Before launching Hedgeye in 2008, Founder & CEO Keith McCullough spent a decade in the hedge fund world. During that time, he consistently refined his risk management model, both in the day-to-day management of his portfolio, and in rigorous back-testing against historical market data.
This risk management model is multi-factor meaning it’s based on the price, volume and volatility of a publicly-traded security. This model is what drives our Real-Time Alerts, throwing off red and green Bullish/Bearish risk management signals throughout the course of the trading day.
What does a security’s last price tell you?
The most popular price-based answers to that question are the 50 and 200-day moving averages, based on closing prices of an index or an individual stock.
Other systems, such as Candlestick Charts, track daily open, high, low and closing prices. But they still work off only a single factor, and thus do not present a full risk management picture.
Price charting is based on the assumption that forces beyond mere Supply and Demand set the price of goods or securities. We don’t disagree with that. We disagree with how consensus tools contextualize it.
Since most investors care about the price of their holdings, shouldn’t they care about liquidity?
If the price of your stock goes up, did you make money? The reality is that you only make money when you sell at that higher price, and in order to do that, you need liquidity. If there is not sufficient volume traded, you will not be able to sell at your price – maybe not at all.
Price moves perpetuate TRENDs. Volume either confirms (rising volume) a bullish TREND, or calls it into question (decreasing volume).
Strong overall volume is generally seen as a sign of health in the markets, though isolated moves in Volume can signal turning points.
Stocks moving UP on decelerating volume have the potential to create a Liquidity Trap and could signal a coming correction, while an outsized burst of volume on a strong UP move in a stock could signal a breakout to new price levels.
If you are combining VOLUME with PRICE, you’re already well ahead of the single-factor technicians. But you’re not quite there yet. Hedgeye’s Model tracks multiple factors in three categories: Price, Volume, and Volatility.
Does it matter? Immensely. But how many people proactively solve for it?
Many Institutional Investors analyze the relationship between Price and Volume. Analyzing volatility is far less trivial – and for some reason, far less common.
Volatility is the statistical dispersion of prices of a security or index; the variance, or the standard deviation of prices for the security.
The higher the Volatility, the greater the price uncertainty of a position. That doesn’t mean that Volatility is bad. It means that you have to take it into account if you want to make good buy/sell decisions, across durations, in what we call the Risk Range.
If you don’t incorporate an analysis of volatility in your buy/sell decision making process, you will have to get used to “averaging down” to offset your timing mistakes. And as any seasoned trader can tell you, averaging down presupposes two things, both of which are unreasonable: an endless supply of money, and a stock price that finally goes back up.
Volatility is measured against other positions in your portfolio (relative Beta), and against broad market averages (market Beta). A “high Beta” stock is more volatile than the broad averages and is likely to both fall and rise by a greater percentage than the market does.
Risk-oriented investors are drawn to Volatility because they generally believe they can get in and out at the right time, and they believe they are better at timing Volatility than most other traders.
This is often based on a small number of lucky trades, or on forgetting unsuccessful trades. This common psychological trap is called Confirmation Bias. There’s also the adrenaline factor, which is great if you want thrills at a casino, but it has no place in a risk management strategy.