Economy and Trade Structuring

There is a very distinct connection between the economic scenario with the sectors and stocks one looks at. However  this can go further to help structure the trade on parameters like position, size and use of different instruments. While putting all the pieces together is difficult, we can still try to set some framework around it. Therefore, if we divide the economic cycle into 6 stages the structure would look something like this:

Peak: Typically, a time of high inflation and interest rates that have started inching higher or are ready to pick up. From a stock perspective, valuations are inching higher much faster than earnings. During such times, be cautious in long addition, use spread strategies and hedge. Do not be in a hurry to short but be patient with hedging.

Slowdown: Generally, a time when high inflation and interest rates have started affecting earnings and the contraction of multiples is sharp. Volatility is also high during such times. Thus, it makes sense to use spreads to reduce the impact of higher implied volatility. Also, it is better to use long–short strategies. Such times see sharp spikes in stocks on either side so reducing the trade size can be useful.

Recession: This is a time when taking long trades is slightly difficult so one can focus more on Shorting / Long – Short. The other big opportunity will be in the form of a Covered Call. Against existing holding writing of Calls is a lucrative opportunity.

Trough: While one can continue option writing. It makes sense to look out for stocks and sectors, which are bottoming. One way to approach them is via Put writing. Keep writing Puts on stocks you wish to own at the strike price where you want to enter the stock.

Recovery: This is the time when earnings expand and not much expansion is seen in valuations. Therefore, the moves can be slow after an initial uptick. In such a scenario, the use of spread strategies is better to absorb the impact of time decay. Also, build long positions selectively.

Expansion: A time when earnings and multiples both expand. This is the time for aggressive Longs. The trade size should be optimum and the use of margin be done in the best possible way to improve returns on the portfolio.

Net-net the top-down approach would go one step further in deciding how to deploy one’s trade ideas. However, creating and sticking to such a structure can be quite a bit of a challenge.