Nothing in life is to be feared, it is only to be understood- Our Precarious Habitat (1973) by Melvin A. Benarde
Previous posts on Trend Following & Capitalmind Chase Here
In this post, we will explore the risks inherent in trading Capitalmind Chase and attempt to put that in perspective.
Incidentally, I am currently reading this book Deep Survival: Who Lives, Who Dies, and Why by Laurence Gonzales, a book that delves into what goes on in the minds of people who manage to survive extraordinary circumstances like accidents or catastrophes, and what in those who don’t.
He spends quite some time on the idea of mental-models, especially the importance of continually updating our beliefs with new evidence, as and when they arrive.
It seems survivors are far more objective of the reality around them, that objectivity helps them prepare better for possible catastrophes. On a spectrum of being fearful to foolhardy, they manage to sit right at the edge of fearfulness.
This kind of approach to risks is something that I find to be relevant to the work that I do, or rather, what we do at Capitalmind.
You may ask, whats all this got to do with overnight or other risks inherent to positional trading strategies like Capitalmind Chase?
Ever since we launched Chase, at least once a day, someone or else asks me – But what if there is a gap? How will we manage it?
While the question is pertinent, but the tone with which people ask – gives me a sense that the overnight risk is being given much more attention than it deserves.
As I answer this question, I would also attempt to help you with ideas to structure your thinking about risks, something that can be applied to other contexts as well.
Start with the big picture.
This would mean understanding Chase as a strategy and how it works. More about it here. Understand leverage and how it affects Chase in particular. Please scroll down on this page to read more about it. In essence, you need to know what makes a strategy work. The key driving factors in any given content.
Classify the sources of risk
The risk here means anything that adversely affects the outcomes. The question to ask would be – what are the different events that can happen which would affect the outcome. You can typically classify two broad sources of risk. The first is Strategy Risk.
Strategy Risk – This is the risk inherent to a strategy. It can be both predictable or unpredictable. For instance, back-tests on historical data may give us some sense of max loss or max losing streak. Still, future events need not be within those boundaries, or as in the case of negative oil prices, not sure if any forecasting model would have predicted that.
There could also be a signaling issue; the strategy may not generate the right signal due to erroneous data, something that may not have happened on historical data.
While these are the risks inherent to strategy logic and signaling, the next set of risks, which amateur traders often ignore, is execution specific risks.
Execution Risk – How sure are you about executing the trades as close to the signaled price as possible? ; What if the broker terminal is down when you get the signal?; What if there are margin/cash related issues due to which you may not execute the trade?; What if your internet infrastructure is down and you are not able to execute the trade?
Each of these risks has to be evaluated and contingencies built accordingly.
No, I do not mean we need to cover each of these; the costs to do so may out-run the returns. However, one has to evaluate the probability of an event happening and build redundancies for events with a higher likelihood for a given context.
Managing Risks, One at a time – Overnight or Gap Risks
A risk that is well within the strategy and is entirely foreseeable. They call it ‘Overnight’ risk or ‘Gap’ risk. To measure it, all we need to do is find the difference between Current day’s Open and Previous day’s Close. If the current day open is lower than the previous day close, its a Gap down, the other way its Gap Up.
The two charts below, show the daily Gap sizes in points and percentage (from previous day close) for the month of March’20 and August’20
I take March’20 as a reference as it shows us how wild wide gaps can be, and it also has one of those Lower Circuit days (marked in orange). Compare that to the gap sizes in August on an average you would see a difference of 10x between March and August gaps.
Why does a Gap or a Overnight price move become a risk?
Because there is little you can do about that risk other than hedge it. Supposed you are long on NIFTY through futures at 11500, next day the index gaps down and opens at 11200. You have no choice but to exit at that price or wait for your trading system to signal an exit. Risky? Yes – very much.
While calling it risky is fine, but how risky is risky? How much Gap can we expect at the max?
To understand this we will delve into the concept of pre-open auction and circuit filters. Deepak explains pre-open auction mechanism here and circuit filters here.
“Currently, market wide circuit breakers apply after a 10% change (1 hour), 15% change (2 hours) and then 20% (rest of trading day). This halt will apply to all stock exchanges, including derivative markets”
What this means for Chase is – at worst you would have a 10% gap in the 1st hour, and the market will again do a call auction before it resumes after 45 minutes of halt. But then as you know Chase has two components, a Passive (always long) NIFTY ETF investment and a Futures (long/short) component. How would it work for each of the components then? Look at the matrix below to understand this better.
Column 2 – ^NIFTY Index – Tells us the Gap Direction; Column 3 – Tells us the direction of the Futures Position at the time of Gap. Column 4 – Is NIFTY ETF which is a always Long passive component. Column 5 &6 – Tells us the net effect of Index move/Gap on Chase. For Example – Scenario 1 tells us that there was a Gap Up in NIFTY, We were long on Futures and were long on ETF anyways, so we make 2x returns.
click to enlarge
There are six scenarios possible, its the 6th scenario that’s the worst for our p&l. The matrix tells us the scenario where we may lose the maximum. ie. when we are long on futures, ETF anyways is long, the index crashes and hits a lower circuit. If this happens we lose 20% of the notional equivalent/capital. 10% through futures and 10% on the Index ETF.
In other contexts where we run the risk of losing at max 10%, like 2nd and 4th scenario, as we are not levered our losses are limited to the extent of the index move.
Now that we’ve established how much we can lose due to an adverse gap, lets find the odds of such a thing happening. In the 12 years, we’ve had only two instances of max 10% lower circuits, 2008 and 2020. That should give us a sense of how frequent such moves happen. Also, we need to assume that the strategy was long when the circuit limit hit.
One gap and next – Building what-if scenarios
Let’s imagine we were long on Chase and a 10% lower circuit hits for we had to exit from our futures position. In other words we book a loss of 5% on notional value.
Now for some reason the signal goes short and we are short on futures and long on ETF anyways. (Scenario 2) – and market hits a upper circuit of 10%. In this case we again lose 5% of notional on futures.
While its important to imagine what-ifs and build processes and risks models accordingly, but its still very bounded in my view, let me tell you why.
Putting things in perspective
Holding period effect
Risk and Returns in any trading/investing system are linearly correlated to ‘holding period’. Lets say you were a pure buy and hold investor. What do you think causes the largest losses, not single day moves, but prolonged down trends. It could be worse for stocks specific portfolios. If that interests you, do read what Anoop has to say about failed investments here.
Likewise on the up-side what gives you alpha in investing is long up trends. We tend to fixate on events like gaps and circuits, because they get highlighted by media, and are much talked about.
True with almost every other aspect of life that works on iteration, incrementalism and compounding. Binging on fries and soda once or twice a year is not going to kill you, do it every day and the outcomes are very different. At the same time, if you are a fitness freak, you can endure that binging even more.
Likewise, if you are trading a system for a few years, one circuit or gap does not matter, what matters more is – Does the system capture long up-trends and down-trends, over a period of time.
Position sizing & Leverage
If you have high cholesterol levels and type II diabetes, the kind of binging described above would have a very different effect. Your body’s ability to tolerate those ‘shocks’ would be much lesser than that of a fit person.
That’s what leverage does to a trading system. Greater the leverage, lower the ability of the system to survive shocks.
One of the key reasons, we follow a fixed position sizing and low/conditional leverage approach for Chase as it eliminates ‘risk of ruin’. As a trader concerned about risks of a system, you would be better off, focusing on aspects like variable position sizing and degree of leverage, if that happens to be a feature of the system you are trading.
Excessive focus on single events like Overnight Gaps leads to some sort of Anchoring bias. It also affects our ability to think more holistically about a problem.
Going back to Deep Survival most instances where people have died in catastrophes involves ignoring early warning signs, typically the ones that happen at the intersection of optimism, denial and self-deception.
Same happens in Investing, usually with the passive kind. Always be wary of loss-creep. Its usually too late before you can salvage anything meaningful. Add a dollop of leverage, discretionary trading and variable position sizing and voila you would have a sweet ‘Little boy’ in the making.
Not sure where I read it, but it said “Just as Rome was not built in a day, it was not ruined in a day either”
To get access to Capitalmind Chase, and to our other model portfolios and slack access, subscribe to Premium. For a limited time, we are offering 20% off on the annual plan. Use Coupon Code CHASE20. If you’d like to try us out with a Quarterly plan, use Coupon Code CHASE15 to get 15% off.
