Monday, 15 October 2018


For many investors, 8-12 October 2018 was the week from hell. The KLCI fell like a rock with a 5% decline at its worst point, or a whopping 90-point drop within two days. Hong Kong's Hang Seng Index, which takes its cues from movements in the US markets, similarly exhibited its rock-meets-gravity tendencies; it fell by 5% to a 17-month low.

On one particularly bad day, Bursa Malaysia's total number of counters exhibited this statistic; 900 losers (decliners) and 56 gainers, with the rest untraded. In other words, assuming you're holding one particular stock or warrant, there was only a 5% likelihood of making money on this day. Elsewhere, retail and institutional investors fled in droves, completely uncertain of where the bottom of the market is.

Amid all this, we managed to make a total of RM3,900 in profits from two trades. We do not see this as a trifling amount at all, and it was not down to luck or incredible intellect. To make meaningful profits when the markets are on fire, you have to understand two things that keep everybody awake at night; fear, and maths.

Our ideal readers are those who were not dissuaded by terms like 'mean reversions' in the blog title. If you're still reading, we love you. Source

We will elaborate on two key concepts that allowed us to derive relatively low-risk but high returns. A 10% gain from a trade lasting under 48 hours is a good outcome. Achieving this outcome when markets were in free-fall is an.. awesome outcome?

Anyway, here are the two things to keep in mind if you really want to make profits during tough times. This is the only way to prove that you're truly contrarian; by doing it in practice instead of just talking like the stock market 'gurus' out there.


From time to time, you will encounter a market situation that can only be described as a perfect storm. A confluence of factors combined to achieve, in this case, a truly frightening outcome for many. Last week, both domestic and external factors pretty much drove the KLCI into a seemingly bottomless pit.

Just look at the following headlines, listed in chronological order over a 48-hour period:

Wednesday, October 10, 2018. Full story here

Wednesday, October 10, 2018 (US time). Full story here.  

Thursday, 11 October 2018. Asia markets react horribly to the declines in the US. Full story here.
Thursday, October 11, 2018 (US time). Total damages. Full story here

A quick quiz: when was a good time to trade profitably? Our very specific answer : when the KLCI fell below 1,700 points, given that it was about 90 points higher barely 24 hours before.

During periods of severe market volatility such as this one, we are just like you; we are concerned about what this decline ultimately means for the market, the state of the economy, and the state of the world. Although we agree that extreme caution is appropriate, which means you should take your money out of the markets, we have also trained ourselves to identify very specific pockets of opportunity.

To put it another way, we know that there are chances to make low-risk returns relative to the rest of the market. This is where mean reversion comes in.

Mean reversion is the financial equivalent of the old adage 'what goes up must come down', in reverse. But we never deal with absolutes. Instead, we believe that markets that have fallen steeply (5% in two days) are fairly likely to rebound.

Furthermore, we are confident that the steeper and faster the decline, the more meaningful the rebound will be. In numerical terms, when a market has fallen 5% over a three-day period, a rebound of at least 1.5% is likely to follow.

You may be wondering... 

We have grounded reasons for saying this, based on our own empirical observations over the past three years. As we are currently in a fully risk averse position with zero stock holdings for the long term, we welcome these periods of volatility as an opportunity to deploy cash and derive substantial short term trading profits.

Just a historical sample of recent mean reversions. Feel free to do your own research on this.

But before we go into the actual trades, we will elaborate a bit on why these steep declines were good trading opportunities. This is where it's good to understand history and have a sense of context.


This concept is fairly self-explanatory. With enough observations and market experience, we are more confident in our ability to identify specific situations where a stock, or warrant, loses its value purely due to fear and desperation, then trade into them. We have already documented many instances where this occurs due to negative company-specific news. The same applies to negative broader markets news, and we dare say it's easier to identify.

In the context of the KLCI, what happened last week was a classic case of peak fear. It exhibited the following characteristics; in hindsight these seem obvious, but not in real time (Editor's Note : we are not immune to thoughts of market collapse or an apocalypse).

1) A very steep decline in the Index (90 points in two days).

2) A very fast decline in the index (90 points in two days!!).

3) A sudden loss of liquidity, as shown by the 'gap down' in the KLCI when it opened steeply lower.

4) Indiscriminate dumping of stocks across the board (blue chips, GLCs, etc).

5) Negative reaction to domestic issues, then external ones (explained earlier).

6) An immediate breach of the supposed 'support point' for the index (1,700 points; anywhere below is a buy call for us).

7) Investors' panic conveyed broadly in financial media (oh yes, this is an indicator of peak fear for us).

Armed with this knowledge, and our rigid, tightly defined game plan, we decided to commit to a couple of trades on 11 October; nothing too big relative to our usual activity. It could've been done on a bigger scale, but we are also risk averse.

We laid it out here, on 11 October. Follow us on Twitter.

We always have a call warrant or put warrant in mind to trade in case a situation like a steep market decline develops; more on choosing the right call/put warrants here. In this case we settled on FBMKLCI-C3Y, a largely previously ignored call warrant with great liquidity characteristics. It was also trading in the 15-20 sen range that we are typically comfortable with (it traded at this price range after the KLCI fell by 5%).

Due to the sudden shock in market volatility, the call warrant fell to its lowest since issuance. We happened to buy in at around 15 sen, or right at the bottom. During this period, the FBM KLCI fell near its intraday low of 1,684 points; it quickly rebounded thereafter.

 FBMKLCI-C3Y; October daily chart. 

5-minute movements in the KLCI on 11 October. Note the huge 'gap down' opening and subsequent rebound.

24 hours later, as the KLCI rose beyond the 1,710 points mark, we exited the call warrant position at 17.5 sen for a 12% gain. As is usually the case, we played it very safe. The warrant actually ended the day on 12 October at 19.5 sen, or a gain of 30% from our entry level.  (Editor's Note: we will always stick to our game plan. When we exited the position there was little indication that the market would head higher as it did)

And remember what we said earlier about markets rebounding by at least 1.5% after a 5% decline? The KLCI ended the day up by 1.3%.

Amid all this, we actually took this angle of peak fear (and mean reversion) to another level. We understood that the market selloff was a global phenomenon; Malaysia/HK takes the cue from the US, and the cycle goes on. So we also decided to take a position in Hang Seng Index (HSI) call warrants, the ultimate barometer of the global stock market's whims.

We have a somewhat unhealthy obsession with the HSI, having tracked the index closely over the past two years. We had maintained a very bearish view on the index and anticipated a decline below 30,000 points. It ultimately did this, but we were spectacularly unsuccessful in achieving profits despite being right. (Editor's Note : this trading lesson was very expensive)

Due to the HSI's world-class volatility (which is reflected in the day-to-day movement of its call and put warrants traded on Bursa Malaysia), we no longer trade them based on momentum. Instead, we switched to the 'peak fear' approach. The principle is the same as the KLCI; in periods of sudden volatility, the 'easy' money is made by taking a contrarian approach.

To do this, you absolutely have to buy into the selldown. After a steep decline and the eventual recovery, there is a good chance that our entry point is good enough to achieve substantial profits from; again, this is defined as a 10% return on investment or more. 

So we bought into a HSI call warrant - HSI-C3T - on the same day as FBMKLCI-C3Y. Our angle is that the HSI will exhibit a recovery on an equal, if not a better, level with that of the KLCI. (Editor's Note : As a general rule, the KLCI is much less volatile than global indices due to a myriad of factors. All else being equal, relative to the KLCI, the HSI would fall further yet rebound more intensely)

The eventual outcome:

There is no conceivable universe where earning RM1,000 a day can be considered bad.

So, to tally up the market recoveries around the world on 12 October:

1) FBM KLCI - up 1.3%
2) HSI - up 2.2%
3) S&P 500 - up 1.42%  


We are not chest thumpers and we will never claim that we are true contrarians (everyone will say they are), but we are aware that we will make contrarian moves from time to time. Going against the entire market (and the entire world, even) is not for the fainthearted, but sometimes you will see certain signals indicating that indeed, the time to make a contrarian move is now.

One of our favorite signals to trade is based on notable excessive coverage by financial media on market panics. We do believe that sometimes the media perpetuates market fears, influencing investors' decisions to dump their stocks. It creates a self-perpetuating cycle; more breathless media coverage on 'markets in turmoil' creates an environment of fear, driving even more shareholders to sell their holdings at all costs. The outcome of this? Peak fear.

If you follow the markets (and the accompanying media coverage) fairly closely, you will be able to sense it. There is a degree of exaggeration in the reporting ('S&P 500 Falls the Most In x /Weeks/Months', 'Stock Market Meltdown as Dow Loses 3%', etc), and you will see special TV segments covering the bloodbath. In fact, CNBC pretty much did this last week, with zero subtlety (Editor's Note : you will also see the same type of coverage, to a lesser extent, by international or Malaysian media).

 Panic on Wall Street. Source.

We have to make a brief but important distinction here; even though global markets fell 5% last week, we do not view this as a genuine panic, or market crisis. Financial pundits and investors have short memories; The February market shock was arguably worse, and so was the post-general election dip in Malaysia. What goes up must come down, and we can only provide guesses as to why the markets fell as much as it did last week.

But panic can occur without substance, of course. It's a consequence of peak fear, and it creates a window of opportunity for trading. We profited by understanding mean reversion and market psychology, not by having grand thoughts about the state of the market (we have those, too, but they are currently not very useful for making money). So the next time you see a special report on how markets are falling steeply, consider the other side of the equation; when everybody's selling, have some courage and buy into the panic.

Except when there's a real financial crisis, of course. But we're not there yet... just maybe.