Newsletter

February 24, 2007

Conquer Guilt

Market & Sector Review
Money Management & Risk

Largest Changes In Raw Numbers (21 Days)

This Week's Economic Reports

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Conquer Guilt

As traders you surely understand profits are hardly a sure thing. Even the "Market Wizards" make mistakes and pay the price. When you experience what you consider to be severe drawdowns, don't feel bad about it. You're not the first person to have this experience nor will you be the last. Understand that psychologically it is almost impossible to avoid feeling uneasy. Facing losses is one of the most difficult issues to deal with emotionally. If you are an active professional trader, your identity and livelihood are on the line. If you are a part-time trader, it's frustrating to feed your account from your day job, wondering if you'll ever make back the money you've lost. Depending on your personality and experience with the market, you may have trouble handling feelings of loss, guilt, and fear. Unless you get your emotions under control, you'll never be able to get back on track.

As normal human beings we feel guilty when we break a personal moral rule. Losing money can make almost anyone feel guilty. We want to live by the rules our parents and teachers taught us, and many of them taught us to work hard and save our money. A requirement of trading is that we risk our money in hopes of monetary gains, and risking money may seem to go against how you were brought up. Well, if you want to make huge profits in the end, you're going to have to risk money, and in all likelihood, you're going to lose at least some of it before you develop the skills you need to trade profitably across a variety of market conditions.

Are you going to lose money? Yes. Is it morally wrong? No. You must identify the beliefs underlying your guilt and change them. Ask yourself first; is your guilt warranted? Feelings of guilt are there to protect us; it isn't a good idea however, to rack up so many losses that you can't pay it back easily. If you trade money that you can't afford to lose, or that you will have difficulty paying back; guilt is a natural reaction. You must make sure that your losses are reasonable and are actually a short term setback. It will be hard to control guilt if it realistically reflects losses that will permanently harm your financial security.

If you determine that you can actually afford trading losses, and still feel guilty look at possible assumptions that may underlie your guilt. One possible reason; you may have been taught that money is sacred and that it is morally wrong to risk it and lose it for any reason. If you want to trade actively, you have to change the way you look at money. To a serious trader, money is merely a vehicle to make more money. It is just part of the tools you need to trade successfully. They think of "money" as "points" used to keep score of how well they are doing. A second possible reason you feel guilty; is the need to be perfect. You believe that you must not make trading errors. You may believe that if you do, you are inadequate. Losses are not personal; losses are a natural part of trading. It's possible that you are merely experiencing a temporary change in market conditions. You may need to change your approach, but it doesn't mean that you are inadequate. It just means that you need to explore more options. When you feel guilty, then you mull over about how bad things are. There's no time to mull while actively trading, however. It gets you nowhere. If you want to stay ahead of the crowd, you must actively problem solve. You must find new trading solutions, and guilt distracts you from freely searching for creative, fresh solutions.

Take a chance! All life is a chance. The man who goes the furthest is generally the one who is willing to do and dare. The 'sure thing' boat never gets far from shore. - Dale Carnegie
Market & Sector Review
Money Management & Risk

With the additions of our Sector Analysis and ETF Analysis sections that include Relative Strength Rankings on both a six month and a twelve month basis, I have received numerous emails concerning the relationship between rankings and risk. The most commonly asked question is: Could it not be the most highly ranked sectors and ETF's are indeed very near their tops and thus contain a good deal of risk? Although I never answer an email in one word, the simple answer to this question is; Yes! Sometimes it is extremely difficult to buy XYZ at $40 when you know it was $20 recently. It is contrary to the old Wall Street cliché: "Buy low and Sell high". In most traders reality the cliché should be; "buy high and sell higher". This week let's analyze what risk is and some ideas on how to handle risk; even feel good about it.

I will be talking today about portfolio risk, not the risk you should or should not take basis a particular stock. If market and stock indicators were always exact in identifying tops and bottoms, the necessity for prudent money management would not exist. Unfortunately indicators are anything but exact. Suppose for a moment that your indicators were correct - say - 99% of the time. The 1% failure rate could conceivably wipe out a trader or investor who did not apply some sort of money management technique. In my 40 years of market involvement I have personally been exposed to many indicators. I have never seen a market indicator approaching that kind of preciseness, or anything even close.

I would assume each of you analyzes both the risk of a trade as well as its potential return. If you successfully limit your trades to those in which your perceived risk / reward ratio is at least 1:3, and you properly limit the amount of capital you put at risk, you need only be correct once in every three trades to be profitable. Just like when you sit down at the Blackjack table, you always have to determine the probability to outcome ratio of any bet before placing your money on the table. Another good analogy would be a baseball player who hits .333, we call him a superstar, yet he makes an out (a loss) two out of three times at bat. The same holds true in trading the markets.

Personally, I approach risk from a portfolio standpoint, as opposed to a perceived risk on an individual stock, but more on that in a moment. In other words the risk is based upon your account size and is limited to a percent of the account size. While many traders I know will only risk one percent of their account size on a single trade, the number you choose will be personal to you, it may be one, two, three or ten percent. Usually the longer your time horizon the more one will tend to risk on a given trade as a percent of ones total portfolio.

Here is a table from our Money and Risk Management dissertation in the learning center. This table is from Victor Sperandeo's book "The Principles of Professional Speculation". In this table we are using a portfolio risk of three percent. Feel free to change the numbers to suit your needs.

This particular table shows another factor many traders should consider. When the account moves above 100 (our original account size) we remove one half of that gain from the account. It is no longer available for trading during this accounting period. Trade number 3 above shows a gain of 8.47 bringing our total capital to 102.56 (94.09 + 8.47), we remove from the account 1.28 or half of the 2.56 gain. Depending upon your goals and aspirations this money removed can be used for a variety of purposes. Perhaps a fixed income vehicle for your nearing retirement or an investment in your investment account. The money can be re-included in your trading account in your next accounting period should you desire, but for now put it aside.

Assume you make 30 trades this year. If you extrapolate this table you will have an annual return on your capital of 27.08%, while never risking more than 3 percent of your available capital in any one position. Now extrapolate this table in the other extreme, if you lose on all 30 trades (a highly unlikely event) you would still have 40% of your capital available to build with. I understand this is an oversimplified example. In the real world, you may lose 5 trades in a row, win the next 2, lose money on the next 4, and win 3 of the next 5. However, if you use this type of money management, and are right but 1/3 of the time, your results should be similar.

Take this 3% rule we have created for ourselves one step further. Risking 3% of your trading capital does not mean that you use all of your capital in one position with a stop loss order 3% below your entry price. Often, in this author's opinion, you must risk more than 3% of your entry price. Depending on market volatility, or the volatility of the issue you are trading; a 3% price move maybe just noise in the bigger picture.

Now let's apply what has been said, in as far as, buying those very strong sectors, ETF's, or individual stocks. This is an exercise and example of Money Management and NOT a comment on technical or any other analysis. In fact analysis for this example, technical or otherwise is being completely ignored. The sectors, industry groups, and stocks being chosen are chosen for no other reason than their present strength.

Understanding good money management will mean you can trade strong stocks without the fear that many experience when trading. For today's exercise we will look at the sector analysis area since most questions concern this area. First let's look at the sector analysis sheet as of last Friday's close.

I will select Metals & Mining for the sole reason that it is a favorite of mine (any sector you have success trading in, over many years becomes a favorite) but you can use any you desire. Now we'll click on the industry groups within this sector and see what the strongest one is.

As we learned in "What Works on Wall Street" (1/27 Newsletter, available in archives), James O'Shaughnessy's cornerstone approach looked at year over year relative strength, so let's select industry group MG132 - Copper since it's ranked the highest with this measurement. Next we will get the stocks within the Copper group and pick one for this exercise. Remember this is an exercise, these are not recommendations.

The two strongest stocks in this group are obviously Southern Copper Corp (PCU) and Phelps Dodge (PD). Selecting the first one and clicking on the chart link, the bottom frame opens a chart of PCU.

It's easy to see that so far this year corrections in PCU have been extremely shallow. You think, for whatever reason, this is an $80, or $90 stock; perhaps even a double from here or $136 stock and you're afraid of missing that move. At the same time you feel that PCU is overbought and ripe for a good correction. What do you do? You basically have two choices: wait for your correction to occur, your risk is PCU moves straight up and you miss it; or two buy your position here and risk more, or risk being stopped out prematurely. However there is a third choice, so let's go over it.

You have an account that is $100,000 in size (just using round numbers). Change any numbers used to suit your own portfolio size and criteria. One of your trading rules: maximum investment in any one sector or stock is 25% of that total or in this case $25,000 (probably should be a lot less, but that's your decision). Personally I use 10% to 15% as a general rule; this again is just an exercise. You can therefore buy approximately 367 shares at $68. Your maximum risk in our three percent example is = $100,000 x .03 or $3,000. With 367 shares and a $3,000 risk you can allow a correction of about eight points or $60 per share before your risk parameters are exceeded.

Stepping back, looking at the big picture, you can envision the possibility of PCU coming back to the November/December highs (old highs become new lows) at around 58 and then resuming the uptrend. That would take you out of the position with the maximum allowable loss, and then of course reverse, because that's what always happens to me. Sound familiar!

The harder you look the more you become convinced that PCU should not come back into its November/December consolidation area, at least not by very much. OK so we will risk to 55 instead of 60. If I'm stopped at $55 that would be 367 shares times a $13 loss or $4,770, well beyond our limit.

Instead try this; a $3000 maximum risk divided by $13 risk per share equals 230 shares that we can purchase, and still be within our maximum risk guidelines. We buy 230 shares instead of 367 shares. We have allowed plenty of room and predefined our risk at three percent. Should PCU just continue higher with no corrections, we participate, just too slightly less of an extent. You can always add to your position later as long as you keep within your risk parameters.

(Portfolio Dollar Risk (3% of available capital) / Dollar Risk per share) = Amount of Shares Purchased

Should you be correct in your doubling from here forecast your risk to reward ratio turns out to be 13:68 or 5.23:1 not bad. Personally if I cannot see a reward to risk of 1:3 I pass on the trade. That's just me!

I believe that once traders understand a very simple money management concept, such as this one, most if not all of your fears will disappear. Take some time and play with the numbers above till you reach a level of comfort for your trading, and you'll never fear a loss again. This should be an integral part of any good trading plan:

  • My Trading Account size is: $_____________
  • I should be diversified with ___________ positions in __________ different sectors.
  • My maximum commitment to any one issue should be ________ %
  • I am comfortable (not happy but comfortable) with a risk of ___________ % of my portfolio size on any one trade.

    Tack your answers to the wall or tape to your computer for constant review until you feel comfortable. I'm reminded of this great quote.

    "October: This is one of the particularly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August, and February." - Mark Twain, Pudd'nhead Wilson.
    Largest Changes In Raw Numbers (21 Days)

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    This Week's Economic Reports

    Have A Great Week!

    Bill

    Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.