Stockscores 4 Pillars - Risk Management
Stockscores.com Perspectives for the week ending December 30, 2007
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In this week's issue:
This week brings part two of my four part series on the Stockscores Approach to trading the stock market. Last week, I discussed the concepts behind when to enter the trade. This week, I look at risk management, an area that is often forgotten to the detriment of the trader. We should all remember that a failure to maintain our investment capital will take us out of the market whether we like it or not. Capital preservation is of paramount importance if you want to be a successful investor.
The traditional method of risk management is asset diversification. The diversified investor buys stocks in a variety of industries with the hope that the strong groups will outweigh the weak and the overall portfolio will do well. Unfortunately, many investors confuse holding a large number of stocks with diversification. Having a portfolio of 12 stocks including 10 from the Mining sector is not diversification since the mining stocks will likely move in the same direction as a group. A truly diversified investor will hold investments in groups that are not highly correlated to one another.
I think all investors should take the spirit of diversification to the risk management component of investment strategy. However, I do not think it should be the sole means of capital preservation.
When I do presentations to investors, I will often ask a somewhat loaded question. "How many of you plan to lose when you buy stocks?" Whether out of shyness or purpose, very few hands are raised. In fact, the question usually brings some snickers, insinuating that my question is entirely preposterous.
It is not, however. Your long term success in the market will depend on your ability to control losses, to not let large losses overwhelm the overall performance of your portfolio. Imagine you have a diversified portfolio where you put $10,000 in 10 different stocks. 9 out of 10 stocks go up and you make an average of $1000 on each in the year. The tenth stock is a company that goes bankrupt and 100% of your $10,000 investment is lost. At the end of the year, with a 90% stock picking accuracy, your overall portfolio is down 1%. What if you could have limited the loss on that one big loser?
So, we must know where the exit door is when we buy any stock. We need to balance the need to have some flexibility with the stocks we purchase, allowing them to move down a little bit in the pursuit of the long term profit, with the need to stop the small loss from becoming a big one.
Many preach an approach that restricts losses by percentage. "Sell any stock when it goes down 10%." This approach is inherently flawed because it treats stocks with different historic price volatilities in the same way. Applying a percentage rule to a penny stock that can routinely move 10% in a day will lead you to exit a stock that may still develop in to a good trade. In the opposite way, applying a 10% rule to a very large capitalized, conservative stock may have you in a loser for months before you actually get to the stop loss point. We must use a better method.
The market itself provides a solution because it is the ultimate arbiter of value. Each day, buyers and sellers argue about what a company is worth based on the information it has. In doing so, stocks go in to trading ranges with upper and lower limits of what investors collectively believe the fundamentals are worth.
The bottom limit, a floor price in the market, is called support. It is the low point where the sellers gave up their desire to push prices lower and the buyers stepped in to push price up. Since the support price is the lower limit of what investors feel the fundamentals are worth, a move below that floor price implies that the market has found some new information that justifies a lower price.
The simple rule? Plan to sell the stocks you own when they go below support.
The Stockscores Approach teaches a concept called inflection points; a price level where the buyers took control of the stock from the sellers. Any time you enter a stock, plan to sell if the stock closes below the last inflection point low.
The difference between your entry price and the support price is the risk per share for the trade. If you divide that amount in to your risk tolerance you come up with the amount of shares to purchase. If you decide you are willing to lose $500 on any one trade and the stock you are considering has a risk of $1 per share, the position size will be 500 shares. This approach essentially gives every stock the same amount of risk; you just buy less of stocks that have more historic price volatility.
There is always the potential that the stock you buy will suffer a price gap through your support price so you are not able to get out at your loss limit. This is why it is still a good idea to diversify your portfolio.
You can apply this method of risk management when short selling too, you just turn everything upside down so that you plan to exit the trade at a loss if the stock closes above the last inflection point high.
None of the concepts discussed here are rocket science and yet I have found that very few investors utilize them. They may know they should limit losses but actually pulling the trigger and kicking a loser to the curb is a hard thing to do. I like to tell people that the stock market is not what is risky, it is the investor that brings the risk to the market. To manage risk effectively also requires emotional control and discipline, but I will save that discussion for two weeks from now when I review the fourth pillar of the Stockscores Approach, Emotional Control. Next week, When To Exit will be the topic of the third pillar.
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Let's now apply the risk management rules to the stock we have been following through this series, AUXL.Back To Top
1. AUXL
The stock gave us a great entry signal on July 31 and I featured it in my daily newsletter that day. When considering the risk management for the stock, we have to first consider where the stock has support. I set support at the low of the inflection point before the breakout, which was at $15.27. With the entry at $17.47, that mean there was a risk on this trade of $2.20 per share.
The trader must then consider their tolerance for risk. If you had a $500 loss limit, then you would purchase 200 shares, allowing for some slippage and commissions to come to the $500 loss limit.
Now that the stock is at $30 a share, the profit per share if sold per day is $12.53, which represents a risk reward ratio of better than 1 to 5. Since we consider any trade with a risk reward ratio of better than 1 to 2 a success, this trade has been a great success!
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References
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See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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