Why Price Volatility Is Your Reward Resource, Not Your Risk Retreat

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Includes: IHE, TECL
by: Peter F. Way, CFA
Summary

Your investing progress score is kept by the size of your portfolio’s value. Value is measured by number of shares times their market prices.

Your number of shares may make tiny advances by DRIPing dividends, but real value portfolio growth comes from capturing price advances. They’re many times the size of a dividend.

And from compounding that expanded, captured capital with price advances from its reinvestment in an appropriately selected new capital gain opportunity.

Appropriate selection involves choices of both the investment subject and the timing of its entry and exit actions.

Let market professionals tell you which security and at which entry and exit prices are favored.

Current examples:

iShares US Pharmaceuticals ETF (IHE) just completed another price-gain trip at a price of $160+. It was flagged as an attractive buy several times in the recent few weeks by the actions of market-makers [MMs] as they helped major investment fund clients add IHE to their portfolio holdings.

It takes a lot of $100+ IHE shares to make much of an impact on a multi-$Billion portfolio, and the usual few thousand IHE shares a day volume isn’t likely to fill an order from a big-money fund client, even if the trade sucked up all the shares in sight.

So, the market-maker goes to other clients who he knows own the stock (ETF) and are active as stock-lenders (for which they get an additional income fee). The MM short-sells what is needed to fill the big$ client buy order and borrows shares from the lender to deliver on the short-sale.

Now, the MM has capital at risk until the short position is cover-closed, and if its price rises, the MM loses on the position. So, before the trade is ever filled for the big$ client, a side-deal is set up to hedge that exposure. The hedge has a cost, paid by the big$ client as a price of market liquidity, allowing the ordered trade to get filled. Unless the client thinks the cost is too large, and then the trade order may get killed, at least for now.

What has to be paid to protect the MM and the way the hedge deal is set up defines what the MM community sees as a range of prices reasonable to expect in the next few months of legal life in the derivative securities used for price-change insurance.

We watch how that range of expected prices relates to the security’s market quote and how all the relationships change as time progresses. Those details are presented for IHE in Figure 1.

Figure 1

Source: blockdesk.com © 2018

The mystifying second column of Figure 1, captioned “RI”, stands for Range Index. It measures that percentage proportion of the whole forecast range of from High to Low which lies below the Market quote, down to the Low Forecast. The Upside column measures the actual percentage price change distance between the Market and the High Forecast price.

We keep score on the outcomes from the forecasts by a rigid portfolio management discipline which “buys” a position in the security at an entry cost of the closing price of the day after the forecast. That position is held ready to be closed out at the first closing price after the forecast day, which equals or exceeds the High Forecast. That Exit price is noted, along with the Entry price to calculate the decimal price change on a 1+ basis.

The exit date is compared with the forecast date to conservatively measure the period of capital commitment to the “position” in the days column. The decimal part of the 1+change is converted onto basis points (1/100th of a percentage point) per day to reflect the appropriate RATE of change coming from each position’s potential. The conventional CAGR measure is also shown for ready reference.

Those rows of Figure 1 which are not complete are ones where the top of the row day’s forecast (in blue) has not yet been reached, or the Days beyond the forecast date are still less than 63. The evolution involved is, for some folks, easier to envision in Figure 2.

Figure 2

(All materials in this article from blockdesk.com have been approved)

This not the usual “technical analysis chart” often seen in investment discussions. Instead of being a history picture of history, this is a history picture of forecasts. Each vertical line here is an out-of-sample forecast of possible/probable coming prices for the subject security as seen live, day by day before the fact.

The heavy dot is the closing market price on the date the forecast was determined. It divides the forecast range into prospective upside and downside pieces. Their proportions are reflected by the RI, while the degree of uncertainty in the forecast’s overall range is subject to unpredictable variance.

What contributes to the incomplete condition of some rows in Figure 1 is the failure of some subsequent heavy dot to be as high or higher than the top end of that day’s vertical range line. Our Figure 1 yesterday looked quite a bit different, since today’s Figure 2 picture had not yet added the right-most vertical with its current heavy dot closing price of the day, being higher than several recent prior forecasts.

That price gain event acted to close out several Figure 1 positions with Exit dates and prices of 12/3/2018 and $160.16. Several other dates’ forecasts are not distant and a continuation of this most recent rise by as little as 1% would capture their gains for further reinvestment and potential compounding in currently available attractive investing opportunities.

But when to buy?

Figure 1 shows the outcomes of all dates when subjected to the portfolio discipline. But it is evident that some days are better than others. A look at Figure 2 shows that some days not pictured in Figure 1 are indeed horrid days to be owning IHE. Like all the red lines and most of the yellow ones. The green lines appear to be very good choices, since their heavy dots are mostly down near the bottom of the vertical forecast ranges.

This is why the Range Index exists, as a warning measure when over 100 (the red lines) and over 80 (the yellow ones), and green as an alert when RI is only a dozen or less.

Of course, seeing just one example of when the discipline worked is hardly a convincer. Figure 2 only covers daily forecasts over the past 6 months. Let’s take the same kind of forecasts for IHE over the past two years, picking one forecast a week (same day of the week) and see how that compares to Figure 2, as Figure 3.

Figure 3

The recent 6-month experiences have been repeated (perhaps not quite as colorfully) a number of times in the two-year period, where low green-line price forecast tops get surpassed, sometimes in a surprisingly short time. Often, yellow warnings are soon followed by productive green buy opportunities. The effect is not just a rare transient one, and the reward sizes can be substantial from the buy opportunities only to the first market prices triggered by the top-of-range sell targets.

When we go back and look at IHE’s entire market existence, starting in September 2015, we find that of 819 days’ forecasts, 323 had RIs less than 20 (an upside forecast of 4x the downside). Those forecasts produced average portfolio-disciplined price gains at 27 bp/day rate or a CAGR of 168% in about 40% of forecasts, easily definable ones.

No Fair!!

That’s right, we knew this would be a good illustration before we posed it.

But that’s what we do with all of our block trader reports. When you look at Figure 2, there is a row of data between its large and smaller pictures which repeats the forecast and tells what other prior forecasts of the same level Range Index have produced in IHE. While they are just history, not a forecast, they do offer some perspective on what might be reasonable to expect, and what other things might be far beyond the pale.

So, where is IHE now in the buy-hold-sell cycle? Look at three things on its Block Trader Forecast picture data row: Current Sell Target Potential (+0.6%), Win Odds from prior buys at this Range Index (43 out of 100), and annual rates of return from prior RI buys (-19%).

This is an investment to be avoided, not entertained – for the present.

It has had its glory periods, plenty of them. But now is time to shut it down.

The Better Alternative

Plenty of other ETFs provide far better alternatives. Here in Figure 4 is a visual comparison of leveraged long ETF Reward~Risk trade-offs.

Figure 4

The reward prospects, measured on the horizontal green scale, are from the upside forecasts of market-makers. The Risk exposures - red vertical scale - are from actual experiences of prior MM forecasts with the same Range Index up-to-down proportions as today's forecasts. Both scales are in percent price change, from zero to 25%. The green shaded area is a reward to risk sector of 5 to 1 or better.

Check the MM expectations for Direxion Technology Bull 3x Shares ETF (TECL) at location [18].

On the same three key tests of IHE outlook, try TECL's prospects, indicated in Figure 5.

Figure 5

Upside sell target potential:+23.9%; Win Odds of profitability from similar prior RI forecasts: 86 out of 100 (better than 8 out of 10); annual rate of return from prior forecasts: +309% due to +11.7% simple gains (net of losses) being captured in one-month average holding periods.

Also look at the Range Index of today’s forecast: -1. In its past 5 years, TECL forecasts have had predominantly higher Range Indexes. They usually get there by prices rising, not by expectations declining. And expectations now are in a rising trend, with ample recent history of prior higher outlooks.

TECL’s longer 2-year weekly experience history provides higher prices and anticipations ranges to return to. The same kind of actuarial records illustrated in Figure 1 on IHE exist for TECL and over 3,000 other stocks and ETFs, many going back to the turn of the century in 2000.

Figure 6

Conclusion

The specific circumstances in these two ETFs provide rather clear motivations for wealth-building investors to be moving from iShares US Pharmaceuticals ETF into Direxion Daily Technology Bull 3x ETF. Here, volatility is working for the investor, not against him/her.

Disclaimer: Peter Way and generations of the Way Family are long-term providers of perspective information, earlier helping professional investors and now individual investors, discriminate between wealth-building opportunities in individual stocks and ETFs. We do not manage money for others outside of the family but do provide pro buono consulting for a limited number of not-for-profit organizations.

We firmly believe investors need to maintain skin in their game by actively initiating commitment choices of capital and time investments in their personal portfolios. So, our information presents for D-I-Y investor guidance what the arguably best-informed professional investors are thinking. Their insights, revealed through their own self-protective hedging actions, tell what they believe is most likely to happen to the prices of specific issues in coming weeks and months. Evidences of how such prior forecasts have worked out are routinely provided.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TECL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.