In the REAP strategy, a “six-pack” as a group of six stocks that you trade against each other according to their relative price movements. The six-pack is fixed in the sense that the stock names never change, just the weightings.
VOLATILITY IS GOOD
Volatility gets a bad rap because everyone now uses the term to mean stocks going down. (No-one seems to complain when stocks go up.) Volatility is really a measure of the degree and rate at which stocks move down and up. Higher volatility is actually good for some REAP stocks, because it creates the price divergences on which the re-balancing calculation is based. The wider the swing, the more money you switch from more “expensive” to less “expensive” stock.
THE SELL/BUY DYNAMIC
For a given $ amount of money, at a higher stock prices, you need to sell less shares, and at a lower stock prices you can buy more shares. If you set aside $ value for the moment, each time you make a REAP trade, you give up less shares than you are buying, and move the portfolio in the direction of slightly higher share owner ship in the group of six companies. This is where the compounding comes from.
HOW YOU WANT STOCKS TO MOVE
In general then, your six-pack should be structured to optimize toward higher price divergences between the component stocks. Ideally, you want some stocks to go down over the cycle; some go up. Next best is some go up only a bit while a few others go up a lot, then some go down only a bit while one or two others go down a lot.
STOCK MATCHING
REAP stocks should then be grouped in a way that they are all likely to respond differently to the same set of economic and market conditions. An example would be an oil stock and an airline or trucking stock. When oil prices are high, oil stocks do well and transportations suffer, and vice versa. A gold stock will do well in times of inflation and higher uncertainty, a bond ETF likely won’t well at all.
My recent fascination with short ETFs actually addresses this specific issue. ETFs usually come in pairs now – long and short, for stock market indices and industry sectors. The beauty of them is that they are perfectly counter-cyclical (mirror image of the other). If one goes up 15%, then you can be pretty sure its mirror will be down 15%, creating a very useful 30% divergence.
Non-correlation (portfolio management jargon for not doing the same thing at the same time) is also important to reducing the overall volatility of the aggregate (total) portfolio, and thereby offers defensive advantages. You could have individual stocks swinging wildly while the overall portfolio calmly meanders along (easier on the heart).
SIX-PACK EXAMPLE
A six-pack of recent vintage was as follows:
Bank of Montreal (NYSE: BMO) – Financial & Cdn dollar & blue chip
Axcan Pharmaceuticals (NASDAQ:AXCA) – Drugs & Cdn dollar & mid-cap
Cryptologic (NASDAQ: CRYP) - Software & US dollar & small-cap & small-cap
Florida Rock (NYSE:FRK) – Infrastructure & US dollar & mid-cap (taken over)
Iamgold (NYSE:IAG) – Gold & Cdn dollar & mid-cap
FormFactor (NASDAQ:FORM) – Semiconductor supply & US dollar & small cap
The themes involved were interest rate sensitivity in BMO, baby boom demographic (Axcan), recession-resistant gaming (CRYP), infrastructure renewal (Florida Rock), inflation (Iamgold), and high technology (FORM). This is a little more aggressive than most, with Bank of Montreal being the only blue chip with the rest being smaller capitalizations, but through its two or so years, this group rose steadily and smoothly although the component stocks were volatile at times.
Going forward, I plan to re-establish six-packs on 6 primary themes for each:
Financial
Health Care
Energy (transitioning to renewable)
Gold / Commodity
Short ETF
Technology
A few additional renewable energy “wild-card” substitutions will be made as more pure-play companies become financially stronger.
Cheers,
Allocator
Copyright George Parkanyi 2007 – all rights reserved. The methodology is free for anyone to use. This material is not be copied without proper attribution.
3 Comments
January 3, 2008 at 8:40 pm
[...] #3 http://stockadventures.wordpress.com/2007/07/02/reap-3-designing-a-six-pack/ [...]
September 17, 2009 at 3:01 am
Hi
Firstly, thanks for sharing this methodology.
I am implementing this system for myself and I would like to ask a few questions:
1. When choosing stocks to constitute the six-pack, do you (a) try to find something uncorrelated with those already in the six-pack, (b) pick something volatile, or (c) a combination of the two?
2. Your methodology detailed here describes a 4-month rebalancing period, but your recent blog entries shows an ‘event driven’ sell/buy cycle. E.g. you seem to sell whenever a stock shows a 30% gain, rather than rebalancing at fixed intervals. Do I understand this correctly? If so, what prompted you to change?
3. Using the fixed rebalancing interval methodology, is there a minimum differential that you require before rebalancing?
Thanks
Harry
September 17, 2009 at 11:14 pm
Hi Harry,
You can contact me at gparkanyi@hotmail.com if you wish.
Some answers:
1 – (a) yes. today I would use a short equity ETF though not the double-short so much. Although I have those now – I will be dialing down.
(b) in the fixed time frame version, in my testing it seemed to work better using at least 2 “anchor” stocks – less volatile blue chips .
(c) yes, as long as you have a mix of characteristics for diversity, you can combine in any fashion – your objective is to create price differential between securities that have staying power as going concerns.
Basically the introduction of double long and double short ETFs prompted me to change. Last year this worked very well, as I beat the market by 12%. I was able to accelerate the compounding effect by trading more frequently. This year I blew it by sticking with double-short ETFs all the way from the bottom. I should have traded them out for something else that doesn’t have inherent mathematical value erosion (from the way they re-balance). The worst that can happen to these is what’s going on now – a long unbroken move against. Also I’ve tinkered too much, trying to time a pullback in this market. I will slowly work to fix that as we go forward.
3 Because of transaction costs, I would probably not re-balance on less than a 20% average delta between the top two and bottom two stocks. Better to wait until the variance rises again.
Cheers and good luck,
George