Think of buying equities for the long term as stepping onto an escalator. The name of the game is growth and we trust that things will go up in value thanks to father time. It is a tried and tested strategy and 97% of all wealth managers buy and hold equities as part of an investment strategy. Of course, when you buy has a huge impact on your potential returns. People that bought the market in June 2008 have a much different return profile than those that bought in March 2009. And therein lies the rub with this strategy and presents an often-underestimated risk.
Picking stocks, corporate bonds, commodities or any other financial securities that are traded on exchanges are subject to market risk. And no matter how sound the fundamental or technical analysis, no matter how “right” we may be, buying and holding any of the afore-mentioned securities entails much unwanted risk. In other words, you may have built yourself a nice sandcastle, but when the tide comes in, it is all for nought. Again, if you buy Vodafone for the long term, then you may wish to ignore any market volatility and look at the position in ten years’ time and see how you did. Nothing wrong with that, but trading is about making money from the calls we make and the more we can isolate the opportunity we have identified, then the higher the quality of our strategy.
For some reason, people always associate trading with making calls on the market, but only amateurs would try their luck at calling the next direction in asset prices. For the professionals, it’s all about finding things that are out of whack, to put it into technical terms. In other words, you look for prices that seem wrong. For most, that would involve performing a fundamental or technical analysis of a financial security and determining that the value is different to the current price in the markets. An example would be to find that Vodafone is worth 300 (according to our analysis) yet trades at 200, and we would therefore buy shares and simultaneously sell the FTSE index in equal measure against it. Clearly, there are other risks this trade would entail, such as sector risk, as the FTSE contains much more than just telecom stocks, but that can also be neutralised by selling so-called sector ETFs. The biggest risk in this strategy though remains timing, as even though we have eliminated market risk, we just don’t know when Vodafone will re-rate to our price target and meantime, we have the market or sector hedge reacting to a much different set of factors.
Much higher quality trades are so called event driven or special situations. Here we are not relying on a seemingly arbitrary analysis of what something is worth, but rather we take a specific view on a known factor. Say, that a company has announced that it will merge with another and there is a specific offer in the market. At that point, the target company is in play and the only thing that matters is if the merger will go through. Market events, volatility, even Brexit or the trade wars – none of these factors will matter so long as the merger gets approved by the regulator and the shareholders. This allows us to focus solely on the merits of the takeover and we can perfectly ringfence anything else that may be happening elsewhere. The other week, there was an attack on the Saudi oil facilities and oil rallied more than 15%. This was a perfect example of a special situation and we could analyse whether the price spike was justified or not. As it happened, oil duly retraced, as the attack was deemed a one off and there were many traders who made a lot of money by trading the event. The beauty of trading around these types of situations, is that we know something for sure and that’s a lot more to go on than trying to time the markets and taking a view on randomness.