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Kass – Navigating The New Regime Of Volatility

Written by Doug Kass | Jun 20, 2018

  • There is no place for dogma and emotion (and sometimes even an intermediate term viewpoint) in developing a strategy to opportunistically trade over short term periods in the 2018 market
  • The market’s structure (and dominance of passive and quant strategies/products) provides exceptional near term trading moments
  • Yesterday was another example of the value that can be extracted from premarket and aftermarket trading (I am a ‘pajama trader’ and proud of it!)

Yesterday I started the day with a negative outlook for the markets in my opening missive,Risk Happens Fast

Soon thereafter, in response to a -40 handle drop in S&P futures (seemingly induced by more aggressive trade rhetoric out of the White House), I covered my entire (and very large) short (SPY) position – as well as covering all my trading shorts in (ALL) and (GM) and adding to several long positions – and, I moved from a medium sized short exposure to small net long exposure in a matter of an hour or two.

For now, the move was the right one as, adjusted for the 9 handle rise in futures this morning, the Spyders are trading more than 30 handles higher than my short cover prices in premarket trading yesterday morning.

Price Discovery In a World of Machines and Algos

Some will say/write that Trump’s aggressive trade tactics, throwing a hand grenade at China’s trade policy, was another example of the market discounting the President’s hard line of policy negotiations (so often seen as part of his negotiating approach) – and another “V” type recovery in the markets, that has “learned” to know better than to take the President literally.

To some degree, I respectfully disagree. To me, it was the machines and algos that materially (and artificially) tanked futures and provided yesterday’s trading opportunity.

The Trump pronouncement over the weekend of more tariffs targeted at China was simply the fuse.

The machines and algos were the dynamite.

Explaining the Juxtaposition of Short Term Bullish/Intermediate Term Bearish

How can one be negative in view and at the same time move into a net long position?

  • Unemotionally trading around a “view” in a period of much more heightened volatility is a key component of my tactical approach to the markets in which passive strategies, products that worship at the altar of price momentum and strategies that allocate to risk (e.g., ETFs, risk parity and volatility trending)
  • These products and strategies exaggerate short term market moves – often artificially extending bouts of depression and elation.
  • If one has a view of “fair market value” in the indices, sectors or individual stocks – this is one heckuva opportunity to deliver exceptional trading profits (by moving contra to the moves) when the difference between that “fair market value” calculation and the current share price widens.
  • Investors and traders have differing time frames. Even traders have differing time frames. Some trade hourly, others trade with positions (often held for several weeks) – and in times in between.

For me, given the new regime of volatility, it is consistent to have a bullish and very short term long exposure at the same time being intermediate term bearish. (Indeed throughout the first half of 2018 I have often been net long in exposure though holding to an intermediate ursine market view).

Depending on my calculus of the downside risk versus upside reward — that condition can continue for “some time.”

However, given my calculation of the bearish skew of risk versus reward it is not likely that I will even be small net long in exposure for very long!

I ended yesterday in a small net long exposure.

Downside Risk Dwarfs Upside Reward Now

Here are my reward/risk parameters:

Market Downside: 2400 to 2450
‘Fair Market Value’: 2500
Trading Range: 2550-2750 to 2800
Current S&P Cash (Adjusted for this morning’s future rise): 2775

Here are the current reward versus risk parameters (based upon the +5 handle rise in S&P futures, 2750 S&P equivalent):

  1. There are 350 points of downside risk against only 25 points of upside reward (compared to the top of the expected trading range) in my new pessimistic case (2400-2450). This is an overwhelmingly negative reward vs risk ratio (14:1).
  2. Compared to ‘fair market value,’ (2500) there are 275 points of downside risk versus only 25 points of upside reward. That’s a negative 11:1 ratio.
  3. Against the expected trading range, there are 225 handles of downside risk and only 25 points of upside reward (to the top end of the anticipated trading range). That’s a 10:1 adverse ratio.

I Remain a Pajama Trader and I am Proud of it!

Investment opportunities take multiple forms and for the life of me I cant see missing market opportunities – whether they arise at 1pm or 1am.

If I blanketly rejected such an opportunity, some of my investors would no doubt reject me as an investment manager!

Some commentators on this subject – though I can’t understand the logic – reject non market hours trading. Here is that view by one of our contributors.

By contrast, as expressed in my March, 2018 post, I am a pajama trader and proud of it – as it routinely yields exceptional opportunities:

“Markets evolve — and, to me, it is the responsibility of market participants to change with it.

I am a “pajama trader” (during outside of market hours) and I am proud of it!

I don’t understand the objection, in some circles, to trading stock futures (and securities) opportunistically whenever the market is open — whether it is 2 pm or at 2 am.

Does this mean the trades/markets are not real in the after hours? Trust me, they are real — these trades importantly impacted by P&L.

Does this mean I shouldn’t capitalize on extreme reactions to news (like the after hours Gary Cohn resignation)? That would be an extremely poor decision, in my judgment.

I try to capitalize on the inefficiencies or quick interpretations to news (and other factors) outside normal trading hours — and so do many others.

It’s an opportunity that Mr. Market affords market participants.

At least I try to exploit the opportunities — with increased activity, particularly in a period of rising volatility.

That said, I now trade at least 40% outside normal trading hours, as I see expanding opportunities flourishing in these periods.

Do I care if the futures go to extremes in the after hours and may not be indicative of the next day and may not follow thru?

Who really cares if an opportunity is being presented in the after hours for me and other pajama traders!” – Kass Diary, I am A Pajama Trader and Proud of It!

Bottom Line

Mr. Market has rallied from yesterday morning’s lows and is now back in the middle of the upper end of my projected 2018 trading range.

While I am small net long in exposure I will likely cut back and move back into a net short exposure over the next few days given my calculation of risk over reward.

Be flexible in approach and avoid dogma as the market’s structure is providing unimpassioned traders with exceptional opportunities in a new regime of volatility.

Finally, never limit your trading opportunities based on the time of the day or any other factor.


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Doug Kass

Doug Kass, since 2004 Doug Kass has served as President of Seabreeze Partners Management, Inc. He runs a hedge fund and individual managed accounts, co-authored “Citibank: The Ralph Nader Report” with Ralph Nader and the Center for the Study of Responsive Law in the 1970s and wrote "Doug Kass: A Life on the Street" two years ago (John Wiley). Since 2003 Mr. Kass served as a guest host on CNBC's "Squawk Box" and has guest hosted Bloomberg's "Market Surveillance" for the last five years. Along with Jim Cramer, Doug is the principal contributor to Real Money Pro.

2018/06/20
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