Current Price
ABC $50.00
BCD $51.00
CDE $52.00
DEF $52.10

Now I don’t believe in putting all of your cash into arbitrage opportunities even if it is a basket of them. I do not believe in putting them all in ABC either. There are always risks of loss, and sometimes big losses when arbitrage deals don’t go through. There may be correlations which are not clearly understood, and there will always be portunities in value, growth and stable returns. Having assets elsewhere will better provide you with capital in the rare event that an arbitrage goes bad, or in the more common event that another similar or better opportunity becomes available. There is always the opportunity that the price of something you already own will decline even more, offering an even better opportunity. As such I believe the correct strategy is to have several asset classes using ETFs, and to have some cash on the side as well, in addition to the arbitrage opportunities. In this particular example, the return of ABC is the best available deal, which is a total return of $10 per share per 3 months on an investment of $50 per share. As a result, this is a 20% gain. Annualized this is a compounded annual return of around 107.4% (if profits are reinvested). The worst deal is still roughly a 75.9% compounded annualized rate of return. Of course this assumes a 100% probability of the deal going through to keep it simple which isn’t the case.

What I would do is value weight them by figuring out the compounded annualized rate of return of all, then adding them all up and dividing them by that number.
ABC 107.36%
BCD 91.56886%
CDE 77.2521%
DEF 75.89496%
add these up and you get 352.0759
Then take 107.36 divided by 352.0759 and you get around 30.5% as a weighting for abc

Rough weightings
ABC 30.5%
BCD 26%
CDE 21.95%
DEF 21.55%

I tend to more aggressively weight the best than this, if I intend on trading more, and if the arbitrage oportunities are not good enough, simply ignore them, and generally only consider a few of the top yielding arbitrage plays. This is also just among the the percentage that I allocate towards arbitrage in my portfolio. So if 20% of my cash is used towards arbitrage and the weighting tells me 10% it is not 10% of my portfolio but 2% (10% of the 20%). It should be noted that overall return is more important if you intend on holding through the closing date of the merger/acquisition, as although a 1% return upside per day may be tremendous in terms of annualized return, it requires a success rate of that is very, very high (over 99% if you are to lose everything when you are wrong) in order for the deal to be profitable, where as a return of 10% in a month may be better. So you have to compensate for the risks.

If the probabilities of the deal going through weren’t the same, I would multiply the payout by the probabilities expressed as a decimal. So 0.8 times the $10 per share expected gain for ABC would curb it to $8 if there were an 80% chance of it going through, (but then you would also need to calculate the resulting share price when it doesn’t go through times 0.20). You would repeat this for all, but we will not do that in this example to keep it simple.

Day 1 Current price
ABC $50.00
BCD $51.00
CDE $52.00
DEF $52.10

You check back a week later

Current Price
ABC $52
BCD $47
CDE $56
DEF $58

It might become a good idea to use some of your cash. The BCD deal is very good now. You probably want to sell out of DEF or greatly reduce the deal. Additionally, you should monitor new deals and reconsider the weightings. You should also consider reducing ABC and CDE to more aggressively weight BCD. It should not really matter too much where prices have been, prices clearly indicate BCD is a better opportunity, so you should have minimal reserves about selling a position that is flat and potentially may go higher in order to buy more of a position that should go higher to a greater extent. If ABC were down to $48, there would be nothing wrong with selling a bit of all but BCD including ABC in order to buy BCD.

Your balance of your portfolio, may be guided by a general rule of thumb depending upon the market’s conditions. However, you can add a bit of flexibility. Such as using an equal percentage of “risk on” and “risk off” money to fund increases in the “neutral” or “arbitrage” section of deals become better, or add an equal percentage to both risk on and risk off (or perhaps a proportional change to maintain the same ratio of risk on to risk off).

Your weightings among different categories of “risk” should be fixed enough that you maintain the principals of buying (or adding) low and selling (or reducing position sizes) high, and to consider the trend. However, they should still not be so fixed as you ignore obvious opportunities and don’t occasionally deviate slightly.

The better the deals and the more independent they are and the higher the probability they are and the lower potential for large loses… then the more willing you should be to deviate from your strategy.

Add leverage to this type of trading and it may be better. Leverage proposes problems not just of the deal not going through, but it drastically effects the results if the deal is simply delayed. Leverage is a very good idea by using options, or even margin at times but it adds additional variables into the mix, that can be dangerous if not properly calculated and if certain variables are unkown, or not understood.

A shifting among assets in the “arbitrage” portion of a portfolio to take advantage of the better deals in terms of annualized return, provid the gain from doing so is greater than your transactional costs.

Although everyone wants a higher return, it must not come at the expense of risk. You can always leverage a low risk, medium return to make it a medium risk, high return if you must although generally it’s better to use both using the low risk to provide stability to your portfolio, particularly if both of the results aren’t highly correlated with the direction of the market. If you want an overall portfolio that is higher risk and has higher returns, simply concentrate a bit more an opportunities that are outliers in the higher risk area, but still have some in the lower risk area to keep you grounded, particularly if you use leverage. It also means recognizing where each given market condition for each particular area is likely to be so you can reduce position when the risk is higher and return is lower (below the “line”) and so you can add and increase position in areas where the return is high and risk is lower (above the “line”).

Looking at individual names in isolation by using that chart neglects the larger picture of your overall portfolio and risk management. The subtle difference is in how “independent” your investments are from each other or “non-correlated” they are. So while identifying these outliers is important, you also want to come up with a portfolio that is relatively independent. Multiple independent bets at a smaller position size are superior to one single bet at the maximum. 1/2 the optimal amounts on two separate bets results in half the volatility (risk) but 3/4ths the return. This means you are moving further out towards the outliers of low risk, high return by having more bets with smaller position sizes. You can, if you must, apply leverage to move roughly parallel to the risk reward line.

The more you can reduce your position size and add as many profitable trades at “low correlation” (ideally 0) to each other, the better.

People say “buy low, sell high”, but many people during a bull market, buy low, and then sell, only to find stocks much higher which they then buy, missing out on the gain. The balance of your portfolio should shift to increase positions low, and decrease higher, so you are not forced to go back in higher and miss out. What constitutes as low and high depends on oversold conditions, and what time frame. You must keep things in a longer term perspective as well. Strictly based on price, this is what it would look like, although in reality it is never this simple, and you will use a combination of indicators to determine what low and high is. Additionally, buying early on in a new trend is also important, and individual growth stocks are the one exception where you may buy relatively high.

It’s difficult to buy such dips with precision, so it isn’t necessarily as cut and dry as the lines show, however the green lines are buying opportunities and the red lines are selling opportunities. It perhaps would be more appropriate to look at a slow stochastic or RSI indicator. When a threshold is crossed, you begin adding to maintain a certain percentage allocation and perhaps even change the allocation slightly to buy more lower, and sell more higher. Theoretically you never should be fully invested, or completely sell out of a stock or asset area entirely, respecting that it could always go lower or higher. However in reality there is a limit to the share price, and due to transaction costs at times it isn’t practical to hold a small amount of shares, and makes it more difficult to manage anyways.so you can’t reduce the shares indefinitely.

The balance must shift from risk on and risk off trades as the market moves like this. Although finding as many 0 correlation stocks to the market as you can and leveraging them each might provide the ideal return, it isn’t realistic to have zero correlation and to be able to find an unlimited supply of independent returning assets. Everything has some degree of connection, so the best thing you can do is to SHIFT your overall correlation to be gradually more positive on the extreme lows and more negative (or at least closer to zero) on the extreme highs. The range of what constitutes extremes and what your allocation is should depend on how well you can time it. . If you are extremely good at timing a move on a daily close, you might only rebalance potentially 3 times where you increase position each time it goes to more extremes. If you are not so good, you might attempt to position more gradually.

Looking at the chart above, lets say this measures weekly extremes and monthly extremes with the longest representing a yearly extreme or contrarian indicator at extremes.

At the monthly extreme high, you might be 30% “risk on” and 70% “risk off”. At the weekly extremes you might add or subtract 10%. So you could be as low as 20% “risk on” (80% risk off), or as much as 40% risk on (60% risk off) depending on the weekly extreme. Given the yearly overbought signal, yearly might be less accurate perhaps, so you might only change 5%. If the oversold is more accurate than overbought, you may have rules that add an unequal amount when oversold to more aggressively get long. This above diagram is more an example of what to do at extreme readings that indicate overbought or oversold as buying those exact dips and selling the peaks is not so easy nor will the market look anything like a perfect sine wave on any timeframe.

Another important thing is identifying trends early and using those situations to get more aggressive in playing the trend, and less aggressive in buying the dip. Depending upon the accuracy of the signals again, you can use trend following to identify the “sweet spot” of a particular move.

This will give you 8 different situations now if you only look at monthly and weekly:

Uptrend

monthly overbougt

weekly overbought

both monthly and weekly overbought

no extremes

Downtrend

monthly oversold

weekly oversold

both monthly and weekly oversold

no extremes

How aggressively you change your allocation depends on a multitude of things, as well as how active you wish to be, and how aggressive you are willing to be, and how much cash you have (Those with very little should trade less to reduce fees and make more extreme adjustments. Those with a lot have more cash to manage and should make smaller, more frequent adjustments.)

An example might be as follows:

Monthly trend up signal=add 50% to stocks, risk on, or neutral trades
monthly oversold extreme=add 55% to stocks, risk on, or neutral trades
weekly trend up signal=add 20% to stocks, risk on, or neutral trades
weekly oversold extreme= add 25% to stocks, risk on, or neutral trades
daily oversold signal= add 5% to stocks

For the opposite trend or overbought conditions, simply reverse it by adding 55% to “risk off” *cash,bonds,etc* or neutral trades at monthly overbought extreme. You may wish to be a little more or little less aggressive at a given extreme, if you believe the signals are more accurate, but you want to decide well in advance so you don’t succumb to your emotional fear and exuberance.

In order to keep this about the concepts, I will try to keep this post as simple as possible… Thus, I will not go into details about what indicators to use and how heavily to weight each one and where to use such indicators or any additional details on this subject.

The concepts of contrarianism and value are important so you don’t add to an oversold market that may appear significantly more oversold in the future, or an overbought market that may become drastically more overbought.

You should have fairly specific allocations for all of these, with maybe a given range of flexibility (such as 5 or 10%) with the ability to continue to gradually and slightly increase or decrease position size depending upon how oversold or overbought you are. If you have reliable daily extremes, you might add a few percentage points as well, but only if the transaction fees are low enough relative to the upside you gain from such small adjustments, and you can consider the same for intraday moves if you must.

You will at times need to weight the portfolio based on putting the best opportunities weighted the most. If you have many non-correlated assets that you consider “risk on” (but not much) you can be a bit more aggressive at all times, so perhaps even when you are bearish you still have as much as 50% “risk on”. If you plan on “shorting” or betting against stocks (via puts),  This is in it’s own category, and you have more flexibility and a wider range to move from with “negative risk” as it’s own category, or else you will just have “risk on” have the possibility of turning negative if the conditions re bearish enough.

Because you have multiple assets that will have lower correlations with the market, the exact allocations are perhaps not that easy as “risk on” and “risk off”. You instead might want to calculate your overall correlation by weighting individual position’s correlation (and weighting by position size) to the SPY which is an index fund of the S&P. You can find correlation calculators all over the place, I will talk about using them and where to find them in another post sometime.

Among the category of “risk on” you may have to shift your assets between say raw commodities, stocks,real estate, metals, or anything of this nature. Aside from trying to achieve the balances set by the conditions of the market, you should use the same principals of using the signals of oversold, overbought, etc… but instead you are comparing how bullish one is in relation to the other, or in some rare cases “the least bearish” in that particular area. If you do not just hold an etf such as the SPY itself, then among stocks, you want to use principals of price based upon value. You want to spread your stocks over multiple sectors, and put a larger percentage into the stocks you expect a higher return. You may use monthly or weekly changes to change the allocation. Going into details about “expectations of return over risk” and considering the risks as well is a difficult thing to do briefly. There are multiple of ways to value  a stock.

The most difficult thing for me to illustrate, is the actual assessment of value within individual names as well as the assessment of growth. I just can’t find a real good way of simplifying this by using a picture, other than one saying given a certain set of fundamentals and expectations, return goes up as price goes down It is based upon numbers. Rather than going into deep detail I will briefly summarize a number of ways at which you can determine a stocks “value”. All anticipated/expected returns should be annualized where possible.

1)Yearly earnings per share times the historic multiple of an area, or better yet what you think the multiple will be in 10 years.

2)Add 10 years of earnings per share to the books and consider the book value. Compare to a book value of 1, the book value of the market, and historical averages.

3)Look at what a companies earnings will be in 10 years, factoring in expected growth, along with an eventual slowing down or contracting of earnings. From that point, you can either add the earnings accumulated over those 10 years, or look at what the expectations might be at that point.

4)Price to Enterprise value, price to book, price to earnings and so on in comparative terms

5)Book value per share plus accumulative earnings per share over time such as a 10 year period

6)Liquidation value, Buyout value,etc

7)Some assets return based upon yield over time discounted for taxes the company must pay as a result of that yield, provided they have more cash coming in than going out and continue to have the finances to pay such a yield. companies that convert to MLPs that don’t have to pay taxes on dividend payouts thus will increase in price to match a risk free interest rate yield such as a 10 year treasury yield. There are a number of different ways to come up with the estimate this way.

8.) Some returns can be a probability game. This occurs for FDA approval, and pre earnings among other things. There could be a 50% chance that something goes through, that doubles the value of a company and a 50% chance the value cuts in half. Take $100 and double it. Multiply it by the percentage or .5 Repeat with $100 and the deal not going through (cutting it in half). Add these numbers up(125). If they are more than the $100 it started with, your expected value is positive. I prefer to use a kelly criterion calculator as it relates my return to my risk. I then have the factor of time to work with to annualized my long term return. The probability game is largely a guessing game because it is difficult to know how likely a particular deal is to go through.

9)Averaging all of the above that are relevant.  This means adding the calculated return from 1 through 8, and dividing by 8.

10)Weighting all of the above by relevance and calculating a weighted average expected return. This is better because you can determine the importance of each valuation. One particular valuation may not apply as well, so you may weight that by multiplying a fraction less than 1 over the number of ways you valuate stocks, if you use all 8 then 1/8 or multiplying the results by 0.125 means the valuation is of average importance. Make sure the sum of all of the weightings adds up to 1 and then add all the results after multiplying up to give you your valuation.

There are many more ways to look at value. Oldschoolvalue has a good blog explaining a lot of different ways to come up with valuation metrics. You may use assistance from a site like wikiwealth or gurufocus to save time at the expense of lack of involvement and ability to make adjustments yourself depending upon conditions.

Now aside from weighting on value, you also will want to keep track of what percentage of growth stocks vs value stocks you have. Growth stocks do the best when money is flowing into the market, and liquidity is high, and this occurs in the middle to later half of the business cycle. In individual sectors and industry, they also do well when capital is flowing in, and capital should be flowing into the specific company. This makes growth stocks very unique as more capital generally can be used to help a company expand and produce higher earnings and continue to grow more, until the company, the sector, the industry, or the liquidity reaches a saturation point and any additional money cannot result in more growth, and the buying pressures simply cannot continue much longer st these prices. Value stocks fall the least during bear markets, and are usually best to own near bottoms after corrections.  In hindsight, the end of 2008 and 2009 would be best to accumulate value stocks, and after the recovery is fully underway in 2009 and 2010 and even parts of 2011 growth would become key. Unfortunately, Growth stocks are more susceptible to large declines if the expectations of growth change since they are priced based on high expectation of future earnings, if there are upward revisions they tend to do well as expectations of growth increase. You can either use method #9 and simply change the weightings towards value or growth depending upon what stage of the 7-11 year business cycle we are at, or you can manually adjust your weightings by being aware of the value stock names and the growth stock names. I believe we are in an atypical business cycle, that will engage in a period of contraction this year due to global concerns, but those concerns globally will mostly be gone, and the cycle will still finish according to the same general time-frame after the problems are behind us.

Another thing to understand are principals of contrarianism as well as the system. At any given time the amount of money is fixed, the changes over time may reflect stocks going higher as more debt is added to take place of the old debt that is coming due. There certainly will be periods of deflation when the amount of new debt and capital added cannot make up for the amount due, but the excesses went beyond what was sustainable, and the amount of capital you have over time tends to still rise. Contrarianism is about understanding both the liquidity cycle of individual areas which is somewhat similar to the overall liquidity cycle, as well as understanding the mechanics of the market place.

At any given time the market is fixed and capital generally reflects sentiment. The market price is a reflection of the most recent transaction. Any transaction can only take place when both the demands of the buyers and sellers meet. Seller at a given point in time may say “I will sell for $8 or higher” and buyers may say “I will buy for $12 or less”. In this case, conditions are ideal for many transactions. Now within this range comes a particular offer as people use past history of the most recent transaction as a guide. This is where you have extreme conditions of price at $8 and $12, provided not much change. Over time as access to capital increases, more people are willing to pay more, because they can. If the confidence and expectations of growth go up, more people sell at higher prices. However, when a particular area erupts in a bubble, the buyers are willing to suddenly pay higher. Their expectations of growth rise, and they see the price going up believing it will continue to do so. They pay more and more for it. Wishing they had bought more lower, they buy more now. Those who still wish to buy at $12 suddenly will have to either do without a purchase, or pay more. There are only so many people willing to sell and unless the prices go higher, they won’t be able to attract enough sellers to meet the demand. Eventually the buyers push up prices to absorb the remaining supply, but at this point, buyers can run out of capital to fuel the high prices. The price has to drop to where there is overlap. So the sellers may still be willing to sell at $8 to and up and the buyers may be able to only pay $10 so it drops. But as the price drops, people’s expectations and confidence may drop as well, so suddenly buyers don’t want to buy, and sellers are more willing to sell at lower prices.  Those who say “I will only sell at $10 or higher” and see prices lower feel they are delusional to think they can get their price, and suddenly they need to lower their expectations, or increase their expectations at how long they need to wait until they can sell. As such they look at their return over time and it seems diminished. Additionally when the company is short of capital, it tends to have trouble earning money. When it gets more money it can use it to grow, and pull in more money to grow more. However too much money and it has trouble growing at high rates indefinitely. Prices based upon expectation of these levels of growth are over confident, and so when the money comes out, the company may continue to do poorly causing money to continue to flea. So there is an inflection point in which “too much growth” becomes a problem, believe it or not. The levels of growth are unsustainable, and pricing stocks based upon these rosy expectations becomes a bad thing to do. Contrarianism means recognizing those extremes. When buyers cannot continue to buy at prices that continue to go out of their reach and when everyone (or at least the majority) who is going to buy has done so. But also, when sellers have already sold and those remaining that hold the stock are not going to sell and are too stubborn to sell into the hype of doomsday. At low enough prices, capital will shift from other areas, nd at high enough prices, capital will eventually shift back towards other growth opportunities. Contrarianism is identifying the areas that have been neglected or that have been oversold. It is the understanding of extreme value. A contrarian must be extremely patient. There is room for a degree of contrarianism within a portfolio in any particular area, however an entire strategy based on contrarianism would most likely be uninvested for too large of a period of time, or not really a true contrarian at all times. The closest model I have during the time between contrarianism is still the same that I have mentioned above, of shifting in and out of “risk off” and “risk on”. The difference is, a contrarian would be closer to 50% “risk on” and 50% “risk off” and only change slightly based upon weekly and monthly extremes, unless very long term extremes are made.

Contrarianism requires you to expect growth that isn’t there yet and isn’t fully anticipated, or to bet against growth that is that you bet won’t be there forever. Valuation metrics still should generally apply, but the key is, having a reason why you think the value is drastically different than what the market thinks.Why should the P/E be higher? Why should earnings come in better than expected?  If you are bullish on an area where supply is abundant and demand is low, why should the demand increase in the future? Perhaps capital will come in because of the cheap prices, and perhaps the high prices of other similar commodities will force society to look for alternatives. Perhaps low natural gas prices are justified based upon the very large amount of supply and new discoveries, or perhaps they aren’t because laws will be passed to use it instead of oil where possible, consumption will eventually rise, the supply will eventually over enough time will be worked off and prices can go up. Sometimes even looking at value isn’t enough because the supply and demand may shift. When capital flows into an area, production is done. When things are very bad, other companies go bankrupt, then there is less competition, and the area can gain higher margins and do well. There are various factors involved, but contrarianism is about anticipating changes and recognizing that so much capital has already flowed away from an area, that it isn’t likely for risk to be high. AlIt is about buying when all the people that are going to sell at this point are not likely to do so. The risk is reduced, even if the upside may take some time, you are likely buying an “outlier” as shown in the graph at the top of the page, even if the reward is less, the risk is less at this point too. The growth name eventually becomes a value name.

Any asset that has fallen 50 to 90% from it’s highs is worth considering, or an asset that has been ignored and neglected for a number of years is fair game.  The growth may be out of the picture at this point, but it is here when the expectations of future growth have already been reduced and it doesn’t have a lot of downside left. How many people are going to sell a stock or asset that has declined by 90% over 3 years if they didn’t when it was at an 80% loss? Short sellers may sell it, but they will probably have to cover. A 50% reduction in price can be simple deleveraging and margin calls, followed by a slwew of trend followers and short sellers. It is an extreme move Typically not much has changed but expectations, which provides for the outliers. However, stocks that have declined 50% certainly can decline ta full 90% and in individual assets perhaps more.. If a stock goes from $100 to $10, the decline from 50% ($50) is still not a remaining 40%, but a full 75%. So it’s important to keep several things in mind.

1) There is a drastic difference between a 50% decline and a 90% decline from a peak

2a)If the peak wasn’t rational, measuring decline from the irrational peak may not be a rational measurement as a way to determine when the prices are rational…. thus

2b)Another rule of thumb other than a 50% to 90% decline is to wait for a decline that at least returns to or near the previous (rational) trend.

2c)Another rule of thumb, is to consider waiting for the price to return at or below the previous low that was made prior to the most recent run up (which lead to irrational expectations and thus price levels.)

3)A purchase of an asset can turn much worse before it gets better and as such…

4)smaller amounts should be purchased in contrarian names than other names, but since prices may decline further you should…

5)Take advantage of lower prices by increasing the amount of shares to maintain and even gradually increase your allocation percentage as the stock goes lower and do this…

6)Over a much longer period of time than usual, and thus…

7)Be very patient before you make an addition in your allocation percentage or even to rebalance, and be very careful to only do so gradually (increase position size by small amounts as well)

8.)Principals of value (earnings, future earnings, price, etc) are still important and valid, so make sure valuation metrics and fundamentals are still at least decent.

That concludes the contrarian concept.

Overall, your portfolio should be made up of assets that do well in good times, bad times, and those with a high independent of how the market is doing. You should seek to add on lower, and decrease higher, and seek to reduce correlation, with a positive correlation when markets are oversold and/or the trend is up, and low, or even negative correlation when the market is overbought or a trend down has been signaled. Your assets should be those that represent principals of value and growth with a balance between value and growth depending upon how far in the business cycle you are, and the principals of contrarianism may apply at extremes.

With all of these concepts in mind, you likely will be able to come up with a spectacular portfolio and make good money from it.

Keep in mind that there will be a lot of fundamental rules that will come with an investment. There are so many factors, and so much data that you will have to consider even when you are making a small and tiny investment at the onset. If you try to ask an experienced trader or stock broker, there is a huge possibility that they are going to spew out tons of growth figures, company profiles, expenditure amounts and other endless possibilities that you would need to work with. The ideal scenario is that you are able to take all these into consideration, but also know that you are not required to toil over so many facts and get bogged down by it.

What would give you the most success? These are the things that you need to think about instead of having more distractions in the process. If you try to put too many information into consideration, there is a bigger chance for you to fail. Trading Academy Reviews can also help you in the process. Good luck!

Try to talk to a couple of financial experts and they will tell you that it is definitely possible to build your wealth in a  great way, even without the help of expensive consulting (or even a broker, for that matter). One of the most basic rules in investments is that you are able to manage your money and your assets without putting all your eggs in one financial basket. The reason for this is quite obvious, as we know that it is difficult to predict what the future holds and you cannot rely on any law or fundamental rule to ensure gains or returns from your investment. The key is all about consistency, and as you buy more future profits and dividends for the current money that you have, you will find that the value continues to increase without you having to make a lot of adjustments. For more information on this, check out the Online Trading Academy Review site and learn more as you go along. Good luck!

In the event that market conditions were going exponential and doubling every year for example, you would invest everything you have and use leverage to do so. You would then try to find ways to borrow out equity in your investments, to borrow more. Real estate would be a great market for this as you can take out home equity loans as the value of your property rises, and use that loan to buy more properties and repeat the process on tremendous leverage. If instead the market was completely random, there is only one possible way to beat the market over a very long period of time, (assuming fees were negligible enough or non existent) and that is to own 50% cash and 50% stock, and to constantly rebalance to maintain this 50/50 split. If the market functioned as a perfect sine wave, you would start to buy as close as the bottom as you can, and sell as close to the top. You would buy and even get on leverage during the phases in which the line is the steepest (in the middle), and get off leverage when it starts to slow (near the edges). If the market went straight down you would sell short. If the market only went straight up, and then straight down, yet did so in a slightly unreliable way with a lot of seemingly “random” noise, you would want to keep mostly stock when in an uptrend, and when the trend wears down, mostly cash and shift to even more cash and possibly short in a confirmed downtrend. This covers all technical patterns of the overall markets aside from certain “shapes” and “bases” which are more relevant for growth stocks to identify periods where the uptrend has started and institutional funds have started buying, pushing the stocks upward yet not overbought. The pattern itself allows you to be a bit more specific.

The actual investment strategy should be a combination of all of these, depending upon which conditions most accurately reflect the current market place, but it should not be all done on technical analysis.

The analysis of the actual company is related to “future value” rather than current value, but the growth rates and prospects for growth (good management, high ROE, and a new competitive or dominant product in an emerging industry and ideally a consumer monopoly or other businesses having a  high dependency on this product) only some of which are based on quantitative analysis (numbers) are important as well.

There is of course “value” investing, as well as growth investing and a combination of both. in both cases, price matters, and earnings matter. In value investing balance sheet and enterprise value matter, and in growth investing, the rate of growth and raising expectations of growth and increased growth in the future matter.

Growth investing and value investing both compliment each other. Understanding what effects the price of stock based on these concepts is important as well. For example, if a company earns $1 per share a year, then in 10 years if the earning accumulation is reflected and everything else is the same, it should be worth $10 more than today. If however the company grows from $1 to $1.1 per year and so on over that 10 year period, the company should be worth at least $15.94 at the end of 10 years. Further more, if the earnings held steady for the next 10 years, after growing the first 10 by 10% per year, the following 10 years it would be worth $23.58 more. More importantly, if the company grew 20% per year instead of 10% per year, it would be worth $25.96 in 10 years. If you try to price a company based on the yield which would be based upon the future value of the company, the growth expectations make a big difference. The future value depend on future earnings power of 10 years worth of earnings as an example, but perhaps less depending upon the time frame. (not a P/E of 10, or average PE over last 10 years, but the next 10 years worth of earnings from now). There is a huge difference if there are relatively small changes in perception of growth and actual growth.

The point here is that an upwards revision will drastically change the value of a company over night if that change in expectation and growth story is believed. Not to mention if growth accelerates. There are many ways to value a company. 1 is based on what you get out of it over 10 years. If you were to buy a company outright, say it’s like a piece of real estate worth $100,000 and you think you will sell if for $100,000. You can rent it out for $100. In 10 years you will get $12000 on your investment, and sell the house getting your initial $100,000 back. The earnings is all that matters in this case, as 10 years will be a 20% return on the investment. If the assets appreciate in value (the price of the house), or if the earnings appreciates in value (the rental income) there is another big difference in pricing. So even with a long term perspective, stocks if perfectly priced based on known information, and such information drastically changes the growth prospects, the value can change quickly.

Well it is very rare for a company to instantly reflect the changes completely efficiently. institutional funds may take weeks or even months to accumulate a position in a particular stock. As such, looking for either changes in expectations, or changing in fundamentals that will change expectations, or changes in the macro-economy such as liquidity and circulation and velocity of the money supply (as this will boost growth stocks) make a huge difference. Similarly, if the prospects for growth are too high, simple changes can make a drastic reduction in the value over a short period of time. Such as Netflix, for example. The growth investor determines 10 years of value. The value investor recognizes growth can change, so he focuses on the current worth of the company.

To understand the ideal way to invest in an environment of growth and value, the best way to explain is using an example of risk arbitrage plays. Say there is a 100% chance of a deal going through. While this is never the case, over 95% of deals went through (or have been delayed but have yet to be cancelled) in 2011. Arbitrage information that you need to know after announcement is much more “perfect” in arbitrage situations than in others. For example, say Coke buys Pepsi (ticker PEP). Say PEP is valued at 100 billion. Assume there are no laws against monopolies and nothing stopping them from growing through. Pepsi might agree to be bought out for say 110 billion dollars, a 10% premium. They estimate they will close in 3 months. The upside is known, the time frame is known.

Now you know not only your return, but you can calculate your expected annualized return if the deal goes through. You can estimate the probability of it going through times the loss if it doesn’t by the probability it goes through times the gain if it does, and then annualize that return and compare it to the other opportunities, if you want to be more accurate about your expectations. If you can return 10% every 3 months for a year, (4 times) that will be 46.41% when the proceeds are reinvested and compounded. Let’s say meanwhile there is another deal where it returns 3% every month for a year. If you take 100 times 1.03 and then you get 106.09 and multiply that by 1.03 for 12 total times, you get 142.5761 or 42.5761% more. This is less than the 46.41% but not by much. The market cap of Pepsi will most likely not rise at an equally spaced out amount per trading day up until the announcement occurs. Neither will “arbitrage B”. Additionally, if it is a stock merger deal rather than cash acquisition, the price of coca cola could change downward which may affect the buy out offer. $110Billion worth of Coke (KO) for example might represent a fixed amount of shares, but as the value of the shares change, so too does the value of the buyout. But to keep things equated to value, you want to further break down the price advancement needed per day both in fixed increments as well as percentage terms. If you are going to see a 10% return of 30 days, that is going to be 1/3rd of a percent of the current price per day. So at $100 per share, when the buyout offer is $110 per share, that represents 0.33 per day. Unfortunately it’s still not that simple. The market is not open every day, but let’s assume it is… if you expect the stock to rise an equal dollar amount, this is a small error because this will not always help you know when the annualized return increases and becomes more valuable than it started. So instead you must figure out the percent return that is the daily return that will result in the same annualized return. You can then have an “expected price” and see where you are at each day. Or each day you can recalculate the annualized return, or use a compounded annual growth rate calculator.

In the example “pepsi” or “arbitrage A” should increase by a factor of 1.00105 or about 0.10%. “arbitrage B” should increase by a factor of 1.00974 or about 0.10%. They are very close to the same, especially when using a calculator and breaking up a year return into a 365 day period. If instead we only include when market is trading or about 260 days, you get what is rounded to a 0.15% increase for pepsi or “arbitrage A” and a 0.14% increase for “arbitrage B”. Now even if the probabilities are the exact same, you will get no 2 money managers to agree how much of your assets should go into each opportunity. The reason is, you get different “risk” if you invest in these two, so although one may be clearly more valuable, there will always be value in investing assets in the other deal, so if one doesn’t go through you still have capital. It’s about your overall portfolio return over time, not expected value per trade. Additionally, if you think other better opportunities will be available, there is additional incentive to invest in the one with less time until the deal goes through. If you think better opportunities will not be available, you are better off locking your money up in the longer term deal.

However, one thing should be relatively clear. You generally want more money into the deal that is expected to yield more compounded annually if all things are equal, even more so as the return reaches greater extremes in differences between 2 deals. What I mean is, if you only had these two assets to invest in, and say Pepsi dropped tomorrow and “arbitrage B” didn’t, you would be more likely to put more assets into pepsi if you wanted a higher return. If Pepsi stayed the same and “arbitrage B” dropped, you would be more likely to want to put it into “arbitrage B”. You would still be putting some assets in both of these opportunities, but you would just put more money in the one with the higher return.

The reason I bring this up, is because part of the market’s function of pricing in value is weighing all other similar opportunities, and measuring the expected return over time. So explaining the functions of how a particular return is priced with KNOWN information, can better help explain what to change if the information is unknown, and also how the stock market functions as a value mechanism based upon expectations. What I didn’t mention is there are often revisions of how long the deal will take to go through and this will drastically effect the expected return. This change of expected return can create large capital shifts from one arbitrage opportunity into others. As a result, expectations of arbitrage opportunities will shift based upon expectations of the annualized expected return (after risk) of the particular deal.

There certainly are other considerations in value companies, as there are potentials for buy out offers, earnings growth and contractions. Also decreased competition and increased liquidity result in higher prices which means people are willing to pay the higher multiple than usual because there is more money to go around and less companies. But what is important is HOW you think about it, and that you still understand the key concepts of how the market’s pricing mechanism functions.  If a particular investment is good but the company may be obsolete in 3 years, how does that change the “future value” vs something that is a slow and steady grower that will likely be here for a long time?

You definitely will want to balance out the risks, and make sure you don’t get exposed in any one direction, and make sure you understand your overall portfolio’s correlation to different aspects of various scenarios and the likelihood they play out. Ideally you don’t want to invest in a stock where any single event can wipe out your portfolio, and if you are exposed, make sure it’s an event that has an extremely low probability of happening, or seek to protect against that risk. That has everything to do with the principals of the kelly criterion, which is seeking independence on profitable bets to have a superior long term growth rate in your portfolio.

One final consideration is contrarianism. When the maximum amount of people that are going to buy an asset do, there will not be enough pressure to keep the asset going higher, same thing when there are the maximum amount of sellers to buyers, or selling panic. As a result, opportunities present themselves to buy assets that are being liquidated, as do those in betting against the popular assets that are going into a mania. More importantly, understanding contrarianism principals can help you identify areas to avoid that represent more risk than many realize, while considering areas that are lower risk because they have already sold off so drastically.

But back to the initial question, How do we invest, understanding what we know about the market?

This is both a science and an art. A mixture of both assets that do well in inflationary times (such as stocks) and deflationary times (such as bonds) and even sideways markets as well as mild bull and bear markets or inflationary and deflationary situations (neutral plays such as arbitrage). As the market is not completely random, you don’t want an even mixture. As the market trends, you want to use such trends as signals to change philosophy. You change philosophy, not by outright sells and buys, but increases and decreases of your percentage position size. Become more bullish when the trend has turned up or when the downtrend is at extreme oversold readings, and more cautious when the trend has played out and is overbought or starts a downtrend. Within each trend there are counter trends, or short term trends within the longer term trends. These can be used as opportunities to make more subtle and more minor adjustments, to play such trends and also be shifting when overbought, oversold or a new trend, or else, you can use such dips in the trend, particularly if they hit extreme points which may form a “trend channel” to “buy the dips” and “sell the rips” by increasing shares on lower prices, and decreasing on higher as long as the trend is intact. Additionally, it is important to be mindful of the longer term value and cycles, as well as the individual names you invest in should be appropriate for the given conditions and respect the concepts of value. Of course this is a very delicate balancing act.

Here is what I mean. If the monthly trend is down, which it is now, you would have more cash than stocks, unless the trend is oversold At monthly oversold, the shift is to bullish from cautious so you might shift to 50% stock, and making sure you risk more if weekly trend is also oversold, or starts an uptrend.

There are 4 conditions in each given trend extremes on monthly, extremes on weekly, extreme on both, or no extremes. Then there are 4 different directions

monthly trend up, weekly up

monthly up, weekly down

monthly down, weekly up

monthly down, weekly down

If you like, you can come up with percentages, but these should only be rule of thumbs or rough guidelines, not strictly followed. You might simplify things and say

Monthly trend up signal=add 50% to stocks or neutral trades
monthly oversold extreme=add 55% to stocks or neutral trades
weekly trend up signal=add 20% to stocks or neutral trades
weekly oversold extreme= add 25% to stocks or neutral trades
daily oversold signal= add 5% to stocks

Monthly trend down, monthly overbought, weekly trend down, weekly overbought and daily overbought would be the opposite, so you would add the same percentage to cash or bonds or neutral trades. You may wish to allow leveraged etfs in times that are above 50% bullish, or leveraged arbitrage deals, assuming other indicators are favorable. The principal is important, but the signals you use should prove to be somewhat accurate. If you have more accurate daily signals and are able to act upon them, you may wish to use those more aggressively.

Analyzing the trend can be a difficult, time consuming task, and there are more than one variable in whether or not there is a “trend” and actually deciding what to do with it will be challenging as well. Eventually I hope to provide a service where I will give you this data. For now, occasionally I will come up with a report each month for free, but it will not be this way forever.

In 2012, the stock market is more dangerous than usual. there are macreconomic factors that present significant default risk, drastic shifts in capital and currency, and the potential for events that may blindside some. As a result, I will advise perhaps adjusting your bias by at least 5% everytime to the bearish (cautious) side. However, historically oversold signals should be more respected than overbought signals in terms of timing, particularly in the RSI.

In 2012 the year looks to start with daily overbought (for now as of 12/29), and weekly overbought in a monthly downtrend So you would be 80% in cash and bonds. The momentum continuing upwards into this year is not surprising, but it would be if it continued much longer.Maximum caution is advised. Based on long term contrarianism, I would avoid bonds, particularly in the 2nd half of 2012 and I would avoid gold for most of 2012, or at least the first half. Real estate on the other hand may present a decent opportunity. The maximum selling pressure of homes will likely occur, and the foreclosures are hitting the books at the maximum pressure. However, there simply will not be much additional inventory for the time being, at least as a result of foreclosures, and the stable inventory which potentially may even decrease, could provide a multiyear flood, particularly if there is some kind of panic that hits in 2012 in the economy. Real estate is a very illiquid, leveraged based market so the actual prices may not behave so predictably. However, I suspect the confidence will begin to return over the next few years, and in many areas where foreclosures hit, you will have an opportunity to buy this year and next year, and potentially sell in a a few years into the peak of the next business cycle which could be around 7-11 years from 2007-2008 So late 2014 to early 2019, most likely around a target date of 2016 (11 years from 2005, which some say was the top in some aspects of the economy), and fits in the range of 2014-2019. Given the government’s debt levels, and the potential for shortfalls and spending cuts, or worse increased taxes specifically aimed at real estate, the liquidity will probably become a trouble a bit earlier.

Ultimately 2012 will be about maximizing opportunity and protecting gains as in any year, but the emphasis will be on protecting gains in early 2012. The principals may shift drastically in the middle of the year though if things get oversold and sell off drastically as Europe collapses and people fear the end and another great depression when prices will already be pricing in the risks and possibilities of such an event and liquidity is sure to return eventually.

Regardless, the plan for 2012, should be to increase exposure to “risk”, as stocks decline, (while decreasing “risk off” exposure) particularly in the more favorable areas (oversold extremes or coming out of oversold and in the early phases of a new uptrend), and to decrease exposure to “risk” (and increase to “risk off”). It should be to reduce the overall amount of correlation in your portfolio while still taking what seems to be profitable trades. In individual stocks, using principals of value and growth and understanding of an expected annualized return over a given period of time. You should weight your portfolio accordingly so that it tends to have more invested in the area that will produce the best annualized return (after taking into account the risks and potential downside and probability of such decline), and less in the ones with the smaller annualized returns over risk.

You want to both look at positions individually, as well as group similar positions together such as you make a “risk on”, a “risk off” and a “neutral” section. The particular allocation towards or away from risk depends on trend, while the individual positions depends on either value or perhaps how oversold it has become and is partially about reducing correlation. You have to weigh multiple factors but once you decide your “risk” you then need to look at how you can reduce positions in one area first, and then add in the other later. You may also want to factor in the leverage of ETFs and how that might increase your position in an area.

When you do this, you may find certain arbitrage positions that yield a lower return have a higher position size. This is likely because of change s in prices. If the deal is more likely to go through or less likely to decline if it doesn’t, it is okay to own more of an arbitrage deal not expected to go through. However, you can often trade a small handful of these arbitrage positions to roll your positions over more aggressively into the one yielding a higher compounded annual return. You also may find too much exposure in a particular area. You might have too much “risk on” in a downtrend because you grabbed a certain ETF that wasn’t strongly correlated in a time when it was oversold and it may have recovered. You may have went overboard in a particular purchase. You may have lost money in a particular area. Either way, you will want to do your best to reduce or sell position sizes, and potentially add on to other ones to come up with the right allocation for the situation. You still want to look at price, but not in the way where you look at where you bought it. If your stock was oversold and has traded well out of oversold territory, then there is less of a reason to own as high of a percentage, even when you started. So you may have owned 5% of assets in DBA, and it may have traded well above oversold and you now own 6%. You do not want to reduce it to 5%, but provided the trend hasn’t changed from the increase of price, reduce it even lower as the conditions are pa little less bullish, and when it reaches overbought it will as well. Having an idea of what a particular asset is worth is useful so you can compare relative value, but in some situations you might just be owning it because you need exposure elsewhere, you need to reduce correlation and it has reached extreme positions and seems like a more reasonable place to put your money than stocks. If you cannot think of a good reason to own it anymore, reduce or close the position out.

I like to put my positions on an excel spreadsheet, the percentage ownership the percentage of “risk on, risk off, arbitrage” and perhaps even the percentage of bonds vs currency within “risk off” the percentage of “stocks vs natural resources” in “risk on” and if I am doing a “neutral” strategy other than arbitrage I might put that down expressed as a percentage. I will look at my “rule of thumb” chart where I am prepared to rebalance my portfolio and change the allocations based on conditions and verify the market is in those conditions and try to ask myself if aiming for that seems to make sense, and to do so. I also will just add up “risk on” and “risk off” and divide the individual area by the sum of the percentage allocation of all including “neutral” to get a percentage ignoring the “neutral” that adds up to 100%. At a minimum, I should have 50% of each, but generally will aim to support the information given the trend. In a downtrend, I should have at least 50% exposure to “risk off”, but preferably more. Sometimes it may make sense to own 3x etfs if I notice a lot of good arbitrage deals so I can reduce the exposure to arbitrage by increasing my “risk off” and “risk on” exposure through leveraged etfs without going on or adding margin.

If this works for you, great. If not, fine. The interesting thing that I will do is although I have these “aims” I will sometimes increase margin to take advantage of an opportunity, and occasionally will add additional aggression based upon shorter term signals if they are ideal. If I think we have sold off enough, I will not usually act, but if it continues to further extremes, then I will act decisively and aggressively. Perhaps those who trade the PPT can look at the hybrid score and buy the SPY or even TNA when the market reaches “oversold” and give yourself room to add more if it declines lower. You do not have to depend entirely on the PPT, but instead can use it when better than usual extremes are reached. So if 2.59 is oversold, perhaps you only buy 2.45. The stability of your other positions will allow you to add some leverage to place the trade with plenty of room to add additional leverage, without as much volatility if you are wrong.

How well does this “system” work? over 10% during a 2 month period in my testing. Only recently have I been more liberal with leverage due to watching the changes in the portfolio failing to move significantly downward from any time. It was more like 7% until recently, but a deal that is pending and has froze any transactions at this time, and expected to close before the end of the year will add an additional 1%. You could be more aggressive with it, or more conservative. A 5% per month return for a year is nearly an 80% return by year end.

In my experience with the PPT, I believe using TNA or in the money calls with lots of time on it is probably the best way to play it. I tried out of the money calls with minimal time on it with mixed results, sometimes I would nail one out of the park, other times, the position would either expire, or had to be sold well before it did. Focusing solely on the PPT and using calls wwas far too aggressive, even with a large amount of cash on the sides as I had. So I then was forced to go back to the drawing board. So I started paper trading first, which is what I am doing now, and this way I will have something to compare with when I use the same methods, only with a more aggressive rebalancing using the PPT, within this system. I don’t believe I want to use TNA just yet, and instead will just be using SPY and other non leveraged ETFs without the PPT.  With the PPT, I am not sure I want to go there either. I will be using margin on arbitrage and occasionally elsewhere, so adding leveraged ETFs while adding margin during oversold conditions even with the PPT accuracy seems a little bit more aggressive than I need right now.

When I went back to the drawing board, I had forced myself to look at the “kelly criterion” from a different angle. Previously I would stick to one method and try to leverage it to the max, aiming for a “full kelly” or “one half kelly”. I realized that multiple bets independent of each other that in total added up to a full kelly or half kelly was a superior use of capital and supported by the same criterion, and understanding the nature of volatility and portfolio growth actually shows the hidden lessons. Risk less with more positions that seek independence of each other. I was only starting to pick up on this idea intuitively as I have only been trading since 2005 or 2006.

Additionally, it is more prudent to aggressively buy the oversold than to sell the overbought.You can certainly prepare yourself to add even more if it reaches a more extreme reading or a second closing “oversold”.

If we want to get into more specifics of how to do this, then you want your positions within the risk profile of the current trend to be weighted based on expected annualized growth rate per year. Using the <a href=”http://www.cisiova.com/betsizing.asp”>kelly criterion calculator</a> to factor in downside risk, probability, etc and then compounding that growth rate over the amount of times you will trade in a year will help you determine what kind of return you will get if you were to bet the full kelly. If you get a “kelly” of 100%, recognize that the calculator does not go above this, so the return per risk (kelly is used) will actually be higher since you are not getting a measurement of full return since your risk is capped at 100% invested. However in all other cases, you are getting a return that is put in the proper context for which it can be compared, as soon as you figure out how many of these deals you are able to do within a year. If your kelly criterion is 75% and growth rate is 5% and you do 1 per every 2 months or 6 per year, you can take the number 1 and multiply it by 1.05 and then the resulting number by 1.05 6 times to get 1.340096 or a return of 34% per year, if you were fully invested. If another asset you project based on the probability and so on you calculate a growth rate of 2% per trade but can trade it 12 times per year, you will multiply 1.02 by 1 12 times and get 1.268 or 26.8% per year. Both of these trades should be made, however the weighting of the return per kelly per year that yields 34% should be larger, while the 26.8% trade should be smaller. You may want to add up the return of all your options and divide the individual return by that total to get your “weightings” for that particular area. Or you may perfer more aggressively weighting to the one expected to yield more. I am not aware of how to figure out the “ideal” amount to consider the best combination of investing in the best return, as well as creating enough risked in the independent bets to reduce correlation and give you the best reward on the least risk possible for your overall portfolio, but since you are making a lot of assumptions here based on the probabilities of a deal going through or a stock returning that much over a given time, any way to determine this would be based upon PERFECT knowledge of those probabilities, which is not something you have in investing. Therefore just some attempt to weight towards value while still staying invested in areas that reduce correlation will be productive, but finding the perfect balance is more of an art form and with values constantly changing, and cost of fees and other risks to consider, and considering how one particular risk correlates with the other it is not something you simply can master with a mathematical formula. However, being aware of this stuff and knowing what factors play into the formula, were information perfect, and the variables you need to consider when making decision, can make this “art” much more in alignment, so the “science” of investing certainly is important.

This is the purpose between my long posts of explaining the kelly criterion and the correlation reducing and boosting return. The trend report is only going to tell you about the conditions that exist. In order to use it in a productive way I explained how you can use it. I created the “trend Trader” post as an example of what someone might do with it. If the probabilities of each trade were perfectly known and you could predict the results and such, I probably would look more into the exactly perfect allocation. I believe it would be dividing the percentage of “kelly” evenly across all assets, but that would assume the time frame of all trades were the same and would never exceed 100%, which is sometimes flawed. If a coinflip paid 10:1 and another paid 9:1 you still have reason to invest in both and you want to invest more in the 10:1, but the formula accounts for that. The 10:1 return would give you a kelly percentage of 45% of your capital, the 9:1 would give you a kelly percentage of 44.1% of your capital. If you had 3 profitable situations to bet on you probably would bet 1/3rd the kelly across all 3 which would be slightly higher in the 10:1. If not for the fact that you can lose more than you put into it and that you have to pay back the money by a certain time frame, you could justify always betting the full kelly across as many as possible, and then when you owe money because you lose simply continue to bet on these profitable situations. however, that is not realistic and this is yet another variable which makes investing an “art”, even if everything was more exact. So we just have to accept the principals of the kelly and understand the context of how we are using it, and do the best we can. However we certainly can use it to compare return on risk among all our investments we view as profitable enough to act on, and use that information to assess which investments should be weighted more heavily.

I personally believe that you want to first break your investments up by “risk profile” categorize it as “risk on” (tends to go up when market goes up) “risk off (tends to go down when market goes down) and “neutral” (tends to have no correlation of market direction or very little). You should assign your investment risk among those 3 groups first based on trends and contrarian indicators and such, and then within those categories you can compare. The reason is, you still want your portfolio to work WITH the market rather than against it, and it is difficult to evaluate “return” one an arbitrage deal the same way you do for a return on a value stock, or a return on bonds or currency. You still need the investment in bonds for your overall portfolio, and unlike in “theory” where we talk about coinflips, there is no such thing as an independent bet in investing that is not correlated with another bet, when the bests are made at the same time, or overlap in time frame.

After you break your investments up, then you can compare the kelly criterion based on the probabilities you assess of each arbitrage going through, of each investment going the way you expect, and of the bond yielding the result it says without default, or the probability of a bond ETF or currency ETF doing well over the time frame you trade it. And of course you also factor in the loss expressed in a negative (on the kelly criterion calculator) if the deal doesn’t go through, if the investment doesn’t go well, or if the nation defaults or hyperinflates and the probability of it doing so. Then you multiply the return as discussed before, and you compare them side by side. You may have to use your own judgement if there is a deal that has more uncertainty about it’s return, or greater certainty about the percentages expressed, or factor in things yourself such as adjusting your portfolio if it is too correlated towards a specific event, but that will give you the returns to make sure in most cases that a 20% annualized growth rate (including risk) has more invested in it than a similar deal with a 10% annualized growth rate.

As you do the work of this several times, it can become a bit more intuitive, and you can start to consider making it a bit more complicated by breaking things down into more than just “risk off” and “risk on” and “neutral”. Instead you can add more in the “risk on” area to achieve roughly the same portfolio. What I mean is if you have multiple minorly correlated bets in that area, you can increase the  percentage “risk on” because your actual “risk” may be mitigated by holding assets that may only be slightly correlated with the S&P and in a much better position to do well. You can also have “value vs growth”, and you can learn to handle a bit more at once. you can have more in “neutral” if you understand the risks and can assess it better, and you can also consider other “neutral” investments. You can consider adding SHORT positions in either of the 3 areas to offset the allocations as well and this way you can bet against those overvalued allowing you to bet more aggressively on specific areas which you feel are undervalued. Much of this would be harmful if you didn’t have an understanding of all of this. Much of it would be harmful if you weren’t comfortable with it. So it can be a lot to take in at once, which is why I believe learning how to make the exact calculations based on probabilities that you asses. When you start you also will have to leave yourself a greater margin of error when guessing the “probabilities” of events, and invest more in “risk off” (specifically cash) than elsewhere. However, you can be a master investor by maximizing this principal of reducing correlation of your portfolio, weighting towards value, adjusting towards trends including overbought and oversold, adjusting on weekly basis, and perhaps even adjusting on daily extremes and putting enough capital towards “neutral” positions, as well as “risk on” and “risk off” to give yourself the ability to profit in all conditions. If you start with 50% cash 50% stock and rebalance you can even beat a random market by maintaining 50%, but if you add in arbitrage that profits in all conditions, trend following which positions you better early on in the trend to by weighted to take advantage of the trend, as well as using extreme conditions as well to anticipate a change in trend, and the principals of comparing value relative to each other and evaluating your positions and repositioning towards value as the value changes, (as well as using principals of contrarianism at times) while evaluating the return over time for arbitrage plays and other neutral plays and evaluating and repositioning based on annualized returns after factoring in risk, you will have a great chance of being able to have crushing returns. You may wish to add in growth and momentum trading as well in the “sweet spots” of a growing company, but you really should try to stick to what you can understand with in the context of this structure. If you don’t understand arbitrage, but understand delta neutral option plays, or understand pre earnings, or pair trades, go for that. If you don’t understand value investing or don’t have the patience, fine. If you prefer to scalp trades in each area, you can still be positioned according to the greater trends to a more limited extent, and use very short term swings in the market to follow those trends… then go for it. If you don’t have an edge and worry about currencies or bond trading, stick to cash. The principals of risk management when structured in the right context are fairly universal.

A mixture of arbitrage plays mixed in with a portfolio that shifts between a balance of stocks and bonds is what is advised here, even though arbitrage plays on their own can work really well.

One of the big questions people have, is “why not put all your eggs in one basket? Especially if you use an index fund such as the S&P?” Many articles point to studies of a multiple asset class case study, or a multiple asset diversification case study. Some may not be exclusive to asset classes, but instead a diversified basket of stocks. Perhaps they show a back test showing results. However, statistics 101 teaches that correlation does not imply causality. In the real world, if you are unable to isolate one particular variable, or verify that conditions have changed, you cannot be confident that past results are indicative of future results. Understanding why it might work is important, but mathematics is the ultimate proof. Simply tracking a correlation is often a mistake, because without understanding “why” you may stick to dogmas and rules of thumbs religiously that may have no weight. In truth, it is very possible that diversification in some instances will actually hurt, and put you at more risk if you do not understand the purpose of diversification, which is to reduce correlation WHILE still providing a positive return, and overall trying to assemble a portfolio of the highest return given a certain level of correlation of the overall markets.

Mathematically, there is in fact proof that the principals of multiple asset class investing can in fact be true. The proof is in the Kelly Criterion Formula. Owning a fixed income return at 4% and a variable return of 7% rather than everything on 7% can be beneficial. The simple explanation is you are never going to be 100% correct about stocks. Occasionally it will go lower, and that provides opportunity to buy more. With a 100% investment there is not the opportunity. Additionally, the volatility is problematic because it adds additional risks, especially if you add leverage.Even if you are very aggressive, and can contend with a large possibility (larger than most investors take on) that you are down very big you still want to add safety. With the right balance, you can actually add leverage, still have a lower downside risk, and greater upside gain. Over time this results in greater portfolio growth. If you can lower the downside swings, it is easier to recover from, and you add opportunity in being able to shift the balance in the variable return after a significant drop. Look at it this way, if a stock at $100 is going to be on average $107 the following year, and it drops to $90, now it only takes a move back to $96.3 for a 7% gain, and a gain to $107 from $90 is a 18.89% gain. You miss on the opportunity to invest at lower prices, if you are “all in”. Over time having the opportunity available adds to your return, and lowers your down years enough to provide much better results over time, also providing more stability.

This view of “7% per year” is VERY assumptive, it doesn’t account for the possibility that you are wrong, that history is wrong, etc. By having bonds which tend to do well when stocks do bad, and tend to still do okay when stocks do good you are positioning yourself more cautiously. More importantly you can add leverage if you want a higher return, or else you can just have a higher return on your risk. You should NOT reach for return by going into riskier assets that you don’t understand or the market is playing you, rather than the other way around.

The reason in providing a large amount of stability, is so you can leverage plays, and have multiple areas of support to fall back on if the low probability event that could devastate most occurs. 2008 was a very low probability event, in relationship to the rest of recent history, but credit tightened, more merger and acquisition deals than usual were delayed or fell through, and stocks went down. The overall amount of M&As were cut by 1/3rd.

You would have lost big in stocks, and you could have gotten in some real trouble, if you did not have bonds and you bet heavily on one or two of the arbitrage plays that did not go through. Arbitrage actually would have probably served you well, but imagine you only had one or two arbitrage plays that went bad, your stocks were down 50% and you had no bonds? Lets say you lost 80%. You would have to produce a 500% return from those levels to get back to even. So it was the type of event that could absolutely destroy people that were not aware of the risks and positioned accordingly. Were you using leverage in the wrong areas, you could have blown up your entire account.. Rare event, or not, 2008 happened, and it can happen again. How do you profit without being overly paranoid? You protect yourself. Less than 4 years away from the meat of the panic (that in reality lasted from part of 2007 to 2009), and stocks have rallied significantly. The markets broke down sharply in August and the signs were there in April, June, and July that the possibility of a decline like that or worse was in fact there. Now we have sharply rebounded near the recent highs, and are still in a longer term downtrend, and vulnerable to a lot of potential issues.

A big part of the concept of using the principals of the “kelly criterion” in your advantage is understanding that you can leverage multiple bets simultaneously if they are INDEPENDENT and that the more independent profitable bets at once, the better (with all other things being equal). The markets rarely have complete independence and there almost is always some kind of a correlation. However, the kind of trades that have a large degree of independence are arbitrage plays. Risk arbitrage has some correlation though, in that if lending rates tighten up and the economy does, deals are less likely to go through AND the economy is likely to turn south and expectations are going to probably drop sending stocks lower. It is more than possible for the economy to turn south for those reasons (or tight credit to exist because of those conditions) and still have many deals go through.

The downside of a deal failing to go through isn’t always a 100% loss, either, since there wouldn’t be a buyout offer on the table if some other company didn’t see some value in the company. If the deal fails, it may decline to where it was prior to the announcement. As such, the near independence that arbitrage opportunities provide, make for a great spot to have significant exposure in your portfolio. You can either lower your volatility and downside risk without lowering return, increase return without increasing risk, (either one resulting in more long term growth) or you can find the happy medium and balance between the two, increasing return while decreasing risk. In any rate, your long term growth rate should increase because of the principals of independence. “Increasing independence” is often known as “reducing correlation” since there is always a limited degree of correlation in the real (investment) world.

Arbitrage deals are high probability trades. With an announcement on the table, arbitrage deals are very likely to go through. They will only make you a small return, but they will do so in a short amount of time and the probability of it occurring is very high. In an uncertain environment, having these bets that are not highly dependent upon the strength of the economy can be a great safety net to provide and boost your returns as it allows you a stable source of returns separate from the “risk off” and “risk on” areas that allows you to reduce your “kelly” of the other two, while boosting your return.

As showed previously, half the kelly in the long run produces 3/4ths the return with half the amount at risk. If you can have 2 completely independent trades risking half the kelly simultaneously, it is better than a “all in” bet on just the one over the long run as the volatility will lead to decline because after a 50% return you need a 100% return to get back to even so increasing risk of a great decline over the long run will lower your return and the more you risk, the less able the additional return is when you are right is able to compensate (if that makes any sense). This diagram posted earlier on this trend following money management post may better explain it.

The volatility of your account gets exponentially higher as you increase your risk size incrementally. The greater account volatility the sooner your tradeoff in terms of return peaks. This relationship means “less is more” Or “less leveraged more times is greater than all the eggs in one basket”. Most experienced traders and money managers learn this intuitively.

So even if we were unable to get a great return relative to other investment vehicles, there is value in reducing the correlation of your portfolio. This is why arbitrage is one potential avenue that is very valuable in a portfolio. Warren Buffett in his pre Charles Munger 1960s days used to do these and he called them “workouts”. His workouts included spinoffs, tenders, going private, buyouts, etc. You know the old man had to do something right to get where he is.

Buying on margin can make these deals more profitable, and allow you to reduce risk through increasing multiple positions to lower correlation (diversification is the over used word that only sometimes lowers correlation). Options can as well. Options also may put you at risk of greater decline if you are wrong or if the timing is off and the deal is delayed. However, if the timing is right, the gains enjoyed will be leveraged even more so. Buying additional time may be a wise thing to do, since option’s time value decays exponentially as it approaches expiration, even though it reduces your percentage return to do so. Also, a recent example shows the upside can also be reduced as was the case in Advanced Analogic Technologies, Inc.
(AATI) The initial deal would have been for $6.13 as the cash side of the deal was guaranteed to match the difference between the current stock offer and the buyout offer of $6.13 per share. However allegations went back and forth, until the company being acquired finally folded and accepted a lower deal of $5.80.

Expected to close in the fourth quarter of 2011 for a closing value of $258.6 million in an all stock deal. Upon completion of the merger, Advanced Analogic Technologies shareholders will receive $3.68 in cash and 0.08725 of Skyworks Solutions common stock for each Advanced Analogic Technologies share held.

The stock component of the price has a nominal value of $2.45 for a total value of $6.13. The cash portion will be adjusted higher or reduced at closing based on the stock portion to maintain a total value of $6.13. So for all practical purposes this could be considered an all cash deal.

Update November 30, 2011: Radio frequency chipmaker Skyworks Solutions said it will buy smaller rival Advanced Analogic Technologies for $5.80 per share in cash, a price lower than the original offer, ending a standoff between the two companies.

Regardless, this stock was available at times around $4 and options were available. Because of it being a smaller more illiquid market to get in you may have had to make a higher offer as the difference between the ask and bid was large. However, when the stock price was $4 an option for a $5 strike price could have been had for around 30 cents per share and it’s now worth 75 cents per share. This leverages the $1.75 return on a $4 stock (or about 43.75%) to a 150% return. Initially if the deal went through (@$6.13 and not $5.8), you were looking at 53.25% return in the common or a 276% return in the options. An additional 3 months were purchased so a March 2011 contract in this example was purchased. Had you bought a Jan or December contract you may have been able to get it for cheaper and a higher return as a result, but the risks of the deal being delayed a month or two would have increased your risk and potentially your return on risk as a result.

It can get a little complicated determining the vehicle selection, and whether or not to use options because of the various factors. The advantage to owning stock is the unlimited time you can hold it for if need be to limit your nominal loss downside drastically, and even if the offer doesn’t go through if they are a motivated seller, they may still be able to find a seller at some point. If you plan to sell if it doesn’t go through your downside (as a percentage) is almost never 100% but with options it often can be.

More goes into assessing arbitrage deals than just the overall percentage return. The expected time frame is very important as well. A 10% return in 1 month is better than a 19% return in 2 months, assuming you will be able to immediately turn around and invest the proceeds of the 10% return into another 10% return the next month. A more obvious situation is a return of 25% in 1 month is better than a 35% return that takes 8 months. You shouldn’t rule a deal out though until you see whether or not it trades options. Even looking at annual compounded growth rates and comparing them doesn’t consider the downside risk, the probability of the deal going through, the dependency of the deal on leverage (which is more vulnerable during times of credit tightening and economic downtrends) and numerous other things that may be difficult to quantify. Really, you have to just make a “best guess” given the information and respect that generally a small amount of risk arbitrage plays in your portfolio is better than none.

The best kind of deals are all cash deals because you don’t have to worry about the change in another stock price and you don’t have to get short one company and long the other to specific ratios, (or the alternative is to accept the risk of the stock that is acquiring the company going down, making the deal worth less, or possibly turning it unprofitable. Which increases the correlation of the profitability of the deal and the market direction.)
You have to consider the costs of transactions associated with the deal so if you have just a small amount of money in the deal, you will need a higher return to compensate for the trading fees and commission. I typically use a spreadsheet.

I first copy and paste the numbers on

http://www.sinletter.com/merger-arbitrage/

It is possible to do a reverse arbitrage where you bet against the deal happening if the deal has too small of premium and too high probability of failing, or instead, if the stock is overpriced relative to the offer. However, keep in mind that there have to be shareholders that vote on the deal, and why would shareholders of a company that currently is priced at $5 a share accept an offer for $4 a share? They almost surely wouldn’t. It is rare that short sited shareholders would vote against a deal and would instead want to lock in the quick premium that many of the shareholders went out and bought the stock for, but still possible.

So on your spreadsheet, you will want to figure out how many shares with a set amount of capital you can buy and then reduce it to the nearest WHOLE amount of shares since you usually can’t buy in fractions of shares. Then multiply that by the price of the stock or value of the deal per share if it goes through and now you have what the stock is worth if the deal goes through, and you can calculate your return. The dates expected for the deal to go through are all listed, so you can take the number of trading days in a year (roughly 260) divided by the number of days until the deal is expected to go through and multiply that number by the return to get a rough estimate of the return. That doesn’t really consider the possibility of you to reinvest and compound your profits, or what happens when you are wrong, but it is close enough. Now you can sort the deals by compounded annual return after fees and expenses and from there, you can narrow your options to say returns that have over twice the current 10 year Tbill rate or so. Before you do that you may want to see if the stocks have options, particularly if it’s a “cash only” deal.
Now what?
Well, you want to look through the details of the deal. Look at the balance sheets of the company acquiring the stock, and you may also want to look at the fundamentals of the company that you would be buying just so you can verify that this deal actually makes sense and isn’t some elaborate plan to keep them occupied and not looking for other deals before they find a way to weasel out of the deal. The deal ideally won’t depend upon outside financing, but if it does, the outside financing as well as the company should have the assets, low debt, low liabilities and high cash flow and credit to finance the deal. Ideally it will be a company like Google, Apple, or Microsoft with lots of cash that is making a strategic purchase as opposed to an investment bank or private finance company making it purely based on trying to take it private so it can take it public later and hope to jack up the premium and make a profit.
There are a number of other things you could get into. There are plenty of books on the subject of what to look for.

I like to first go through the tickers and see which one’s trade options. Then among the options I like to sort by potential return, and do the same with the non optionable. This way I can look through the deals by most profitable to least. Once I do this, I can attempt to recognize pitfalls and either buy a smaller amount, buy more time on the option, or ignore that arbitrage opportunity and repeat until I have the ones I want to invest in, and then I can size my bets according to my return over my risk. This is guess work at best, you guess the probability of the deal going through, you guess the downside if it doesn’t go through (based upon roughly where it was before the deal was announced) and where it is if it does is known. Then you probably want to divide the percentage up by a fraction of the “kelly criterion” for each that makes up a total of approximately your target amount. It’s an inexact science. This may sound like gibberish so in the future I will come up with a few examples of the entire process of building the portfolio based upon trend signals.

Even those who have monopolies on boardwalk and park place will end up not having the funds to build houses, so those that live within their means and keep things tight to the belt will survive and position themselves to thrive when the opportunities hits. Calculated patience and caution is what is advised, and then there becomes a point where you must shift aggressively into accumulation where the rules will change and suddenly the deflation will have run it’s course even though everyone repeats the story as if it will get bad forever indefinitely. Making trades below intrinsic value for cash actually can make sense in this game, because you in monopoly can calculate that there will be more deals and everyone else will be even more short of cash than they are now. So even at the expense of giving someone else a monopoly, provided you take their funds to build houses will make sense since there will be opportunities on the auction block later where you can accumulate properties to generate more cash (by buying below the mortgage value), have cash to force trades into people who are near bankruptcy, and collect monopolies yourself in areas in which you can afford to build. In the stock market in real life, when liquidity dries up, selling assets below intrinsic value can make sense if other people will be forced into liquidation, thereby having less cash to be able to keep all the assets at their current PEs, and even better deals will become available. However, there is a very fine line between doing this and overdoing this. Eventually the people that are on margin and leverage collapse, the excess credit collapses, and those waiting for an opportunity strike and start to go on margin making up for that which was lost, and the markets refuel.

Knowing this well in advance, you should keep your options open by having lots of cash at all times and employing a strict minimum such as 40% that you must not go below.

Here are my predictions for 2012.

The increased leveraged in the euro to try to save it without an ability to print like the fed, and the fed having a different policy, globally will be like an atom in nuclear fission with 1 too many protons… It becomes unstable until it causes a chain reaction. We’ve seen it happen time and time again after efforts to keep Greece alive continued. Now yields are blowing up everywhere and they may come up with one final “solution” but it won’t be until a culmination of everything unwinding until they will be able to stop it.

The sovereign defaults will finally hit in 2012. Rates have risen dramatically and if €600 billion euro will be rolled in Spain and Italy in 2012, the national debts will begin to explode strangling the economy producing stagflation as was seen in the US during the late 1970s.

Capital fleas Europe initially for thee dollar. Shortly after the default event, everyone who will ever get into bonds will have already done so at maximum velocity. That means there will finally be a bottom in yields and a top in treasury demand in the US, the lack of new buying pressure will finally form a bottom around the middle of 2012. June will be the “panic” month.

In spite of trillions more of stimulus, deflation will hit as new debt comes due, but food prices and fuel prices will go up. Stagflation will occur due to slow global growth and domestic inflationary policies. Gold bugs will proceed to move into their bunkers in spite of falling gold prices.

“protect capital” is the #1 theme of 2012. This means more cash. Also, more frequent “rebalancing” and allocations a bit closer to the vest when bullish, (close to equal amounts risk on and risk off) and being more cautious about using leverage in arbitrage deals, and elsewhere.

Real estate will bottom along with interest rates shortly after the panic. The real estate “bottom” this year will be part of the first “double dip” assuming you don’t call the volatility a double or triple dip already. The real estate rally that unfolds will take a handful of years but not be great and it will never quite recover to the 2005 highs before it makes another multiyear decline.

The CDS market lack of “default” is triggering a sell off in bonds and spiking yields in Europe, while treasury demand in the US spikes. The “legal” insider trading of government official (while having a conflict of interest and working on the bill that effects companies they invest in) also feeds into the dissent along with MF global and potentially other scandals, and people will lack the trust needed to continue to buy goods and services, fuel the economy, push prices higher, and so on.

So in 2012 be sure to protect yourself

What is being missed in all the stories hyped on TV is the long-term perspective. The entire reason why the US National Debt exploded during the 1980s was because Paul Volcker raised interest rates to an insane level. The 1970’s saw an 88% increased between 1970 and 1977. Just since 2007 the rise has been 150% due to Tarp et el. If interest rates rose, rather than declined, that debt level would have risen by at least 300%. This is what we are facing int Europe in the years ahead. Rates have risen dramatically and if €600 billion euro will be rolled in Spain and Italy in 2012, the national debts will begin to explode strangling the economy producing stagflation as was seen in the US during the late 1970s.

-Martin Armstrong

This can make investing very difficult.

The traditional investment model that I recommend in this site, is to let the trend dictate the action, and have certain target allocations given certain conditions. You break down your investments into “risk on” “risk off” and “neutral”  and change allocations depending upon the environment. If you were to ignore “neutral” or relatively neutral strategies, you might for example have 75% long stock and 25% cash when you are bullish and 75% cash or bonds and 25% stock.  In conditions where you can both be confident about the move’s direction and magnitude of the move and that magnitude is strong, you might bet more aggressively at such extremes. You might go for 85% long in bullish conditions or potentially even get short in bearish conditions.

The environment is full of traps. It will be difficult for capital to survive in 2012, and the risk will be high. Therefore you probably want a more defensive position, with perhaps a bit of a bearish bias more than usual. For example, the most bullish you might get in 2012 could be  say 60% but you might go to 80% cash if the trend is bearish. The euro collapse that everyone has talked about may be near. The budget shortfalls and so much cash coming due, but so little available will be problematic, however governments may attempt to print a lot of new money to make up for the global credit shortage, but it may not be enough. So the newly printed (digiitally) cash will circulate and go somewhere, but the money in stock markets may flea or enter elsewhere, or money could be injected into the market, it’s really hard to say. I believe the market will be very vulnerable in the first half of 2012, but the response afterwards will probably be monetary inflation and the net result will be stagflation. slow growth but increasing debts.

You don’t have to avoid the market completely to get defensive, but avoid growth names, seek long term value purchases or etfs and have most of your portfolio to protect you and outperform. Even arbitrage deals will be vulnerable in 2012 to failed deals, and rising credit and failed financing of these deals, so you have to be very cautious.

The stock market can be a brutal place for those unprepared, making it difficult not only to recognize the future market direction, but also to position yourself properly for the given conditions. However, what if you could find away to make money regardless of market direction?

Why would you want to profit in all market conditions especially if it may lower your return per dollar at risk? Because in doing so, it provides a more stable portfolio and as a result, your long term growth and gain per risk (measured in draw-down, not dollar used) is higher, and thus by adding leverage you can either provide yourself with a GREATER return with the same risk, a greater return (although slightly less than if leveraged to the max) with less risk, or the same return with considerably less risk.

There is in fact several reasons to do this, as well as ways to accomplish this task.

The simplest way, but by NO means the best way is to have 50% of your cash in an index fund, 50% of it in cash on the sides and to use that cash to maintain that 50%. To maintain, you buy shares if stock goes lower, and sell shares if it goes higher, so you are adding lower, and selling higher. This makes money in a “random walk” if you are adding money lower and subtracting higher, when stocks return to where they started, you will be up a very small amount. However, the problem with this is it will take a considerable amount of time before stocks return to the levels you start at over time, and in bull markets you will under perform the market. Additionally TIME becomes your enemy as you wait a significant period of time for the market to return. If you would have started in 1929, it would have been quite some time before prices returned to their 1929 level. So while this is one possible way in complete random conditions to eek out a small amount, it’s probably the least ideal way to do so.

The better way is to understand “delta neutral” strategies or to aim to maintain a portfolio of a correlation of zero to market direction. By doing so, your overall portfolio still has to be positioned properly, you still will have to identify value and bet on stocks or asset classes you anticipate will go up, and against stocks or asset classes you think will go down.

For example, if a company has $200 million in natural resources in net inventory (after subtracting that number from the liabilities) and is valued at a market cap of $200 Million, but you anticipate growth and/or there is suddenly a new discovery and the stock has yet to move to reflect that, you have yourself an opportunity. If you just bet on the stock and the value of all natural resources decline as discoveries pop up over the world and demand declines, then you still can lose as this will hurt the value of the company, perhaps even after adding on the discoveries. However, if you bet against the natural resources in the company’s inventory at the same time betting on the stock, it doesn’t matter what happens, as long as there is not accounting fraud and the company eventually reflects the value of the new discovery or growth, then it will at least go up relative to the price of the natural resources.

Sometimes the price of mining companies might reflect expectations about the future price of certain metals, rather than valuing it relative to the metal. This can result in greatly over priced stocks in mining relative to the metals if people are bullish on these materials, as they may be using mining companies to get exposure to gold. Conversely, this can result in very underpriced metals if people are trying to avoid exposure. While people may make fairly reasonable decisions over time with regards to an asset, most do not short, and thus relative to another asset stocks can be greatly undervalued or overvalued, even if in isolation it was a fair price. For example, in the example, say the company discovers $50M in material (at the current price. However, the price of the metal drops 33% over the same time. The company would be “perfectly” priced given the information and the future, but imperfectly priced relative to the metal. People betting on the metal itself, easily could have overlooked the number of discoveries that can effect supply (such as the $50M discovered by the example company), or the growth in the industry and as a result, the metal could be overpriced. Betting against metals the company owns while owning stock in the company is a good hedge in this example.

This is only ONE such idea. Typically those bullish on gold own BOTH gold and the mining companies, and sell both when they are bearish, however sometimes being bullish in one and bearish in the other is the more reasonable strategy.

You can also use valuation metrics relative to other companies within the same industry and bet on one and against another. Since a stock’s move is largely based upon where money managers are concentrating their capital into, you can reduce the risk of a particular industry falling in and out of favor by placing a “pair trade”.

Another way to make money regardless of market direction is called “risk arbitrage” but there are other forms of “arbitrage” as well. In the late 1700s and early 1800s when trading was not as efficient and you could not move money digitally online with the push of a button, and information wasn’t as freely available, so Gold in Boston may have been 8 shillings per dollar while gold in New York may have been 6 shillings per dollar. If you were aware of this, you could contact a friend in Boston, while you were in New York, and you could buy all the gold you can up to 7 shillings per dollar, and have your friend promise to sell all the gold he could down to 7 shillings per dollar. You then could exchange the physical to your friend, and split the profits. This was going to have some risk because there were a few things that could go wrong. You could end up with fools gold, you could end up with unequal amounts, but more commonly, you could have errors in communication or not communicate fast enough to take advantage of the opportunities, or one of you could start buying at 6 shillings, while the other seeks to sell at 8 and then 7 only to find the price drops in both to 4 while only one of you made the purchase. You also had to be aware of how much money you were making on the bets to be sure you could perform the arbitrage correctly. Additionally, if you had another location not as far away, the travel time and time it takes you to perform your return of roughly 2 shillings per dollar.

So it wasn’t a fool proof strategy in the 1800s, and it isn’t now. Weighing the risks cvs the rewards remain important. However, it is relatively “market neutral”. In the example, despite the risks, none of them are really related to the changes in the price of gold and are more about communication, and timing and execution of the strategy, than about whether gold goes up or down in price.

Many people buy at a garage sale, looking for bargain antiques that they know is worth more. This is close to arbitrage, but isn’t quite unless they are buying and selling simultaneously. If th antique loses value before they sell, their return depends upon just how much of a discount they get.

Risk Arbitrage is usually done with mergers and acquisitions. There is a ton of information available on this and that you will want to learn before you start implementing it.

Like mentioned with the antique example, one way to protect yourself against a decline is have an edge and recognize value and only buy those with superior value. If you buy an antique for $2 that is worth $200, it would have to fall a ton in order for you o lose on the deal. If you buy it for $100 instead, you have a 50% margin of safety against a decline in fair market value. In investing there may be components of an investment worth more than the fair market value. It’s like discovering a rare item at a garage sale worth far more than they are giving it to you. It’s still possible that by the time you are able to sell it, you lose out, so it is not completely immune, however it is certainly close!

Value investing is not a way to make money regardless of direction, but it can protect you enough from direction that you are relatively immune from a decline. It is theoretically impossible to be 100% protected from a decline by being long only one stock with no hedge, however, it is possible to own something at 50% of it’s value and so even if conditions negatively effected it’s value by 50% it still would be fairly valued. Value investing eliminates some of the hedge required if you wanted to buy options to completely protect you from the remaining 50% of the decline (using a protective put). However, that assumes you are able to assess value and that others either don’t look there, or are not. So large cap companies are NOT the place to look for “value” unless you are somehow an expert or have awarness that other people don’t. Warren Buffett and others like him would have bought and pushed the price up of big cap stocks that are undervalued. When you have hundreds of billions of dollars to manage, you simply don’t waste your time with a 50M company, it would barely put a dent in your overall return even if you could buy the entire thing. So for this reason, smaller market cap areas are more likely to provide mispricings. The problem is, unlike the hypothetical example of buying it at a garage sell and selling it to an antiques dealer o pawn shop,  You cannot do that since it all sells on the same market. You can only either collect a dividend, or wait until someone comes along willing to pay you what it’s worth. So value investing can be frustrating, especially when there are thousands of other stocks, many of which could become undervalued while you wait.

A way to make money even when the market turns against you, is not to have 50% stocks and 50% stocks, but be able to assess value and have the ability to be right more often than not about trend direction. If you have even a 55% chance of stocks going 10% higher vs a 45% chance of 10% lower assuming a normal distribution, then you can have a slightly greater than 50% investing in stocks, you still can make money when the market goes against you, because you will be able to rebalance at a lower price similar to before, and although your return will be less than if you had 50% of each, over time, you don’t need the market to be as strongly in your favor to do well. A volatile market in which you at least position yourself by buying lower and selling higher, will at least give you the chance to do better than if you bought and hold at the market. Additionally, the constant rotation into value will give you an edge.

One way to make money regardless of market conditions, is to be aware of it and position yourself for each move. If the move is going to be higher, you should have more stocks, etfs and risk assets than bonds/cash/etc, and if the move is going lower, you should have more cash, bonds, currency, etc than stocks and risk assets. Of course, this isn’t typically what people look for when they want to profit regardless of market direction, but there are inverse etfs to profit when stocks go down, and things like bonds which are slightly inversely correlated with the market (tend to do well when stocks do poorly). Correlation, however is usually only looking at the past and the correlation could change.The trick is to recognize that you will not be perfect about guessing directions and not position yourself as if you are certain. Remember how you can profit from “random market conditions” with half fcash and half stock as long as eventually stocks return to where they started? Well the markets aren’t completely “random” and the signals may give an indication of where stocks are “more likely than not” to do, but they certainly don’t predict direction. So you can sstill make money if stocks go against you almost half the time, provided you position for it, especially if you are much more aggressively invested into stocks when you have the most reliable signals that stocks will do well.

Selling overbought conditions and buying oversold conditions does depend on market direction, but when used in a portfolio that takes other aggressive measures such as a balance that is better than most between cash and stock, arbitrage, hedges, pair trades, delta neutral trades, and value and so on the return from such strategies can compensate enough where if you are wrong about direction, you can still beat the market.

Most people will tell you stories about how to execute option strategies and promise you riches, but it is simply not going to be easy to do well regardless of market conditions, reliably.

The best way to do well in the market when you don’t know the direction, is to use a combination of these features mentioned and position yourself cautiously enough in risk (those that do well when the market does well) so that if you get a more reliable signal, or identify a more extreme mispricing and representation of value later on, you have enough cash to move aggressively on it. Unfortunately, there is no “magic pill” or “silver bullet”that is without consequences. You can’t just throw your money in one area, and always make money with no thought and make a lot of it. As soon as it seems like that, throughout history those areas have resulted in major crashes, so don’t get caught up in the hype. There is significant work involved. You have to analyze deals, you have to position yourself properly, you may need to be very patient. You may need to rebalance and once there gets to be extremes, get gradually more aggressive as others get gradually more conservative, and vise versa. You may need to do a lot of work on a lot of bad stocks before you find the right ones, and when you do everything right, something can still happen to make it wrong. Believe me, it is not always easy. But over time if you continue to do the right things in the right way at the right time, you will be rewarded. Continue to advance your knowledge, and you may get there.

The key to making money regardless of conditions is to reduce correlation and pick winners. You can bet against something that will only yield 1% while betting on something that will yield 3% when times are good, and that will yield negative 3% and the thing you bet on returns negative 1% and you will do well regardless. So identifying underperformers and outperformers and using both long and short bets as pair trades, or just identifying value and lackthereof and responding in accordance to that is a way to do well regardless of direction.

Finally, one thing often overlooked with regards to arbitrage is hedging against tightening rates by “reverse arbitrage” This is where you essentially bet against a deal that has a very low yield that will not complete for a very long time since it will probably underperform your other deals. You can also bet on those with negative returns going through, since if it doesn’t go through, you may be better off, or you can bet against those with a mildly negative return since even if it does go through you will do okay, but if it doesn’t go through, (similar to betting against the very low yield over a period of time), it will still underperform the market and the other deals. Bet against what underperforms, even if it is slightly positive and on those which do so you can reduce your exposure to the market direction.