Managing Your Risk
Friday, January 19, 2007 | Teeka Tiwari
We find ourselves at an important juncture in the market. Virtually all of the technical indicators I use are deep in the danger zone of over bought territory. Statistically speaking, when the indicators become this overbought it is typically a terrible time to go long stocks. The only caveat to that is my primary indicator: the New York Stock Exchange Bullish Percent is still on a buy signal, albeit at very elevated levels.
The NYSE BP being on a buy signal tells that we can still go long; the level of the NYSE BP however (currently at 70%) tells us that we must be judicious. (In Point and Figure charting, readings of 70% plus are indicative of over bought markets. The optimum reading to buy stocks is when the NYSE BP falls to 30% or lower).
So I wanted to share with you a few easy strategies that can help you manage your risk with your short term trading positions.
The first is the tried and true good old stop loss order. A stop loss order, once executed, will sell your stock once it reaches a certain price. However, your execution price is not guaranteed. For example, assume you own 1000 shares of XYZ Corp at $20 and you wish to risk no more than $2,000. You would simply instruct your broker that you want a stop loss order placed at $18.
If the stock hits $18, your stop loss order now becomes a market order and will be executed at the next market price ... which could actually be below $18, especially in a fast market. So it’s not a complete guarantee that you will only be risking $2,000, but it's better than nothing.
The second approach is to use options instead of buying stock. Hold on a second, I’m not suggesting that our mythical investor place his entire $20,000 into options. The way to control your risk is to use the amount of money you are willing to risk, in this case $2,000, and use that amount to purchase your options.
Where possible, you want to use my five and five rule. That is, go at least 5 months out and as close to 5 points in the money as you can. This approach is going to give you the highest chance to get a profitable trade, and by having a set dollar risk it gives you huge staying power in the trade.
If I’m conducting short term trades on stocks and buying the stock instead of an option, I typically place my stop loss two points below support, so a strong stock should never trade there. If it does, I don’t care what it does afterwards ... I’m out.
If you are buying fundamentally and technically strong stocks, placing your stop losses a point or two below support levels, and you find your stocks hitting your stop losses, don’t misinterpret that as bad stock picking.
Let me explain. A bull market ceases to be a bull market long before the bear market “officially” starts. Lots of trades tripping their stops can be an early indication of something amiss in the market. So simply sit on your cash and wait for better times to develop. Believe me, they will come. You want to make sure that you have the cash to put to work when the market is showing the best bargains. The stop loss/options approach goes a long way to ensuring that.
There is no need to fear the market if you have a good risk management game plan. No matter what happens, you’re prepared and ready to take advantage of whatever the market throws at you. You sleep easy at night because your good friend Mr. Stop Loss (or Mr. Option!) is "Johnny-on-the-Spot” protecting your interests vigilantly.
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Teeka Tiwari
Chief Investment Officer
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