Someone had said that he is jumping on stocks, moving with 100 mph with an inch stop for protection. There is a lot of wisdom behind these words. They reveal two essential elements of many systems for consistent profits: momentum and risk management.
Being right and being profitable in trading are two very different definitions. You could be right in 90% of your trades, making a $1 per share. Then you could be wrong on the 10th trade and lose $10 per share there. The final result is -$1 per share from all the ten trades. Percentage of winners is not what traders should be paying attention to.
You might decide to use a tight stop of 10 cents to exit quickly trades that don’t go in the desired direction. As long as you make 50 cents per share on your winning trades, you could afford the luxury to be wrong 4 out of 5 times and still be in a profitable position. The point is to jump on stocks that are moving and have the potential to provide much bigger reward than your initial risk.
Blindly using a tight stop might be useful in the begining stage of the learning curve of a developing trader, as it will teach you to lose. Sometimes you have to lose the battle in order to win the war. Losing will always be painful. The point is to use that pain as a catalyst to work harder and smarter next time. The point is, when you lose to lose small, so you could recover faster.
Using 10 cents as a stop is only an example to illustrate a point. Stop losses should be defined by the individual volatility of each stock and its supply and demand dynamics. 10 cents represents 5% of a $2 stock and it might be a proper stop, but 10 cents is only 0.1% of $100 stock, which is a normal move and might not be a stop that makes sense. Certainly this will depends on your trading horizon and trading skills. Use tight stops, but make sure there is a reason behind that stop. Don’t just randomly chose a number. Let the stop be the signal that will tell you that you are wrong and you should exit in order to chase other trading opportunities with better odds of success.
10% of your trades will account for 90% of your profits
1 or 2 months will account for most of your annual profits
1 or 2 days will account for most of your monthly profits
Good investors and traders know that very well. They are ready to press extra hard when realize that they might have a home run in play. They are ready to disappear in 60 seconds when things don’t go as planned.
Gio from IBC knows that rule very well and he pressed on his GMCR investment to achieve 190% return.
Dennis Gartman knows that The Golden Rule is what distinguishes smart from not so smart money:
We’ve learned one good lesson from that one trade, and that is that we only get one or two or perhaps three good ideas each year that work. So, when they work, it is our duty to beat them into submission; to add to them when we can; to embrace them as they insulate themselves from random market noise, and to use them to make up for the myriad numbers of truly idiotic ideas we are capable of coming up with, keeping those losses small.
Sometimes one good opportunity could turn your life upside down.
Tonight I was watching STL Cardinals losing shamelessly against Cincinnati and an interesting thought occurred to me. People go to see a game for entertainment purposes. There are three major ways to offer good quality entertainment to the fans (other than being in nice company and overconsuming beer):
1) they see a good quality, exiting game
2) their team wins no matter how
3) they see a good quality game and their team wins.
Therefore we might conclude that people are getting more satisfaction and better quality entertainment when their team wins. Higher quality justifies higher price of tickets. Here it is my proposal for every team, who wants to boosts its overall income and fans’ satisfaction.
1) Raise your tickets with 10 to 20% from the current prices.
2) If your team losses during a home game, give all ticket holders the right of 50% discount for the tickets of the next 2 home games. The promotion will work as “first comes, first served” until all seats are sold off. From one side people will get retributed for seeing their team losing and from the other, the owners will sell more seats for the next games. (seats that otherwise would stay empty)
3) If your team is winning at the beginning of the 8th inning, offer ½ price off on all drinks for the last two innings. By the end of the game, most people have consumed what they usually consume and if you see statistics, only small percentage of the overall sales take part in the 8th and 9th innings. Therefore a 50% discount mixed with the euphoria of the coming win would certainly boosts sales. We all know that margins on everything at the stadiums are gigantic, so even after 50% discount, profits will be sizable.
139 stocks went up 50% or more during the month of May. To create this list, I used a liquidity filter of average number of shares traded per day >100k and a quality ratio of minimum price of $2.00.
Distribution by sector
The move in the Basic material sector has been impressive during the last 4 weeks. The 10 year treasury yield has been steadily climbing since end of March. Higher yield is usually caused by selloff in the bond market and it is often an indicator of expectations for higher inflation 6 months ahead. As a result of that, all commodities groups were dramatically boosted and I expect this trend to continue during the summer.
The changes in the accounting methods and the steep yield curve were more than welcome by the financial sector, which again performed well despite multiple secondary offerings. The difference between the short-term Fed’s rate and the 10 year T-note rate is practically risk free money for the banks. In longer-term perspective, the higher yield means higher mortgage and consumer credits rates and I believe that will be devastating for the banks from 2010 forward. In the meantime, they might continue to offer “earnings surprises”. Let the banks worry about that and concentrate on the opportunities that the market provides now.
Earlier this week, the Consumer Confidence Index jumped unexpectedly – a first sizable jump since 2003. I believe this is a consequence of higher savings. People feel more confident as they have gradually built a cushion by saving more, paying off their debt, trying to live within their means. An increasing savings rate, higher yield, higher commodity prices, rising unemployment will rob the consumer purchasing power and I have no doubt that this will affect negatively the retail sales and the real GDP growth. When is going to happen. I don’t know. Probably the consequences will be felt in the fall or early 2010. Let the retail and the government worries about that and concentrate on the opportunities that the market provides now. And currently, they are in the commodities.
People, suffering from cold, were asked to buy medicine with different price range. When surveyed, those who tried the more expensive medicine, reported that they recovered faster. The reason wasn’t in the price. It was their expectations. When you pay more, you expect that you’re getting the best possible decision to a problem. Your expectations become a self-fulfilling prophecy. This is why placebos work so often and this is why the effectiveness of new medicines is always compared to the effectiveness of placebos.
Another experiment was performed. People, suffering from headache, were asked to try 2 pills. One was sold at the market for 1 cents, the other for 99 cents a pill. The surveyed didn’t know which pill is which and in the end of the day the results from the two pills were very close. A week later, the same experiment was conducted. This time all participants were told that one of the pills is state of the art, miracle of the medicine and very expensive. The other was an ordinary aspirin sold for a 1 cent per pill. The difference in the results was stunning. The people who used the expensive pills got better, faster.
Relying on price is the most often taken shortcut in our world. It is natural for a human being not to be proficient in everything. After all, the available information doubles every month. There is no physical possibility to keep up with everything and be an expert in everything. This is why, we often choose to rely on price. Expensive is often regarded as high quality; cheap is often thought to be inferior. That doesn’t mean that we are always right. On the contrary. Such simple minded approach guarantees that we will be wrong in many cases. But in a world that gets more complicated by the second, relying on price as a measure of quality is a safe bet. Safer than anything else.
The same approach could be applied to equity selection. It is true that high priced stocks don’t double as often as let say $1 prices stock, but they are also more liquid and less volatile. In my position sizing approach, I always take into account the individual stock’s volatility and its price. Higher priced stocks provide the opportunity to use tighter stop in percentage terms, which means much better trading opportunities in term of risk to reward.
I will be glad to hear what is your take on the subject.