Other people's money

opm

I judge for the current market sentiment by the way investors react to companies’ earnings’ reports. When risk-aversion is the popular theme of the day, speculators subconsciously look for a reason to sell. The slightest weakness in an earnings’ call will be exaggerated and extrapolated and the stock will be sold. It doesn’t matter if a company beats the analysts’ estimates or if it guides higher for next quarter. It matters how market participants react to the news. When “good” earnings reports are getting sold, market is in defensive mood and you should act accordingly.

The story is different when investors are confident about their own and the economy’ future. During such times, people are looking for a reason to buy. They tend to ignore any weakness and a single ray of hope in an earnings’ report is enough to get them excited and start buying like crazy. You know the spirit of Wall Street is high, when slightly lesser than expected losses are generously rewarded by double digit one day gains.

Earnings’ season is here and it will provide hundreds of good trading opportunities. I will illustrate a variation of what I am looking for through one of the good trades I had lately in American Greetings (AM).

am

1) Reaction to news is more important than news itself. I am looking for 10%+ gains on at least 5 times the average daily trade volume.

2) Stock beats estimates by wide margin and guides higher for next year.

3) The breakout is from relatively tight (preferably flat) range – the longer, the better. It is a sign of a neglected stock. Stocks that run up in front of earnings’ reports, tend to be sold on the news.

4) The stock finishes the day in the upper 1/4 of its  daily range. With other words, it forms a nice, long, green candle without too long shades.

5) The low of the first 30 min candle might be used as an initial spot to place your stop. The real winners rarely revisit that point. The best trades are profitable from the moment you enter. Along its way up, the stock will form several bullish flags and wedges and offer opportunities to raise your stops or enter if you missed the initial move.

American Greetings reported a profit after 2 consecutive quarters of losses. The reason behind the sudden green bottom line wasn’t higher sales or margins (typically what I am looking for), but lower expenses. The important part was the market reaction. AM went up 41% on the day it reported it EPS number.

On a side note, the company was paying 48 cents dividend, which before the earnings’ jump accounted for more than 7% annual yield. Dividend is usually the last thing I care about, but in this case it was notably good.

AM earned 25 cents  per share compared to a profit of 27 cents for the same quarter, last year. Normally I look for triple digit Q/Q growth, higher margin and at least double digit sales growth, but in this case we had a discontinuation of a losing streak and a promise of higher margins in the future. To be honest, you don’t even have to put so much effort analyzing those details. The important thing was that investors were buying AM’s shares like they’ll run out of fashion.

There was only one analyst, following the company and he expected revenue of 20 cents per share. Is it possible that a tiny 25% earnings’ surprise (25c vs view of 20c)  can cause an almost 100% move in a matter of a week? In general, anything is possible, but this was only one side of the story. AM has relatively small float – 36.7 mill. I prefer stocks with float below 25 mill or even below 10 mill shares as they tend to move faster. The evening before AM’s report was announced, it had over 20% of its float sold short and a short interest ratio of over 15. The last figure played an essential role in the AM’s gigantic move.

Cutting losses

hattori

There is one big difference between traders, who make money and traders who don’t. It is called risk management. Even if you blindly pick your stocks, in the long-term you will make money as long as you cut your losses short. Add to risk management a proper equity selection model and then you are in top 5% in the world. The 5% that actually make money, consistently. This is the biggest secret of successful traders – cutting losses short. It saves capital and it saves your piece of mind.

If you browse on the internet, you will find thousands of articles that preach that losses should be cut short. It is well known fact and yet you’ll be surprised how few people actually utilize it, even those who write about it. Words are free. You can say whatever you want. Many people don’t practice what they preach and this is why the biggest edge someone could have is called discipline.

There are two types of traders: the ones that cut losses short and the ones that lose everything and go out of business. If you can’t define your risk in advance and most importantly if you can’t accept it, you should not be trading at all. Reading about cutting losses short will never be enough. It is human to believe that you are different and that you know better and that it will never happen to you. You have to experience it to realize it. It is part of the learning curve. I knew about this rule long before I committed serious money to trading and yet I didn’t practice it until I had my portion of outsized losses. Today, the thought of how and where I’ll exit a trade, is the most important.

I know that there are many people who preach that they don’t use stop losses and yet they are successful. Well, if they are successful doing that, then they are not really traders. They are investors and they limit their risk by hedging, which is a whole new chapter.

Press_SouthBeachPoolNight_lg

I will spend the next week and half in South Beach, Miami. Hopefully the weather will be nice and the girls …

About tight stops

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.