The main premise of this site is to develop and communicate new trading strategies, but sometimes there is a shock that comes along that tests even the best disciplined investors.
Tuesday, February 27, started out with an approximate 10% drop in the Chinese A-shares stock market, which sparked a worldwide equity sell-off. While the 10% drop sounds like a lot, the Chinese stock market since February 5th has seen a non-stop 15% growth up until this drop. The problem is that there is so many risk-adverse investors right now that they weren’t valuing investments with appropriate risk premiums. The emerging markets do present some risks that are not an issue in developed markets, but investors were valuing those securities as if they were in a developed market environment.
Another issue was that of the massive selling and profit-taking that went on domestically and around the world. This little shock in a somewhat unrelated region of the world sparked this weak open and market performance. The problem with investing is that people trade with their emotions and the belief that the stock market can go up indefinitely without much of a pull back, which drives them to bid up prices in stocks and basically taking on too much risk for little return.
The problem is that stocks tend to overshoot their intrinsic values and a correction is needed to take those values back in line. Tuesday was one of those days, it was a breather that needed to be taken so that stocks can continue on their healthy uptrend.
You could tell that people were unhedged and were taking on risk because the VIX, the CBOE Volatility Index, was around 10-13 for the past couple months, which means that there was very little expectation of risk in the marketplace. After yesterday, the VIX reached a level 18, thus increasing the cost of becoming hedged in the market. I would expect for this value to come down, because people have a way of forgetting recent events and will continue on with their risky investing styles. Obviously the Chinese stock market has rebounded 5% today, so maybe people have forgotten yesterday already. The problem is in China, investors are mortgaging their homes, borrowing funds to invest in the market; if Americans can remember back to 1929 that is the exact reason why the Great Depression occurred.
It was unwarranted for the market to fall that much yesterday; panic selling and stop losses were the main culprit. Emotions are the biggest hindrance to a rational marketplace, and it is harder on one’s mind to lose 1% than it is to gain only 1%. Options and other hedging instruments could have been used yesterday to protect against such a sudden market downturn. The Covered Call Put Option Dividend Strategy, which has been described on this site, would have provided the investors with a protected investment, where the 4% drop would not have been felt at all, because of its long term time frame. I will continue to provide updates on the strategy and will be looking more into testing this strategy in the real-world.
