Education Newsletter

Jack Schwager is renowned for his "Market Wizard" books, and his newest addition, "Hedge Fund Market Wizards," came out recently. This series is a must-read for novice and veteran traders alike.

I have not gotten very far into the newest installment, which features interviews with some of my favorite traders. But I have seen a number of interviews with Schwager about the book that address the idea of risk versus volatility, and it is indeed a topic worthy of further discussion.

Many people equate volatility with risk. Yet Schwager is quick to point out that such an idea is not only false, but even dangerous. When choosing a strategy or a fund to invest in, people are drawn to smooth upward sloping P/L graphs. Schwager, however, points out that those graphs often betray the real risks:

"There are many strategies that make moderate money most of the time, giving low volatility track records. Once in a while, these strategies are prone to huge losses--they are highly left-skewed. They make money most of the time, but once in a while can lose a lot. These are strategies which are explicitly or implicitly short volatility."

Case in point: The least volatile investment one could have made in 2007 was in Bernie Madoff's fund, and we know how that ended. Many other funds and strategies that are not fraudulent still have low volatility that masks their true risk. As Schwager mentions, strategies that are explicitly or implicitly short volatility do just that.

Nassim Taleb discussed just this problem in "The Black Swan" and provided a nice example of low volatility and high risk in the life of a turkey, as shown on the graph below.



Many traders are drawn into option-selling strategies for just this reason. They produce steady, solid returns most of the time with the P/L in a nice upward-sloping track.

But I know of one option newsletter/auto-trade service that provides amazing steady returns and then blows up about every four years. That may be OK for hedge funds and newsletters, which make money when things are good and don't give up anything when they blow up because they can always start again. It's a different story, of course, for individual investors and traders.

I honestly don't have a problem with short-volatility strategies, as I use some of them myself. But don't be fooled by the low volatility levels, especially when looking at returns that don't include steep drops in their respective markets.

In one of the most infamous examples of this problem, Long Term Capital Management supposedly did not include 1987 in the risk models of their strategies when they blew up about 10 years later. So using protection and limited-risk selling trades is the appropriate way to approach such strategies, even if the returns aren't necessarily the most impressive.

The upshot: Don't be fooled into thinking that low volatility is low risk. And, by all means, don't be a turkey.

One of the basic rules in trading is that uptrends consist of stocks making higher highs and higher lows. Despite all the noise in Europe, that's exactly what we have now.

The S&P 500 bottomed around 1010 in July 2010, followed by 1075 last October. Now it appears to have bounced at 1267. This most recent trough is also about the same level where stocks peaked in October and December, so it's a logical place to expect support.

One nasty personality quirk of this market has been a nasty tendency to pull back violently after rallies--especially in the last year as European debt problems intensify. That's what happened in late November, and it's what has taken place in the last month. Don't worry; it's just trying to shake you out of your longs.

But now sentiment appears to be shifting, and we're making a higher low. Before looking at some potential trades, let's consider why things are improving.

The first reason is that European calamity is once again priced in now that we've absorbed a steady stream of negativity surrounding Greece and Spain. People vaguely expect some kind of fiscal union or "Eurobonds" at some point in the future. It may not pan out as hoped, but the market could rally in anticipation of such a development in the next 1-2 months.

Washington could be another catalyst. I generally try to avoid politics, but it will grow increasingly important into the summer. Personal feelings aside, most investors and business leaders have grown unhappy with Barack Obama in the White House, so they will get bullish if Mitt Romney moves up in the polls.

Those hopes got a big boost just yesterday when Wisconsin's Republican governor, Scott Walker, survived a recall vote by a wide margin. And it wasn't just any recall vote: It was essentially a mini-version of what the 2012 presidential election, a referendum between big government and economic growth. With the mess in Europe fresh in people's minds, sentiment will probably oppose government spending, and it could be 1980 all over again.

One final thought: The economy is just bad enough to weigh on Obama, but just good enough to permit a Romney Rally in stocks.

My favorite investments at this moment are gold (GLD) and its manic-depressive cousin, silver (SLV). I got bullish toward precious metals on March 28 because gold had broken above a key resistance level. So far it looks like that call was premature but not wrong. The option action has also been heating up in this space recently, and I have been adding to longs.

Hertz Global (HTZ): Car-rental companies have gotten no respect despite a steady stream of good earnings. HTZ has seen repeated bullish call buying in the last week, and looks like it could easily go back to $15 from yesterday's close of $12.18.

Fortinet (FTNT): An obscure maker of network-security software, FTNT has had nothing but strong results, and now bookings are picking up as well. It also had bullish options action on Monday.

Calpine (CPN): Natural gas is cheap and becoming more popular for generating electricity. CPN is the best way to trade that trend and is looking good on the recent pullback to its 100-day moving average.

Datalink (DTLK): Earnings have been nothing but strong, and valuations are stunningly low for this small-cap software company. It trades at about 9 times forward earnings despite profit growing at more than 20 percent a year.

VirnetX (VHC): I won't pretend to understand this company's patent portfolio, but it recently received a favorable legal ruling in a case against Apple. VHC is also a favorite among some traders on our premium chat forum. The stock could go back to $40 from yesterday's close of $31.50.