For today’s investing advice, JC Parets of All-Star Charts provides a great discussion of How to Manage Risk.
Everyone always wants to talk about how high the stock they just bought is going, or how much money they’re going to make on a new position. “JC, I think Apple goes to a Trillion Dollar Market Cap!” or “JC Bitcoin is going to $100,000!”. These are things I hear frequently, or at least some sort of variation of these comments.
This is perfectly normal behavior. We should not be afraid of it. But more importantly, I think we need to be aware of the implications of these feelings. The thing is, once we are already in a position, our emotions get involved. When our stress levels rise, we act emotionally, rather than logically. This is how we’re hard-wired. It would be abnormal for us not to think this way. But again, the important thing is to be conscious of it and not let it dictate our actions.
So how do we do this? How do we behave in the exact opposite way than how nature intended? Well, once they reach the age, little boys start getting certain feeling about little girls. This is perfectly normal. But these kids are then taught to control these emotions and behave appropriately. Why should it be any different in the market?
As much reading, studying and executing that I’ve done throughout my life, the one flaw I consistently find in every investor is themselves. I am my own worst enemy. I can’t get out of my own head, and not just on the golf course, but in the market. And there is nothing wrong with that. We are hard-wired to do the exact opposite thing that we should be doing at the exact wrong time when our stress levels are high and therefore acting emotionally. That’s just evolution and cognitive behavior. The important thing is to be aware of it.
So what do we do? How can we fight nature?
For me, the only way to avoid letting our elevated stress levels negatively impact our decision making is to have a plan. The plan should consist of two outcomes: What happens if we’re right? And more importantly, what happens if we’re wrong?
I want to identify the price where I think a stock is going and I want to point out exactly the price where my thesis will be proven wrong. Marty Schwartz, one of my favorites, put it so nicely, “Know your uncle point”. Bruce Kovner also said it well, “I know where I’m getting out before I get in”. I don’t know why some investors are so arrogant to think that their opinions will always be correct. Just imagine if it’s not? What then? Remember, we’re not in the business of being right, we’re in the business of making money. There’s a difference.
Premium Members have access to our Trade Ideas Page. Here is where I outline whether I am bullish or bearish on a particular security and what the risk level is moving forward. Many of you have heard me say things like, “We want to be long XYZ if we’re above 50”. But what exactly does that mean?
Well, to me that means that if XYZ is not above 50, we do not want to be long. Why not? Well, it means we have an elevated level of risk, if we’re below 50, that I do not want to incur. In other words, if prices are below 50, then we have 2 new risks: downside price risk (losing money) and the idea that we could have done something better with that money (opportunity cost). Both of these are not scenarios that I want to be a part of. However, if we are above 50, then yes, a long position makes sense.
How do we know that a long position is appropriate? The way to do that is by first determining who you are as an investor. What are your goals? What is your time horizon? What is your risk tolerance? These answers are different for everybody. I don’t like to risk more than 1-2% of the portfolio on any given position. So first I decide how far my entry would be from where I would admit to being wrong.
If I enter a position at $51/share and I think it’s going to $60, then if my risk level is $50 and we do not want to be long if we’re below that, I have a reward to risk ratio of 10:1. Does that fit your goals, time horizon and risk tolerance? It does for me! But you need to decide that for yourself. We’re all different.
The ability to implement this strategy consistently over time means finding a balance between money at risk and the distance from your “uncle point.” If you want to have bigger size on and therefore put your stops closer to your entry price, the chances of getting stopped out and whipsawed increase. On the other hand, if you want to give it more room, you then need to have a smaller position size to account for that added risk. No one can tell you where that balance is. You need to decide for yourself. Also See: Position Sizing
But what happens if I get stopped out, and then the stock gets back above the risk level? I think you have to be willing to get back in. The tighter the stop, the higher the chance of that stop loss order getting triggered. So if the deal you’re signing with the devil is a tight stop, then I believe you need to swallow your pride, accept the commissions and slippage and get back in if the risk vs reward still fits within your overall goals.
But what happens if I get stopped out for a second time, and then the stock rises above the risk level once again? At this point, I would reevaluate your risk level to make sure that you have the right price. More importantly, if the risk vs reward still fits your parameters, why not get back in for a third time?
I’ve had this conversation in past with some of the best traders I know. Three attempts is the common denominator here. The successful traders I talk to tend to believe that after 3 shots at it and 3 failures, then just move on to another trade. I would agree with that. There are always plenty of other opportunities out there.
Don’t be afraid of the whipsaw. It’s not a bad thing. To the contrary, I think getting whipsawed and getting back in can be a very profitable strategy. Some of my best trades have come that way and some of the best traders I know have shared similar stories. The psychology behind it is very simple. Think about it – you’re not the only one who saw this trade developing. If you’re piling in on a breakout, for example, with everyone else, then if the stock falls back below an important “support”, then all of those participants piling in are having the same experience as you are, which is not a pleasant one. This, many times, can be the final shakeout before the big move.
Sometimes market participants see an “obvious” bottoming pattern in a stock. The trade becomes a situation where investors get long with stop losses below the recent lows. The risk vs reward is very favorable. But what happens when the stock falls below that level, executing all of those stop losses and even triggering new short positions from the bears? Well, this one more low, shakes out the weak hands but then gets back above support creating a momentum affect that drives prices substantially higher, without most of the participants that got taken out. The idea is to not be one of those that got taken out and then did not re-enter.
Two great examples of these whipsaws near epic lows were Gold Miners $GDX in January of 2016, and before that, U.S. Treasury Bonds $TLT in late December 2013. Those are two that I will personally never forget, but there are many more.
I approach the market from the perspective of a market participant and someone who needs to execute. This is very different than a journalist, economist or analyst who have no interest in participating. We’re here to make money and we’re here to not lose money. Those are the two things that matter most, and not necessarily in that order.
