AIM UK

[ls7550]

RE: Ladder and Stop-Loss

Generally collective volatility is indicated by 1/SQRT(n) where n is the number of stocks.

For example 16 diverse stocks each allocated the same initial capital amount have collective overall volatility of 1/SQRT(16)=0.25 (25%) that of the volatility of a single stock.

Which is the better?

$30,000 (initially $20,000 stock, $10,000 cash) invested in each of 16 different (diverse) individual stock AIM's using Classic AIM settings (10/10/5) or $480,000 (initially $320,000 stock and $160,000 cash) invested in a single Index AIM using LD-AIM scaling of 4 and a 4 times smaller hold zone to account for the reduced (25%) volatility.

I suspect that generally both are comparable on a risk/reward basis overall. Yes a single stock might fail (6.25% loss against the total fund value), but equally another single stock might double up in value or more to counter that failure.

However a principle risk is that when AIM'ing the Index no account is given to scaling down the hold zone nor scaling up the trade size (LD-AIM) to counter the lower volatility, and instead Classic AIM settings are used - which installs the risks associated with lower overall investment returns (but has the benefit of lower overall risk).

In practice the difference between scaling and not scaling is relatively small. Generally AIM's volatility capture benefits amount to between 0.5% and 2% of the total fund value. Perhaps something like 5% of stock value trade size = 3.3% of the total (stock and cash) value (assuming 66.6% stock/33.3% cash average) being round-robin (buy/sell paired) twice per annum (4 AIM indicated trades, 2 buy, 2 sell) against a 30% hold zone (buy to sell price range). 3.3% * 2 * 0.3 = 1.98% of the total fund value volatility capture benefit. (These figures are demonstrative only, more commonly AIM's buy and sell pairs occur over periods of years rather than within the same single year - perhaps 4 sells one year, 3 buys the next year....etc.).

When no trade size scaling/hold zone size reduction is implemented for an Index based AIM then perhaps only 25% of that volatility capture benefit is achieved - providing a lower 0.5% of the total fund value volatility capture benefit.

The typical conclusion drawn being - '..that AIM'ing an Index fund is not good - the volatility is too low - not enough trades...' etc.

Simply the hold zone is often too large (and the trade amounts too small) when AIM'ing index funds and volatility capture benefits are missed.

What I've personally done to address this is to strip out AIM's volatility capture component and construct a ladder that's similar to Don Carlson's EZM rebound column. The ladder is constructed at the micro AIM hold zone size (I'm more recently using 0.1% price movement steps). The ladder also is constructed to scale up the trade size in a manner whereby the bottom rung (the point at which 100% all-in stock is reached) is pre-calculated (known in advance). Each rung has an indicator as to the next buy and sell points from that point - calculated based on scaled down conventional AIM hold zone values.

I don't trade each and every rung, but I'm free to trade at any point whenever I deem fit based on the amount the stocks price has moved since the last trade, the trade gain that would be realised (and associated trade costs), my view of the possible trend continuation or reversal etc.

Which leaves me free to focus on cost-averaging multiple steps. If for example I can cost average 20 buy steps into a single purchase at the lowest of the 20 purchase price levels then I've achieved some benefit - the same goes for cost-averaging multiple sales. I personally see such cost-averaging to be the primary potential to add the greatest amount of alpha (surplus) investment return benefits.

Generally the initial funds at risk are very low, only if the stock price falls significantly are larger amounts invested. The ladder singularly seeks to trap volatility capture benefits. In association with the ladder I therefore use a stop-loss based strategy that has much more invested from the offset, but sells out relatively quickly when prices fall. The stop-loss and ladder combined have a negative correlation in the sense that as one sells out so the other starts buying. However the sell out occurs a lot quicker (stop-loss) than that of the cost average based buying (ladder), which is generally a good thing during a Bear phase.

In practice actual market orders placed at any one time reflect the overall sum of the two styles.

Its all in the very early practical application stage at present, but I've set a target volatility capture goal of 6% of the total fund value as I believe that cost averaging multiple rungs can significantly amplify conventional AIM's volatility capture benefits. For the stop-loss style I've set a goal of 9% such that the combination of both style is a 15% overall target (of total fund value (cash/stock)). I'm also still running in parallel with conventional AIM holdings.

In view of an expected average of 70% overall stock exposure I'm further considering applying elements of leverage to lift overall average stock exposure levels closer to 100% levels (around 50% leverage) as much of the leverage costs (cost of debt) can be internally financed via the cash reserves (periodic external cost of debt will however at times be required). Based on 8% cost of debt, 5% cash rate and a half and half internal versus external debt rate (6.5% average overall cost of debt), I suspect that the 15% target return could be lifted to approaching that of a 20% total return. I am however waiting until I'm comfortable enough with the basic unleveraged returns before implementing the leverage element. Most likely I'll also align periods of leverage with that of favourable vWave indicated levels.

I feel that the targets are not too stretched and that potentially the rewards could be even higher as the volatility capture target chosen is somewhat conservative in my opinion.

Practical running is a breeze. My stop-loss style and ladder are all pre-calculated and its just a question of a few minutes position checking time once each day (periodically with a market order being placed).

I'll be posting periodic updates here to advise of how the live run is progressing. Hopefully I'll be contender at matching or exceeding Firebird's 25% ATTIC target.

Clive.