This is How You Survive Black Swans

Friday, 31 January 2020
Melbourne, Australia
By Murray Dawes

I saw a chart yesterday showing the geometric progression of the Coronavirus. By the look of things, the next week or two will tell us whether the number of cases will balloon above 100,000 or not.

Potential growth in Coronavirus infections



chart image
Source: Zerohedge.com
Click to enlarge

The orange line shows you the model’s prediction if 2–2.5 people are being infected for every person that is currently infected. It shows a line growing at 53% per day. Notice the Y-axis is a log scale and not a normal scale. That means the chart is showing percentage changes rather than nominal changes.

The actual path of infections is following the model very closely at the moment, so if it keeps going on the same path we could see over 100,000 cases in a week. If that is the case I think the markets will take fright and we will see further selling pressure.

Option dealers are facing negative gamma if prices keep falling so they will cause further falls as they sell futures to flatten their option book.

Markets

US markets managed to rally overnight despite the global pandemic declaration by WHO with the Dow Jones up 124 points to 28,859. The S&P 500 was up 10 points to 3,283 and the NASDAQ was up 23 points to 9,298.

European markets fell with the German Dax down 187 points to 13,157 and the FTSE 100 down 101 points to 7,381.

In Asia, the Japanese Nikkei 225 is up 1% after a tough week at 23,233. The Hang Seng has seen strong selling pressure this week and was down over 2% yesterday to 26,394.

Gold is catching a bid at US$1,574. But other commodities are heading south with copper down 10% in the last two weeks to $2.54. Iron Ore is also seeing heavy selling pressure with futures prices down over 10% this week.

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Bitcoin and gold are picking up and oil, copper, lead, zinc, nickel and iron ore have been dropping like a stone over the last couple of weeks.

The Aussie dollar is reacting to the weakness in commodities and the threat to Chinese growth as a result of the virus. It has dropped over one-cent this week to $0.6717. If it heads below $0.6670 it will be at its lowest level in over a decade.

The next major support below there is around $0.6580 but if that can’t hold there is little support until $0.6200.

30-year bond yields in the US are about to go below 2%.

Safe haven buying and commodities sliding fast. I’m not sure why the ASX 200 is rallying today but I don’t think it’s going to last if the modelled numbers on the chart above start happening next week.

The World Health Organisation (WHO) declared a global pandemic last night and the first human to human transfer of the virus occurred in the US.

I reckon it will take a few months to get it under control and I am optimistic the long-term outcome will be a positive one. But this is definitely a black swan event and we don’t know how it is going to evolve over the next month.

I think the news has to get worse before it gets better and the markets are priced for perfection at the moment.

Therefore, I have hit the sell button on a number of stocks in the Alpha Wave Trader portfolio. I am not panicking out of positions but have decided that now is a good time to take some money off the table.

The momentum to the upside is still incredibly strong in US markets, so I have no interest in going short. But there is nothing wrong with taking profits and raising cash levels when faced with a potentially explosive situation.

I remain long each of the stocks that I sold. I just took another chunk of profits out of them. We have now taken profits on two thirds of the original position and remain long the final one third, which I am willing to hold longer-term.

The outcome members of Alpha Wave Trader will receive going forward in each of the stocks is now win/win. They will either make some money or make more money.

It’s as if someone pays you money to own a call option over a stock. Who wouldn’t want that?

By splitting up the investment into three sections I take care of various aspects of trading that need to be managed.

The first thing that needs to be managed is our emotional state. None of us make good decisions when we are emotionally charged. Holding on to a position that goes in and out of the money is incredibly draining.

We waste time watching price action because we feel great when it goes up and terrible when it goes down.

When you have been tossed around by that cycle a few times you usually end up dumping the position at a loss just to end the pain, even if it hasn’t hit your stop-loss.

I eradicate that cycle by selling a third of the position as quickly as possible and adjusting the stop-loss on the remaining stock to a point where we will break-even on the whole trade.

At that point we have created a payoff similar to a free call option. We will either breakeven or make money.

The first profit target isn’t about money. It’s about managing our state of mind.

Once you know your initial capital is safe you stop looking at every tick up and down in the stock. The madness stops and the clarity begins.

The second profit target is about money.

We want to ensure that we will walk away from the trade with a win.

I am sure we have all experienced the pain of having a big win in a stock and holding on too long. The stock turns down and keeps falling but we hold on because we have memories of how much money we’d made.

We don’t want to get out with a 50% win when we were up 150% only a few months ago! So we hold on and it keeps falling.

We sell out in disgust when it hits our entry point and then we look on in horror as the stock finds a bottom and turns back up again.

By taking another chunk of profit when the stock is flying I ensure that we won’t go through that experience. We have banked a good chunk of profit and remain long a third of the original position which we can leave in the bottom drawer.

If the stock keeps trending, who knows how high it can go and how much money can be made with that final portion of the trade? If the music stops as it so often does, we will stop out of the trade and walk away with a win that continues to build capital.

Remaining on the front foot is the name of the game. Staying humble and accepting that you don’t have a clue what’s coming next.

Risk management is so much more than meets the eye. When you do it well you lower the volatility of your P+L over time, which stabilises your frame of mind.

When you have a clear mind, you make good decisions. You see more opportunities because you aren’t spending your time managing crappy positions.

There are plenty of articles being written about the virus and what comes next. But no one has a clue what is going to unfold.

My bet is that the news gets worse and markets take fright. We could see a short sharp sell-off in equities but there will come a point when buy the dip will be the order of the day.

I’d prefer to increase cash levels and lower risk while uncertainty is so high so that I am not reacting to high volatility with everyone else.

Regards,

Murray Dawes,
Editor, Alpha Wave Trader