RISK shift - you need to know when it happens !
For most investors and traders risk is something they need to accept in order to come up with decent returns. Most of the times risk is measured in your account by how much you are losing when trading different positions. But sometimes risk shifts and it is not measured in the account any longer. When this occurs some positions can be made bigger without risking more but you need to know how to find out when this happens.
Let´s take a look. One of these opportunities is unfolding in front of us as we speak, so now is the right time to talk about it. Most of the times you have no idea whether a position will work for you or against you when you open it. Technical Analysis or fundamental research can tell you only so much up front, you might have an idea of what could happen, but you will never know until you finally open it and watch the position either winning or losing. Therefore all positions are controlled with riskmanagement as to not lose too much money in a single position. You use stops and other tools to keep a position from going to far against you. But sometimes a position works for itself and shows a crystal clear picture about its future and you don´t need the usual riskmanagement for such a position.
When Warren Buffett announced back in November 2009 that he would aquire Burlington Northern Santa Fe he also said that Berkshire Hathaway Class B stock needs to be split for fairness reasons and that the split would take place in February 2010 after the board meeting. This was amazing for most of us being around as traders for quite a while, since we never thought we would see the day Berkshire stock gets split.
The announcement was interesting in a couple of ways. First of all it would hit the investment world as a positive shock. Plus it meant that liquidity would pick up after the split because of a lower share price. The stock would become cheaper optically, this is what usually happens in such a situation, liquidity picks up. That could mean that the stock could be added to the S&P500 Index.
Well, all of this has happened, the stock was split, liquidity picked up, it was added to the Index and now we are looking at a stock that has already risen by some 20% since its split.
But why do we have a risk shift here and what is it?
Well, that is fairly easy. Even though the stock already went up by 20% it doesn´t mean that it can´t go up further. To the contrary it will probably do so. People start to love that stock, mainly because they were not able to buy Berkshire Hathaway before. It was to expensive to do so with the Class A shares around $100.000 and the Class B shares still around $3300. Now that it split it can be bought at a cheaper price (which doesn´t mean that it has lost its value it just got cheaper optically). Somehow Berkshire Class B stock has become a status symbol, almost like the Mercedes Benz logo. You want to own it, because then you own quality and now after the stock split you are able to own it. So lets compare both sides. If you want to go long BRK.B at this moment there are a couple of things helping you out. It got split, so it is cheaper, the liquidity has picked up, which is good and it was recently added to the S&P500 Index. These are all things that make it easy for you to go long. But what about the downside? Are you willing to go short? Well maybe but when reading the above it becomes difficult to really go short since you have all these things working against you.
When such a situation occurs, most people are not interested in shorting such a stock, but wait, if nobody wants to go short, obviously the stock has no real downside. So when people sell their positions in the stock they will do it because it went up and they want to secure the profit, so they will sell from stock already owned but they are not actively shorting the stock.
In such a case we can scale up our long position in a stock like this, because the risk we encounter has shifted from the account into the stock. It still bears some risk, but it is a lot less on one side of the market than it is on the other side. So it is less dangerous to have the position within our portfolio and keep it on the longside. You still need some basic risk management in your portfolio and use a stop but this stop most probably will not be hit in the near future.
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