Risk Control for Dummies

Whenever I change my positions, the market makes a major move, or reaches a key level, I look to stress test my portfolio by inflicting various scenarios upon it and analyzing the outcome.

This is second nature for most hedge fund managers. If fact, the larger ones will use top of the line mainframes powered by $100 million worth of in-house custom program to produce a real time snapshot of their positions in all imaginable scenarios at all times.

If you want to invest with these guys feel free to do so. They require a $10-$25 million initial slug of capital, a one year lock up, charge a fixed management fee of 2%, and a performance bonus of 20% or more. You have to show minimum liquid assets of $2 million and sign 50 pages of disclosure documents. If you have ever sued a previous manager, forget it. And, oh yes, the best performing funds have a ten year waiting list to get in. Unless you are a major pension fund, they don’t want to hear from you.

Individual investors are not so sophisticated and it clearly shows in their performance, which usually mirrors the indexes less a large haircut. So I am going to let you in on my own, vastly simplified, dumbed down, seat of the pants, down and dirty style of scenario analysis and stress testing that replicates 95% of the results of my vastly more expensive competitors. There is no management fee, performance bonus, disclosure document, lock up, or upfront cash requirement. There’s just token $3,000 a year subscription and that’s it.

To make this even easier for you, you can perform your own analysis in the excel spreadsheet I post every day in the paid up members section of Global Trading Dispatch. You can just download it and play around with it whenever you want, constructing your own best case and worst-case scenarios. To make this easy, I have posted this spreadsheet in for you to download by clicking here.

Since this is a “for dummies” explanation, I’ll keep this as simple as possible. No offense, we all started out as dummies, even myself. I’ll take my trading book at the close of February 17 and project the returns in three possible scenarios: (1) the market is unchanged by the March 17 expiration of my front month options positions, which is 16 trading days away, (2) the S&P 500 rises 2.7% to 1,400 by then, and (3) the S&P 500 falls 5.2% to the 200 day moving average at 1,292.

Scenario 1 – No Change

The value of the portfolio rises 54 basis points from a 1.10% loss to a 56 basis point loss. I’ll leave the (SDS) price unchanged and forgive three weeks’ worth of management fees and expenses. The (BAC) $7 puts fall from $0.38 to $0.26 because of time decay. I get a close approximation of this price by looking at where the (BAC) April $7 puts are trading today. No change in the market means that my (AAPL) $430-$460 call spread expires at its maximum profit point of 2.5%.

Scenario 2 – S&P 500 rises to 1,400

The value of the portfolio declines by 98 basis points from a 1.10% loss to 2.08% loss. The (SDS) price is easy to calculate. A 2.7% increase in the index causes a 5.4% loss, from $16.26 to $15.38 a share, in this double leveraged short ETF. The (BAC) $7 puts fall from $0.38 to $0.22. I expect that Bank of America shares will underperform from here in a rising market because of their lousy fundamentals, but there will be some substantial time decay. I get a close approximation of this price by looking at where the (BAC) April $7 puts are trading today and knocking off a few more cents. Apple stock may drop in a falling market, but I doubt it will be more than the 8.4% down to the $460 needed to eat into my $430-$460 call spread profit.  So it still expires at its maximum profit point of 2.5%

Scenario 3 – S&P 500 falls to 1,292

The value of the portfolio rises soars by 673 basis points from a 1.10% loss to a 5.63% basis point profit. The (SDS) price jumps from $16.26 to $17.29. The (BAC) shares will really take it on the nose in any real “RISK OFF” move, and should fall from $8.02 to $7, allowing the May $7 puts to leap from $0.38 to $0.59. I get a close approximation of this price by looking at the price of the (BAC) April $8 puts today. No change in the market means that my (AAPL) $430-$460 call spread expires at its maximum profit point of 2.5%.

So on that day, with this particular portfolio, the downside performance is better than the upside by a ratio of 6:1. The P& L swings from a 1.10% loss to a 5.63% gain. This is the type of extremely asymmetric risk/reward ratio hedge funds are always attempting to engineer to achieve outsized returns. It is also the one you want after the stock market has risen by 27% in five months with little fundamental change in the economy.

All that’s really happened is that the world has gone from slightly bad to slightly no so bad. I can rejigger this balance anytime I want. If I think that a global quantitative easing increases the chances of a continued rise in the market, then I can add another deep-in-the-money call spread, such as for Microsoft (MSFT) stock, to reap additional premium to give us positive returns in all three scenarios. This is what I did with my trade alert a few hours ago.

Keep in mind that these are only estimates, not guarantees, nor are they set in stone. Future levels of securities, like index ETF’s are easy to estimate. For other positions it is more of an educated guess. This analysis is only as good as its assumptions. As we used to do in the computer world, garbage in equals garbage out.

Professionals who may want to take this out a few iterations can make further assumptions about market volatility, options implied volatility, or the future course of interest rates. Keep the number of positions small to keep your workload under control. Imagine being Goldman Sachs and doing this for several thousand positions a day across all asset classes.

Once you get the hang of this, you can start projecting the effect on your portfolio of all kinds of outlying events. What if a major world leader is assassinated? Piece of cake. How about another 9/11? No problem. Oil at $150 a barrel? That’s a gimme. What if there is an Israeli attack on Iranian nuclear facilities? That might take you all of two minutes to figure out.  The Federal Reserve launches a surprise QE3? I think you already know the answer.

To show you the potential merit of a negative three-week view, take a look at the chart below. Its shows the percentage of S&P 500 stocks rising above their 200 day moving average, which is one of the best leading indicators for market action out there. Today, it is close to an all time high at 87%. It nailed the 2009, 2010, and 2011 market peaks, and could well to the same this year. That is, unless things are different this time.