Stock Market Risk Into Brexit: What Does Risk Mean?

| About: SPDR S&P (SPY)

Summary

Brexit becomes an event for all investors.

It may compare to US Fed day on steroids.

This is a public service announcement of sorts.

Into Fed events we typically bring down positions, reduce risk and watch like on The Fourth of July.

Click to enlarge(Picture above: The 4th of July is coming and we're all waiting for the fireworks spectaculars. We're all happy that we're not literally in the war leading up to July 4th 1776. It's a big difference having bullets whiz by versus watching the fireworks on a relaxing summer eve. Brexit is that risk. Where do you want to be sitting?)

What's Risk Really Mean?

We wanted to take a moment to convey what risk means. Risk is the thing of Wall Street trader photos in dismay losing money. Volatility and risk are usually tough to react to. Emotions get a hold of a person to make wrong decisions especially if they "placed their bets." The simplest action is to reduce exposure ahead of such events rather than getting fancy or worse, "going for it."

Reducing Positions Into Events Is A Sign Of Discipline And Safety

We remember reading the advice of Mark Fisher in his The Logical Trader. (We have no affiliation to him whatsoever except that we used some of his formulas on occasion after reading his book). He said in that book to take positions down by half into major releases like FOMC decisions or an oil inventory report. He is a master trader and runs one of the major futures clearing houses on Wall Street. He handles much of the oil transactions that take place.

If an expert trader thinks it's smart to reduce positions into and during such an event, so do we.

He does say that volatile markets are good for expert traders, but before the numbers and during it's better to be on the sidelines.

For Brexit, that period "during the numbers" is an all day affair on Thursday and could be an all day affair on Friday.

All that said, even after the numbers are reported, there are many pitfalls to trying to "play the reports."

We've followed this and it is sound advice.

Major pitfalls that we see trading events like this.

1) If you are too big, it's very difficult to react.

2) If you are too big and it goes against you it is very difficult to react.

3) If you are not a master trader who consistently makes money from the swings, you don't want to use this as a practice day. This is Indy 500.

How we see the best philosophy going in.

1) We will wind down positions to core longer term holdings and wait for the weekend and the following week to decide how to rebuild those holdings.

2) We will not have anything on that we can't afford to lose.

3) We know going in that all but a select few traders will be able to ride the bronco.

We call this watching the fireworks on July 4th. We'd prefer to watch the fireworks than have bullets zing past us. Brexit is something with the potential to be issues for many traders. We are leaning bearish but it can go either way.

And, even with all that, some want to play it anyway.

1) If we wanted to play it anyway we would play much smaller than we otherwise normally would. We need to be in a position that if the market goes much further than we'd expect, it will not destroy us.

2) We may set wide stops and limits in the system and put them in ahead of time. We've seen these type of "far" limits get picked off in fast market swings. They are longer term move type swings so we want to be ready for them.

What we don't want to see.

1) We don't want to see investors just waiting like the super-bowl with full trading positions to see how it's going to play out. All investors are on the field Thursday and Friday, not merely a spectator.

2) We want to think through what market volatility may force us to do or force us to (hopefully not) make mistakes because of the speed of moves.

Here are some charts from this year's "Fed Days." We think the volatility of Brexit has the potential to be much larger. We expect much bigger and faster swings to take a lot of people with them. The market is the house and on fast days has the potential to lower the odds to those "playing."

You can see the volatility that started at 2:00 when the Fed releases its statement. These charts show the S&P 500 ETF (NYSEARCA:SPY) reactions.

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Those are the Fed days from this year with the vertical line posted at 2pm when the Fed generally comes out with their release.

Brexit has the potential to be a Fed day on steroids with more unknown and more global participants playing multiple types of trading instruments.

Brexit is an all day affair with no real 2pm event intraday. We expect many to be positioning all day in many types of trading vehicles which could effect markets going into the event.

Another issue with Brexit is that all the hype could sound like a decision one way or another at any time Thursday or Friday. To stay or leave could sound like they lead ahead of time, which can swing markets. Even though the vote is expected to be decided by Friday morning there is always a risk it could also take longer.

VIX (NYSEARCA:VXX) still showing complacency

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Above is a longer term chart of the VIX, the volatility index. On a longer time scale the VIX doesn't look like it's pricing in anything surprising. During the event, though, it may price in more volatility, which, to us, means down markets.

Fed Telling Us To Be Careful

In our "Stock Market Catalysts For Downside This Week" we point out that the Fed and banks are meeting to figure out ways to sidestep LIBOR. The reason is because the market is thin enough to be rigged. That fact tells us that multiple players coming in on one day in London and European financial markets bodes risk.

The Fed in their minutes even told us Brexit is an upcoming risk. Risk means volatility and downside. We want to take heed.

Levels

This could be counterproductive but we wanted to say where are good levels to buy or sell in any event. We think if there is volatility these levels, even though they seem far, could easily get picked off. We show them on the chart.

The levels go like this.

On the upside to sell quick moves by having limits in the system higher ahead of time: 207 and 209.

On the downside to buy quick moves by having limits in lower ahead of time: 198, 193, 190, 182.

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That's how we see it. Many will disagree, but this is our report so that's what we see.

We say this may be counterproductive because all too often a trader could find themselves buying and selling at those points bigger than they wanted because they really didn't believe the market could get there. Then it goes against them by continuing in that direction which causes losses. That's why every move needs to be done much smaller, which helps account for the unexpected.

MSTRTRDR, I am not

That's the reality. Emotions in volatility are tough to win over unless you are an expert trader like our friend mstrtrdr (We call him master trader. You can see him catching some rays after making some great trades). When markets became volatile this week, he wrote on our pages that this was his type of market.

Besides beating me up all day on our SA article comments he's shown me great and obvious trading acumen watching for reversals and catching trends.

I am not the intraday trader he is. I do not profess to be which is why I expect to go more to the sidelines. But someone like mstrtrdr, from what I've seen in our comments looks like he is one of the few that has the skills to ride the bronco.

That said, many, if not most of us, unless you are piling up money each year trading, should not try to ride the bronco like mstrtrdr can.

Conclusion

Our definition of being cautious is moving to the sidelines, going to cash and playing smaller. We are bearish and will probably have shorts. That said, we will probably cut our positions in half ahead of Thursday and/or Friday to avoid the market's wigs and wags with each breath of news. Those wags could hurt if traders are too big.

Good luck and please be in touch. All of your comments teach US a ton.

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