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    MARKET EDGES

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“The successful warrior is the average man, with laser-like focus.”

-Bruce Lee

Bruce Lee was a Chinese American born in California in 1940, then raised in Hong Kong until his teens. He then returned to America as man of many inspirations. From philosophy, to screenwriting, and the martial arts, Lee was an average man who proved to be a successful warrior of life.

If you want to be a warrior of risk management, you need to be able to survive the daily battles of short selling. This is not a blood sport, nor is it one that deserves the attention of your emotions. It’s a mathematical martial art that requires flexibility and laser-like focus.

Overall, I’m probably a better short seller and risk manager than I am long term investor. That’s probably because I have more experience in down markets than I have in up ones. I entered this daily battle of ‘don’t lose money’ at a hedge fund in the year 2000. The first 3 years of my ‘be right or be gone’ experience were in down markets. Call me biased, but the only business I trust owning for the long term is the one I am building with my own hands.

Experience in short selling doesn’t equate to long term success unless you allow yourself to learn from your mistakes. You need to be mentally malleable. You need to have a multi-factor risk management model that isn’t pre-programmed or fixed. Your planning and strategy has to be dynamic.

Today, every mistake that I make ticks live against me on an open web portal. I am sure there are other effective ways to hold oneself accountable to reality in this world but, for me, this does the job.

Yesterday I made two short sales into the market’s close. I sold both the US Energy Sector ETF (XLE) and the SP500 ETF (SPY). Since I remain bullish on a continued Buck Breakout here in Q1 of 2010, my intermediate term bearish views on Commodities have been clear – but that doesn’t mean I need to be short Energy, Oil, or Gold at every price. If you want to be a successful warrior of short selling macro markets, start with this advice – don’t short and hold.

Bruce Lee’s martial arts philosophy was called ‘Jeet Kune Do’, or ‘The Way of The Intercepting Fist.’ Metaphorically, that’s a good way to think about the art of short selling. You are tasked, daily, with understanding all of the investment styles within a style that could affect your position.

Per Wikipedia, “Jeet Kune Do is primarily an open hand system. The system works on the use of different 'tools' for different situations. These situations are broken down into ranges (Kicking, Punching, Trapping, & Grappling), with techniques flowing smoothly between them.”

When I think about making moves on the short side of a market, I definitely break my decisions down into ranges. While sometimes I write like I am punching someone, there is obviously no physical kicking or fist punching in risk management – but there most certainly is a constant pounding of the keyboard that helps me understand the probabilities embedded in the ranges that I am breaking down.

Let’s consider a live position here – shorting the SPY:

1.       I have an immediate term (as in today) probability model that shows me max upside to 1103 and downside to 1074.

2.       I have a 3-day probability model with a wider range of 1048 to 1103

3.       I have an intermediate term TREND (3 months in duration) line of resistance at 1100

4.       I have a long term TAIL (3 years in duration) line of support down at 984

5.       I have bearish volume signals (yesterday we had +1.8% SPX up day on a down -11% immediate term volume study)

6.       I have bearish volatility signals, provided that the VIX holds my immediate term support line of 20.82

So, what do I do with all of that information? I short the SPY with a plan to short more if the top side of my immediate term range of (1103) isn’t violated to the upside in concert with a reversal in both my volume and volatility situations.

That’s a simple 3-factor model (price, volume, and volatility) that I update every 90 minutes of marked-to-market price action. That’s definitely not the only 3-factor model I use. That’s simply the one I was using yesterday when I made my decision to ‘Enter The Dragon’ on the short side of the US stock market.

Bruce Lee would probably sign off on this thought process, primarily because it leans on a philosophy of mental flexibility rather than a rigid investment mandate. Some people call managing risk proactively, “trading.” Some people call it whatever they want to call it. I call it waking up expecting to be a risk management warrior. And being considered an average man by my competitors is plenty fine by me.

Best of luck out there today,

KM

 

LONG ETFS

 

XLK – SPDR Technology — We bought back Tech after a healthy 2-day pullback on 1/7/10.

UUP – PowerShares US Dollar Index Fund — We bought the USD Fund on 1/4/10 as an explicit way to represent our Q1 2010 Macro Theme that we have labeled Buck Breakout (we were bearish on the USD in ’09).

CYB - WisdomTree Dreyfus Chinese Yuan — The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP - iShares TIPS
— The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are mispriced and that TIPS are a efficient way to own yield on an inflation protected basis.
 
SHORT ETFS

 

SPY – SPDR S&P 500 We re-shorted the SP500 at an attractive re-entry point on 2/16/10. We are bearish on US Equities for the immediate term from this price. Shorting green.

XLE – SPDR EnergyWe remain bearish on Oil for the intermediate term TREND and bullish on the US Dollar on the same duration. Everything has a time and a price.

 

GLD – SPDR Gold We re-shorted Gold on this dead cat bounce on 2/11/10. We remain bullish on a Buck Breakout and bearish on Gold for Q1 of 2010, as a result.

  

RSX – Market Vectors RussiaWe shorted Russia on 2/9/10 and maintain our intermediate term TREND bearish view on the price of oil.

XLP – SPDR Consumer StaplesThe Consumer Staples sector finally broke both our TRADE and TREND lines on 2/8/10. Given how many investors own these stocks because it was a "way to play the weak US Dollar" last year, we have ourselves another way to profit from a Buck Breakout with this short position.

EWJ – iShares Japan We re-shorted Japan on 2/2/10 after the Nikkei’s up move of +1.6%. Japan's sovereign debt problems make Greece's look benign.

IEF – iShares 7-10 Year TreasuryOne of our Macro Themes for Q1 of 2010 is "Rate Run-up". Our bearish view on US Treasuries is implied.