stocks you are currently holding, if you’re already holding high beta stocks, going short the NASDAQ or Russell 2000 probably won’t generate any extra profit.
After all, the crux of the “aggressive hedging” strategy lies in taking advantage of a beta mismatch. I.e. no beta mismatch, no extra profit. (But also less risk of the hedge not working in your favor)
Other alternatives include purchasing put options, which might not be the most cost efficient at this point simply because volatility has moved much higher (look at the VIX).
More advanced option strategies, like selling a higher strike call to offset the purchase price of the put could work, but this requires a higher level of experience and knowledge about options.
Of course, you could always stick to the much simpler strategy of maintaining stop loss discipline and waiting out the current market storm.
If you get stopped out, just wait for markets to calm down before reassessing your next course of action. If you don’t get stopped out and the market turns back in your favor, good for you!
Note the first two of the strategies can be used in a non-hedging sense. That is, if you are comfortable doing so, you can deploy an option spread with the sole objective of attempting to profit from market uncertainty.
The same applies to the “aggressive hedging” strategy, although in this case it would be more accurate to call it a pair trade. The idea here is to take out a short position in one of the higher beta indices and hedge it with a long in the SPX to limit your losses in the event the market shakes off the geopolitical situation and keeps rallying.
This pair trade is the same as the “aggressive hedge” in that it profits from a beta mismatch, except that the pair trade is entered into with the primary objective of generating profit, while the hedge is entered into to mitigate loss.
Finally, if you really want to, you could just go short the most bearish indices or stocks. This would be the most aggressive way to trade equities in this environment.
If you choose to do so, make sure your stop is calculated and in place once you enter the position. This will help keep you from trading on emotional swings if market volatility spikes higher.
Also, be prepared for wild swings and getting stopped out only to see the market fall sharply again. Being short without a hedge in times of massive uncertainty is almost always a wild ride.
You can follow our take on trading opportunities in equities (expressed via ETFs) over at ETF Edge.
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