Trading Strategy which capitalizes on loss aversion triggered off by hyper media coverage

Trading algorithm

Large Dip Scenarios

GOVERNMENT versus Government
  • Pre-requisite: Company’s industry impacted by political event
  • Action: Short position
  • Trigger:
    • Company explicit modifies earnings guidance based on macro political event
    • 2018/2019 – US/China trade war
    • 2014-2016 – Saudi Arabia/Iran/Russia/US oil crisis
  • Pattern
    • Tracker reports more than 5 companies experiencing large dips.
company versus Government
  • Pre-requisite: Company has strong fundamentals
  • Action: Long position
  • Trigger: Threat of potential regulation
    • No negative macro event
    • Bug in software
    • Accidents not directly related to them
  • Pattern
    • trigger threshold 30-40% drop
    • expected exit level 20-25%
    • exit principal and level profit of 20% in position for risk free bonus
company versus Wall Street
company versus company
  • It is important to understand the underlying market structure to figure out if the new entrant will have significant long term impact on existing player in the market. Areas to consider for analysis (from Micheal Porter’s 5 forces model)
    • No negative macro event
    • disruption of existing distribution channels
    • market segment differentiation
    • customer lock in cost
  • Warning don’t do it if you don’t understand the dynamic clearly
  • Examples:

General restrictions

  • Only employ strategy when the macro economic trend is clear.
  • know clearly the exit prices before entering into position
    • don’t be greedy
    • helps guard inability to execute caused by procrastination
  • Long positions: strictly trade only on loss aversion and recovery to mean pattern in companies with strong fundamentals
  • Short positions: strictly trade only on companies within industry directly impacted by political event

Portfolio Allocation

  • Application of rule of 7 +/-2
    • hold no more than 9 open positions at any time
  • Micheal Porter’s 5 forces
  • Kelly model: determine percentage of fund allocated to position
    • Equation: ( (expected win amount * probability of win ) – (probability of lose) / ( expected win amount )
  • Proposed portfolio allocation levels for each large dip occurrence
    • 1%  – large dip
    • 2% – large dip + 1 positive Micheal porter’s 5 forces check offs
    • 5%
    • 10%
    • 25%
    • 50% – large dip + 5 positive Micheal porter’s 5 forces check offs

Execution Time Line

Short term: loss aversion

  • 1-2 weeks time horizon
  • Magic number 5: social proofing threshold beyond which 100% conversion occurs within population
    • in this case, we watch for coverage of bad news by at least 5 major news network
  • Capitalize misalignment of stimulus/news’s negative impact with business model fundamental
    • Company versus Government
    • Company versus Wall Street
    • Company versus Company – no longer term impact
  • Be very wary not to take positions when conflict is between
    • countries where tactics directly impact affected industry
    • Company versus Company – with long term impact
  • Don’t be too eager to jump in too early
    • Ok to wait till the coast is clear
    • Ok to make less on the rebound
  • if entry was done too early and price is still going down, exit at 10%.
    • Johnson: Much easier to buy at a cheaper price later than to ride it all the way down and then back up. Latter requires a lot of crowd confidence which is not common.
      • a 20% down is a 25% up
    • Dan Kwon: Don’t catch a falling knife
    • Don’t double down capital on a bad decision
      • lesson from bad trade with BreitBurn  in 2015
  • Exit at 75% price range recovery
    • save yourself from unnecessary mental anguish by running various what if scenarios for not going along with the rest of the ride
    • a good gauge is when information parity has been achieved between main street and wall street

mid term: reversion to mean

  • 3 month period – a financial quarter
  • exit at 75% price range recovery

Main detractors of ability to stick to strategy during execution phase

  • Inability of manage symptoms of craving – greed
  • Inability of manage symptoms of aversion – fear

Long term: lessons from Berkshire Hathaway

  • Warren Buffet:
    • When management with good reputation meets industry with bad reputation, its the reputation of the latter that remains intact
    • A rising tide raises all boats, it’s only when the tide goes down when u know who is not wearing pants
    • When two companies make the same returns, the one that needs borrow less is the more capital efficient one
  • Charlie Munger
    • Don’t just do something, stand there

Warren Buffet Portfolio Strategy – Kelly Model

  • Expect to utilize a long time horizon when using the Kelly model
  • don’t use leverage as it will force u out of a position when price tanks
  • dont overbet when using the Kelly Model – penalties of over betting is much worst than under betting
  • holding more than 15 positions is suboptimal
  • study models in multiple domains which will help triangulate probability better
    • Models from field of Psychology
    • Models from economics
    • Models from Physics
  • read widely. It’s cheaper than making own mistakes
  • stick to domains you are very familiar with and have a decisive advantage versus the average investors – even tech which is becoming a bigger sector over time

Advice from Johnson on trading

  • Remember clearly the outcome you were expecting when you enter a position
  • Don’t be greedy and expect to ride all the way to the top to levels beyond your expectation. The fall usually occurs beyond that level.
  • Be conservative and hop off just slightly before your expectations are met
  • changing strategy (self-narrated story) in-flight makes it hard to measure the actual effectiveness of the strategy over prolonged periods of time
  • Thinking that a strategy is perfect and can be repeatedly applied without micro-calibrations and occasional drastic changes assumes environment holds constant. That is wishful thinking.

Advice from Jake on trading

  • Entry at a 52 week low level is ideal during a scare
  • Historical context based analysis is really useful.
    • PCG was trading at USD7 during bankruptcy proceedings back in 2001 and was trading at the same levels period prior to bankruptcy proceedings in Jan 2019

Related Case Studies

Useful frameworks for dissecting companies

Useful resources worthy of reference

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