Mind your fungibles and plan to sidestep falling knives
- Fungible stock prices can fall hard and fast, causing further panics
- A stop can be placed, but not guaranteed without undue additional costs
- Holding fungible stocks, consider a defence utilising a slower stock to act as a brake
- Another aspect for traders to consider is elasticity
The classic professional floor trader mantra is liquidity of product and ease of immediate exchange. It's known in trader parlance as ''fungability''.
Such events are called "falling knives". Bargains can be found, but do you really want to catch that falling knife?
In the UK, Barclays and Lloyds banks are fungibles — extremely liquid stocks with a market depth that ensures your trade order will be filled immediately. Rarely will you suffer the effect of needing to seek a requote.
But Barclays moves far faster than Lloyds Bank. If you are long Barclays, you could preset an order to trigger short Lloyds as a slowing stock value. Why would you do that? If you have Barclays as equity and believe it is a growth story for, say, the medium term, falling knife scenarios can be painful.
Equities that are dragged down through no fault of their own will recover, so rather than suffer the drawdown, you could use Lloyds as a brake. It will track Barclays downwards and earn a profit (albeit slower), but give you time to re-assess the situation.
Perhaps Barclays will become a bargain, and you could then use the proceeds of the Lloyds' short for future purchases.
Perhaps you should consider an options defensive play. The options guys here outline plenty of these strategies. In times of low VIX, puts are cheaper than the implied volatility rank (IVR).
You could also sell an out-of-the-money call option, which should also be cheap. At times like this, I would try to preset an alarm to short the VIX when above 28, with the assumption that sooner or later the falling knife will hit support/floor of some kind, and profits can be made.
Trading at a VIX extreme of market volatility is often safer. Falling knives don't have to be caught, but can be played defensively as long as you are trading fungibles only.
In fact, we consume pretty much the same amount each year. We tend to cut frivolous expenditure before cutting core energy spending. It isn't just oil that has inelastic demand. Consider water, food and other consumer staples, and you can see why such sectors become defensive plays.
Furthermore, such sectors are big parts of indices and totally fungible. Equity portfolio managers should perceive when the commodity cycle is at a low for the establishment of long-term diversity and defensive stock positions.
Last week I mentioned rates of change between three currency pairings traded as one large-scale trade, and previously the correlation between the Nasdaq and S&P 500 using their moving averages.
— Edited by Adam Courtenay