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Date of Entry : 2015-06-28
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Pigs Get Fat

on Sun Dec 11, 2016 7:24 pm

The saying I’m using for today’s headline gets used in a lot of different settings, so the odds are pretty good that just about everybody has heard it at one time or another. When I started to learn about directional, short-term trading strategies like swing and trend trading, I had this idea drilled into my head to reinforce the mindset that acting quickly on exit signals, especially if I was profitable, was far better than waiting on the mere hope the stock might keep moving in my favor and give me a bigger profit. It was useful to me then because it helped me start to learn and develop the discipline to disconnect my emotions as much as possible from the investments I made.

More than any particular timing method, over the years I have learned through hard experience that how much of my capital I put into any one single stock position is a bigger factor in my success or failure than any skill I develop for technical or fundamental analysis or trade timing, which is why I put so much importance on the subject.

I think that the idea that “pigs get fat, but hogs get slaughtered” applies not only to the kind of mindset you have to be willing to adopt for any successful investing method, but also to your ability to recognize increased market risk. It’s one of the reasons I start to twitch if I hear “experts” talking about how great the stock market is and how much longer the latest bull market is going to last. History has shown that when everybody seems to think the stock market is a can’t-lose way to make money, things are more likely to turn back to the downside for a while. It’s the folks that fail to see the warning signs—or worse, saw them but chose to ignore them—that end up taking the biggest losses in these situations.

I was one of those hogs in the late 1990’s. The World Wide Web was the latest, greatest technological innovation, putting every kind of information imaginable at the world’s fingertips. We take it for granted now, but you might remember what a revolution that really was. The idea of conducting commerce over the Internet was just starting to take shape, and the darlings of the stock market quickly became the companies that were immersed in all things Web. I remember reading magazine and newspaper articles (blogs still weren’t really a thing yet) written by experts that I respected, claiming that this technological revolution was also changing the way the stock market behaved, and that the “old school” methods of analysis and investing would drop by the wayside. 

Some even went so far as to predict that the bull market, which by then had already gone more than a decade without a serious, extended bearish correction had no end in sight. As an enthusiastic mutual fund investor, I was happy to see my retirement funds loading up on these incredible tech companies and excited to see my fortune unfold. I even shifted my money away from more conservative-minded, broadly diversified funds into more aggressive ones that were taking the biggest positions they could into one tech company after another.

If you were invested in the stock market in 1999 and into 2000, you know perfectly well what happened. The market entered a strong bear market in late 2000 that took about two years to find bottom. Over that period the S&P 500 dropped almost 50% from its highest point in March 2000 to its lowest point in October 2002. Like most mutual fund investors, I watched my retirement accounts dwindle more than 50%, to the point that I felt like I was going to have to start back at square one. I was a hog in this situation because when the signs were starting to show up in early 2000 that the market might be poised for a big, negative downturn I was still all in, buying into the hype and the belief the market’s bull run would never end. That kept me from making adjustments that probably wouldn’t have kept me from losing money, but that could have limited those losses enough that being able to recover wouldn’t have seemed impossible.

You’re a hog, exposing yourself to more risk when the market is heavily overvalued but you keep doing things as if nothing is different. Turning a blind eye to conditions around you usually means you’ll do what I did all those years ago – you’ll stay too long and you’ll be severely on the wrong end of things when the market turns against you.

It might sound like I’m calling for a brand new bear market just around the corner, but in reality I’m not. I have been saying for quite some time, however that the market in general is overvalued. Even if you include the market correction we saw from September 2015 to February of this year, the fact is that we haven’t seen a broad market drop of 20% or more since March 2009, when the last bear market finally reached bottom. That’s more than seven years of almost uninterrupted bullish sentiment and momentum. The market is in a very mature bullish long-term trend that is bound to reverse at some point. The longer it lasts, the greater the risk is that we could see a major decline that I believe may exceed either of the last two bear markets we’ve seen.

Lately, the market has seemed to be picking up bullish momentum, which has been great for the stocks I’m currently holding. Investors seem to be keying on indications of increasing economic growth and optimism about what a new administration in the White House might mean for continued growth. In that light, talking about increasing market risk might sound sound a little silly. I’m not the type to beat the “gloom and doom” drum, but the contrarian side of me twitches when more and more of the talk and media buzz about the market seems to turn almost completely bullish. I’ve learned over the years to trust that twitch, which is why I think a conversation about managing risk under current conditions is appropriate.

It’s hard to say that when you see the market is about to turn, you should move your money to the sidelines and just plan to wait for the market to recover. And putting your money into “safe” investments like bonds, money markets and certificates of deposit isn’t really a practical option in today’s low-yield environment. We all need to keep our money working for us, which means that there needs to be a way to stay engaged in the market while at the same time being able to give ourselves some measure of protection. Buying protective puts against the positions you’re holding is one way to insure yourself against a sudden immediate drop. I want to take the rest of today’s post to talk about how using position sizing and making adjustments can help as well.

Staying In The Game When Risk Increases

Ultra-conservative, directional investors tend to move out of stocks and into cash when they think the market is due for a major downturn. I think that approach makes sense – but only under certain circumstances. If your focus is on high-growth stocks that you’re looking for double-digit returns from over any length of time, scaling back when you see these stocks start to form downward trends is usually a smart thing to do. I do something completely different, which is one of the main reasons you’ve seen me say in previous posts here that I’m not afraid to keep looking for good, income-generating trades—which also means holding onto stocks I am assigned from put sales—even when I think the broad market is highly overvalued.

Putting my focus on stocks that are already at the lower ends of their historical trading ranges and showing signs of stabilization helps to minimize some of the downside risk the stock might expose me to. Making sure the company is sitting on a solid fundamental base of strength, with a clear value proposition, are two additional factors that work in my trading system’s favor. Even so, “staying in the game” means that you have to be willing to accept the fact that sometimes the stocks you hold are going to move below—possibly by several dollars per share—the price you bought the stock at. And it is true that if you’re selling puts near the top of a bull market, that downside risk is higher, even on deeply undervalued, fundamentally solid stocks. I work with an active understanding that this risk is greater under current circumstances.

When I’ve written about position sizing in the past, I’ve recommended limiting your exposure from any one put sale to no more than 7 to 8% of your account’s buying power. That is a good general guideline to apply no matter whether you are working on a cash-secured basis or with a margin reserve, and it gives you the ability to own as many as 10 or 11 different stocks at the same time, which is a healthy level of diversification for a normal investor. Here’s where I think it makes sense to make an adjustment to your trading plan when you want to limit risk even more: try lowering your position size to no more than 3 to 4%.

Here’s an example to illustrate what I mean. Let’s suppose that you have $250,000 in capital in an IRA account, and you want to buy a $30 stock. Using the 7 – 8% bench mark means that you could use between $17,500 and $20,000 of your account’s buying power, which means you can buy between 580 and 660 shares of your $30 stock under normal circumstances. If you wanted be more conservative as I just described, you might decide to buy only 300 shares, using up $9,000 of your buying power, or only 3.6% of your total capital. That’s also well below the 7 – 8% threshold I normally work with and right in the 3 – 4% range. 

Taking on a smaller position size means sacrificing a portion of the total return you could generate on that trade, of course, but the tradeoff is that even if the stock does keep moving lower, your total exposure on that position is only half as large as it would have been under normal circumstances. It also helps you preserve cash, which improves your financial flexibility. That means that if the market does begin to drop lower, and the value proposition for stocks that are currently overvalued becomes more attractive, you’ll be in better position to work with the best ones you can find.

You might wonder, if you intend to follow my suggestion and start working with smaller position sizes, how long should you stick with it? That’s a pretty subjective answer; I’m planning to hold this course for as long as I feel the market remains at risk for a major reversal, and I will keep doing the same if and when that reversal actually comes. If the market proves me wrong and surges to new highs, I will also continue to be more conservative with my position sizes, since that means an already mature and extended bullish run is becoming even more so. I don’t expect I would change my approach back to a more aggressive approach until the market has corrected and begun to show new signs of stabilization.

Stock Accumulation When Risk Increases

From time to time I write about selling new put options against stocks I already own, as a way to average down my actual cost in the stock. Remember that if you decide to use a stock you’re already holding to sell more puts, you have to be willing to work with less diversification in your account than you might otherwise be doing. When the broad market’s reversal risk is increasing, I think it is also smart to think very critically about how much you really want to increase the size of these positions.

First, take the time to review all of the stock’s pertinent fundamental and value-based information. Book values, free cash flow, earnings and revenues, and debt are all items that can and do change from one quarter to the next. If you’re looking at a stock that has dropped below the strike price you were assigned at (or that you simply bought outright) and thinking about trying to accumulate more shares to average your cost lower, make sure that these items are still attractive, because you really only want to do this if you still believe the long-term potential gain is still well above your current buying price. If you see deteriorating fundamentals, or something that makes you change your opinion about the stock’s bargain status, don’t keep selling puts on it, or buy more shares. It may even be a situation where you would be better off selling the shares you have, taking the loss, and moving on.

Secondly, if you’ve decided you’d like to try to average down, you should be very careful about when you do it. If the stock is only a little below the price you bought it at, you won’t see a major difference in your average cost. Potentially worse is that you may only slightly lower your average cost to end up with a larger position that leaves a larger portion of your account exposed to a big drop that hasn’t happened yet. I think a reasonable guideline to minimize this risk when you want to be more conservative with your position sizes in general is to only average down on stocks that are at least 30% below the price you bought them at.

Let’s suppose you bought 500 shares of a $50 stock. Your total cost is $25,000. You’ve since watched the stock drop below $40 per share, but the stock’s fundamentals are still great and the value proposition is even better now, and so you’re starting to think it might be a good idea to pick up some more shares. Following the 30% guideline means that you would actually want to wait for the stock to get to $35 before you try to add to your position. If you want to sell a put, which is what my preference is, $35 provides a great reference to start looking at Bid prices for the stock’s put options. If the yields are good, selling an out-of-the-money put is probably a good idea at this point.

If you do end up buying more shares, and you’re maintaining proportionality with the shares you already own, you’ll average your cost down to about $42.50 per share. That’s a 15% difference in your average purchase price – a big difference that will make it much easier to work with the stock when it finally begins to recover. You may also consider selling half as many put options as the shares you already have if you want to try to keep the total position size—and therefore your account’s total exposure—more conservative.

If the market is at increased risk of a significant downward reversal, as I believe it is, it’s smart to think about what you can do to minimize your exposure to that risk. I want to be able to keep taking advantage of great bargain opportunities as I find them, however, and so the steps I’ve outlined here are some reasonable things I can do to be a functional income investor even as I want to be more conservative.

source: investiv
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