The Tycoon Report

Start Cutting Risk RIGHT NOW!

Wednesday, July 29, 2009 | Teeka Tiwari

During the last several weeks, I’ve been tackling various investor-education subjects as part of a multi-part series designed to make you a better investor. I wish I could push a magic button and automatically make you a trading rock star.

Unfortunately I can’t, but what I can do is share with you what I’ve learned on my 20-year stock-trading journey. These articles are the distilled knowledge of hard-won experience that can save you a lot of time (and even more capital).

I highly recommend printing this series out and re-reading our discussions on focusing your emotional and financial capital, the best way to determine position size and deciding how much money to allocate to a position.

I’m not going to insult your intelligence and tell you that you are going to "get" all of this stuff overnight; you won’t. But what I can tell you is that, if you are serious about becoming a real student of this game, you absolutely will learn how to be a better trader and investor through reading this series.

Now that we've talked about narrowing your focus to specific strategies and dollar amounts, along with how much we can buy and where to set our stop-losses, we're ready to tackle the very-important next step of reducing our risk in the markets.

My "secret" isn't so secret at all. But if you haven't tried it yet, you'll no doubt be telling the world about it the way I'm about to do now!

Kick Your Single-Company Stocks to the Curb

This week, I want to cover one of the greatest risk-mitigation tools of our era. I am referring to Exchange-Traded Funds; also known as ETFs for short.

ETFs, as I am sure many of you know, are securities that represent entire sectors usually by mimicking a particular index.

They are somewhat similar to a sector-focused mutual fund. But they offer some tremendous advantages over mutual funds. ETFs trade just like stocks -- you can buy them, you can short them, you can buy options on them and you can sell options on them. Plus, they are typically very liquid and often have much-lower fees than mutual funds.

When faced between the choice of owning an individual stock or an individual ETF, I will pick the ETF almost every time.

Why?

It all comes down to lowering my risk.

Spreading the Pain ... and the Wealth

With an individual stock, company risk always exists. This can take many forms such as a bad earnings report, a management shake-up, management scandal, fraud, natural disasters etc.

As investors, the above issues are way out of our control. We can do everything right from an analytical, position sizing and leveraging standpoint, and still be blindsided by any one of these issues.

This is where ETFs have it all over stocks; you see, an ETF is made of a collection of sector stocks; no one stock can derail an entire ETF. 

There are some serious advantages to this. One of the biggest risks professional and non-professional investors face is the risk of a downward-gapping stock that you are long.

When a really bad piece of news strikes a stock overnight, that stock can open FAR lower than the previous day's close. This is known as "gapping down." So even if you were smart and used a firm stop-loss point, your stock could still "gap" through your stop-loss point to a far-lower figure than you game-planned for. This is especially devastating when employing a highly leveraged strategy.

One way to mitigate (notice I didn’t say "eliminate") this risk is to use ETFs instead of individual stocks. While ETFs can gap lower in particularly nasty markets, you typically won’t see an entire sector ETF gap down 30%-40%.

In fact, a 3%-6% gap move lower on an ETF would be a major move.

Again we aren’t eliminating “gap” risk but, by employing ETFs in lieu of individual stocks, we go a long way toward mitigating "gap" risk.

Move the Odds Even Further into Your Favor

The diversification that ETFs offer is another reason why if I’m going to buy options, I’d rather buy options on an ETF than a stock. I’d rather employ leverage on a diversified financial asset than a concentrated one.

How much upside do you give up buying ETFs instead of stocks?

It really depends on the sector that you are investing in. Volatile sectors such as China can see 100% moves in their ETFs!!!! That’s why, when I trade ETFs, I tend to focus on those that are in very volatile sectors.

Now, we've come this far together -- don’t let the word "volatile" scare you.

ETFs allow you to play in markets that were once absolute snake pits for the average individual investor. China, India, Latin America, etc. used to be the markets for the mega-rich and well-connected.

Not anymore.

ETFs allow us to surf the volatility of these emerging markets just like the multibillon-dollar hedge funds but with only a fraction of the risk of individual stock ownership.





Teeka Tiwari
Chief Investment Officer
ETF Master Trader