Loans and cash

Fixed Initial Investments

admin — Thu, 10 Dec 2009 10:14:44 +0000

How much should be invested? The optimal amount is difficult to pinpoint because you would have to know what risks lie ahead, and of course, that’s not possible. However, based on a very small likelihood of losing 50% of the portfolio when 50% is invested, one might say that a portion under a 50% investment is best. To account for greater uncertainties in the future, you could increase your confidence by investing only 25% of the initial portfolio. This approach has negative effects, because a smaller relative investment reduces both risk and returns. When the investment becomes too small, the returns are no longer attractive.
The chance of a catastrophic risk is an important concern for any investor or portfolio manager. For practical purposes this is always figured on the historic profile of the data or trading results. This still leaves uncertainty in the final values. Nevertheless, the most extreme situation is often found by using the calculation for risk of ruin, most often applied to gambling situations in which the bet sizes, pay out, and odds are well defined. When there are enough test data and trades, this technique has been applied to trading systems.
Some analysts have tried to deal with the uncertainties of price movements by using a Monte Carlo technique in testing, which shifts the sequence of blocks of data, or profit and loss results, so that they occur in random order. The worst results are considered the greatest risk. This approach may be unrealistically severe, yet even the real performance is not likely to reflect the size of the risk in the future. For those traders applying a long-term trend-following technique to capture moves that are based on economic or government policy, sustained profits are most often followed by a reversal before the trade is ended. In fact, the ending change of direction is directly related to the sustained move. To move this data around so that the loss comes at a different time may create a large loss without the offsetting profit, which is a situation that is unfair to the trading strategy. Before applying a Monte Carlo analysis, it is first necessary to identify the dominant period of sequential correlation to avoid segmenting the series incorrectly.
For an initial investment, the optimal f is simply the maximum part of that portfolio that can safely be traded without any significant risk of ruin. For those investors who take out profits when they occur and continue to trade based on the same assumed initial investment, nothing need be changed unless exceptionally high risk causes a reassessment and decrease in the amount of leverage. However, it is more common and more complicated for the investor to vary the amount committed to the market by either increasing or decreasing leverage. This involves (1) determining the right time to change the leverage, (2) calculating the amount to increase the investment when there are profits, and (3) figuring the size of the reduction when there are losses exceeding some designated amount. These are issues that are addressed by optimal f.

Adding Equal Positions

admin — Mon, 07 Dec 2009 10:13:43 +0000

As larger commitments are added, an inverted pyramid is created in which the risk of an immediate loss due to a small reversal becomes greater.
Adding equal numbers of contracts reduces the proportion of the original commitment in the event the trend does not materialize but increases later exposure (when, hopefully, there are large profits). The shift of risk can only be determined by the trader. With this approach, as well as the other inverted pyramid formations, the speculator should follow the rule that no unsuccessful secondary position should offset the entire profits of the prior positions.

The Scaled-Down Pyramid

admin — Fri, 04 Dec 2009 10:09:08 +0000

The patterns used to compound positions can be represented geometrically as pyramids. The standard pyramid, or uprigbt pyramid, has a larger base than its top. The largest portion of profits are developed early and an adverse price move is not as likely to be disastrous. The profit-compounding effect of this technique is comparably reduced. A favorite scaling method of this type adds one-half of the prior position at each opportunity. The maximum number of contracts to be held must be planned in advance. The total position, if followed to completion, will be about twice the number of contracts that were initially entered; starting with 20 lots, 10, 5, 2, and 1 would be added, respectively. An advantage of this or any other pyramiding method is that an initial loss will be based on a smaller number of contracts than the final commitment.

Financial risk

admin — Tue, 01 Dec 2009 10:07:52 +0000

Financial risk is the uncertainty introduced by the method by which the firm finances its investments. If a firm uses only common stock to finance investments, it incurs only business risk. If a firm borrows money to finance investments, it must pay fixed financing charges (in the form of interest to creditors) prior to providing income to the common stockholders, so the uncertainty of returns to the equity investor increases. This increase in uncertainty because of fixed-cost financing is called financial risk or financial leverage and causes an increase in the stock’s risk premium.

COMPOUNDING A POSITION

admin — Tue, 24 Nov 2009 10:06:40 +0000

At some point, all speculators find themselves adding to, or compounding, their position. Many traders view this as a means of concentrating on those commodities that have more potential. There are two lines of thinking among these traders. When a trade becomes more profitable, it is confirming its move and is thought to deserve more of a commitment than a trade that has not become profitable. On the other hand, by adding positions to a trade at preset intervals, the effect of a single poor entry point is reduced and a better average entry price is created. This latter technique is called scaled-down buying in the securities industry.
The following sections will assume that positions are added based on profitability as a means of increasing leverage. There are a number of techniques used by experienced traders, but the time to add must be carefully selected. The situation chosen must have potential for a long move with limited risk; the sustained consolidation period of a market that is priced near its historic lows would be a candidate. No matter how well chosen, each method will result in the largest holdings at the highest (or lowest) price; when the market reverses, losses occur on a larger base and profits will disappear quickly. Compounding a position is very fragile, hard work and must be watched cautiously for a changing market; there are enough stories of speculators who leveraged small capital into a large fortune in less than a year’s time and then lost it all in a week. As in all investments, the risk balances the opportunities.

Real-World Complications

admin — Fri, 20 Nov 2009 10:05:44 +0000

By recognizing your ability to shut down the gas turbine plant, you are able to estimate a much more precise value than you would assuming a stupid “always running” plant value. However, many problems remain with the $28.6 million value estimate. Even if you cannot address each and every one, you want to at least recognize them.
Your most important concern is that you need to estimate the electricity price process for 2000, not for 1999. This is a self-contained task—you can do so, even before you ever consider the plant itself.
1. Your $28.6 million calculation was for profits if you had operated in 1999. Alas, it is more sensible to assume that 1999 would only be indicative of 2000 in terms of the electricity price process (e.g., mean and standard deviation). Moreover, you know that 1999 closed with a price of $28.89, not the average price of $28.09. Can you make use of this knowledge? In any case, you should assume that history will not repeat itself, but that it can teach you a lot about the future. This is exactly analogous to our earlier assumption in the investments sections of this blog, where we stipulated that historical return statistics (means and standard deviations) are indicative of future statistics, but that the exact future return realization could end up quite different from the past.
2. Even if you use 1999 data to estimate the statistical process for 2000, it could be that the historical process is not a good guide for your future. If your experience in electricity management makes you capable of better estimating the price of electricity in 2000, then you can come up with a better cash flow estimate. But to improve your estimate of the value of the plant, you must be able not only to forecast the mean electricity price, but also the standard deviation in the electricity price. (In retrospect, we know that the past turned out not to be indicative of the future. California experienced a famous energy crisis in 2000, partially due to price manipulation by the energy producers themselves!)
3. If you look at the historical prices, you will see that each weekly price is not exactly a random draw from a fixed distribution. When the price the previous week was high, chances are that the price this week is also high. For example, at the end of the year, the price stood at $28.89. This implies that the next price is unlikely to be $50 or $18, but more likely something between $26 and $32. In contrast, when the price was $50 last week, you would expect it to be something, say, between $44 and $52. (Note that this is not necessarily symmetric around $50!)
You know that in order to value your plant, you must forecast some process for the electricity price in 2000. Your technique itself can range from the simple to the fancy. In the real-world, the better you are at electricity price process estimation, the better will be your value estimates. Typically, the best forecasts combine qualitative managerial knowledge of the industry and business with quantitative statistical modeling techniques. We shall explore two kinds of electricity forecasting processes in the next two sections: a simple qualitative version, in which you write down a reasonable and intuitive binomial tree; and a quantitative statistical time-series estimation, in which you estimate a time-series model from the historical electricity price data.

Portfolio Calculations

admin — Wed, 18 Nov 2009 10:04:44 +0000

Deciding which systems and markets should be traded at the same time, in an effort to reduce risk through diversification, is an entire field of expertise called portfolio management. While markets have always changed, reflecting economic policy and the growth of participation, more recent years of globalization have made portfolio management much more difficult. As more institutions trade international markets as they do their own, they cause a higher correlation of price movements throughout the world. This increase in correlation between previously unrelated areas makes it more difficult to reduce risk through diversification, and makes previous asset allocations obsolete. One answer to this problem is simply to rebalance the portfolios more often, regrouping assets by their similar price movements.

DIVERSIFICATION part 2

admin — Sun, 15 Nov 2009 10:03:43 +0000

Practical diversification can be implemented using a broad selection of markets within a single tactical system, a selection of different trading strategies for one product. or a combination of multiple systems and products. The objectives of diversification are:
1 . Lower daily risk due to the offsetting of losses in some markets and systems with profits in others.
2. Insure participation in major moves by continuously trading those markets in various groups that are likely to reflect fundamental changes. This avoids the need to identify which market will perform the best.
3. Offset unexpected losses caused by a system failing to perform in the current market, or a single trade that generates a large loss. It may be only had luck that one System gave a short signal in coffee the day before the freeze that moved prices limit-up for 21 days, but another system might have given an offsetting buy signal
4. Reduce cynosure in any one market or related group by, having funds distributed over many groups. If there are 10 unique asset classes. then an equal allocation only risks one-tenth of the portfolio. The more groups. the less the risk.

Diversification

admin — Thu, 12 Nov 2009 10:02:35 +0000

Diversification means spreading risk; it is the well-established way of lowering systematic risk, and every investor is well advised to diversify’. For the purposes of risk reduction, it is necessary to distinguish between systematic risk, which can be reduced by diversification. and market risk, which cannot he eliminated. The benefits of diversification are greatest when the markets traded are very different and the methods of making decisions are also unrelated. Typical investment portfolios contain a variety of fixed income. equities. real estate, art, as well as different investment philosophies, all intended to provide different rates of return with different patterns and not suffer losses all at the same time. Unfortunately, this is not always the case. Market risk, including catastrophic risk, is not predictable, and can surprise even the best investors. Avoiding market risk is the subject of this and other sections in this series of posts.

LIQUIDITY

admin — Tue, 10 Nov 2009 10:02:27 +0000

The realities of trading are directly related to the liquidity of the market. Even though liquidity can have more than one meaning, lack of liquidity has only one trading result: poor execution. A liquid market does not necessarily mean good fills, but an illiquid market assures bad ones. Two types of illiquidity are most often encountered in the markets:
1. Fast-moving markets, in which there are mostly buyers or sellers, and few traders are willing to take the other side of the position.
2. Inactive markets, usually in the deferred months in which there is less interest in either hedging or speculating.
The fast market is the result of a supply-demand imbalance, or perceived imbalance, where everyone is in agreement on the direction the market should move. The few hedgers and traders willing to take a position do little to offset the vast number of orders that flood the floor, pushing the price in the direction of the trend. In the inactive market, a premium must be paid to attract another trader to take the opposite trade.