Risk Management, Tips, Trading Education

False Diversification – 2020

Risk reward - day trading 101 - 5 steps

The global macro economy is currently in a state of shock without a precedent, and matched with a monetary fiscal response greater than the GDP of many developing nations.  The COVID-19 virus was quick to disrupt global economies and supply chains, leaving investors scrambling to implement a better diversification strategy for any future bear rallies or black swans.  The previously accepted belief that asset classes with a negative correlation as sufficient for portfolio diversification failed, as in reality, this shock affected all assets in portfolios.  On paper, long equities and bonds maintain a negative relationship, which makes it a popular risk management strategy.  However, these assets did not respond in accordance with their formulas.  Even though they were negatively correlated on paper, they did not act that way in a crash of this magnitude.  This response prompts the importance of developing a portfolio where assets behave in a given way in actuality, not strictly following a formula.  

Without implementing a strategy for black swans, the next market disruption will leave you as devastated as this one.  You must have assets that perform well when the markets go down, such as options or gold.  It is important to take the necessary steps to hedge one’s bets for a future that may be volatile.  When liquidation goes up due to the volatility in markets, there is increased volatility as individuals are forced to cut losses.  As forced liquidation goes up, so does volatility, leading to their positive correlation.  

Two recommended strategies to analyze, given the current economic environment, are the call backspread and the put backspread investment strategies.  The call backspread serves as a bullish strategy in options trading.  It involves selling a number of call options and buying more call options of the same underlying stock and expiration date at a higher strike price.  This creates the possibility of unlimited profit, with very little downside or risks when there is a belief in a significant upside movement in the near term. Alternatively, the put backspread serves as a bearish strategy in options trading.  It involves selling a number of put options and buying more put options of the same underlying stock and expiration date at a lower strike price.  This once again places the investor in an opportunity for unlimited profit, with little risk in an environment where the market will experience significant downside movement in the near term.  It is important to implement the correct strategy when looking towards the possible upcoming volatility in the markets.  Take the time to research the recommended strategies and finetune to one’s own comfort and feasibility.  

Some general themes moving forward to also be aware of is the secular shift towards inflation after this period of deflation.  It is no longer a conversation about it, but rather when, this secular move towards inflation will take place.  This emphasizes the importance of hedging one’s investment portfolio towards a prediction of inflation.  In addition, experts predict a continued debasement of fiat currency, as nations continue to print money into the economy, further emphasizing the upcoming inflation.  As inflation is on the horizon, precious metals may become the place to be.  An investment in gold may prove to be worthwhile.  

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