In the financial media, sometimes you'll read about strong hands and weak hands. Strong hands are the share owners, who believe in the underlying company and will hold the shares they own through thick and thin on the strength of their convictions. They'll vote their proxies and keep up-to-date on the goings-on: new executives, new products, analyst's recommendations, projected earnings, etc. Weak hands are share renters, who don't know much about the company and will dump their shares on seemingly the slightest negative movement in the price. Given that description, it would seem much better to be in the group of strong hands, right?
Think again. As a proud weak hand (and former strong hand), I can tell you that weak hands are wrongfully tarred, first by the pejorative adjective "weak," and then by the sense that they don't hold any convictions. On the contrary; weak hands have strong convictions about one important principle: risk management. I believe more in the rightness of preserving my own hard-earned capital than I believe in the management, technological edge, continued financial success or any other business metric related to the company underlying the stock. This belief translates as a commitment to stop prices. Get out sooner rather than later when price moves against you, and thereby stay alive.
Sometimes obeying stops will make you feel like a fool. A good example is Thursday's pick Mueller Water (MWA). The signal was elected near the open at 10.83, with the stop price of 9.75. After initially rising, MWA starting dropping precipitously, hitting a low of 9.74 before rebounding. It continued its ascent Friday, closing at 12.48. Using my recommended stop, instead of a gain of 1.65/share, we have a loss of 1.08/share, and on top of that the ignominiousness of getting out at the low of the day. And this kind of price action is not uncommon. If only you didn't use the stop, right?
Tabling for now the question of where to place the stop (e.g., you could choose a stop price 5 cents lower than mine, or 0.1% lower; or only sell if the stock trades below the stop price for 15 minutes, or only if it closes below, etc.), the answer is: stops are vital. Take the example of Foundation Coal (FCL), which I bought for 62.21 on 8/27/08 on an encouraging setup. Here's the chart from the day prior:
It looked like FCL could go up to visit at least the 50-day moving average. Also, as I've disclosed earlier, if there's any group I have a weakness for, it's the commodities. Not to the point that I'd be a strong hand, but I nevertheless have strong beliefs about the sector, especially gold. In the event, I purchased FCL with a stop at 58.75. It started falling not long after I purchased it, getting as low as 58.80 that Friday. It hadn't violated my stop, so I didn't sell. Over the weekend, Hurricane Gustav failed to make as big an impact as traders imagined, and oil sold off hard. The rest of the commodities sector followed suit. As an equity trader, I was shut out as participants in the coal futures market traded Labor Day Monday and came to consensus about the market price for coal—without me. Had the stock market been open Monday, I could have been part of that decision-making process, and gotten out closer to my stop. As it happened, Tuesday FCL opened on a gap down to 57.51, over a dollar below the price I had originally accepted as my maximum risk—and kept falling:
All the risk management in the world couldn't help you if prices were always this discontiguous. At this point, the stock has fallen too far, right? Over a dollar more risk than I had planned (and counting), on a gap down, falling farther every second; it's too late to sell, and it's bound to rebound soon, don't you think? Wrong. I didn't know what would happen. The stock is trading below my stop price, therefore I sell. I strive to be an inveterate weak hand, and so I got out. FCL could have rebounded right away like MWA did, and I might've sold at the low of the day, making me look like a fool. But which turned out to be the graver mistake: selling MWA too early or holding FCL too long? Check out subsequent action in FCL:
Losses suck, but they are part of the game. I don't know anyone who only picks winners, except maybe
Andy Askey, but he makes two picks per year. So why not make an effort to keep all your losses small? You don't know what will happen; for every pick that whipsaws you like MWA, there's a pick like any financial stock during 2007, when the bottom was nowhere in sight. My mom was furious when I stopped her out of Merrill Lynch somewhere in the 70s last summer. I think she bought it in the 70s—the 1970's, that is! (Just kidding, Mom!) Now she owes me dinner.
On a personal note, the start of September was really rough for me. I had practiced poor risk management by overdoing it in commodities. Many charts looked like FCL's, and I took several of them; purposefully ignoring the fact that they are correlated to one another. The amount I thought I was risking ended up being double that given the nasty gap down Tuesday, September 2nd. Yet by getting out early, I emerged with medium-sized rather than large losses. By putting that capital into more promising trades, I was able to make all those losses back less than three weeks later. Even with a few more losers, all it took were some good trades on the short side, which I closed this past Thursday (just in the nick of time). I hope some of you were able to participate with me on those trades, and I'm happy to say that I'm now up 1% for the month of September, after being down over 6% at one point. Time after time I am shown the value of sound risk management; it hasn't failed me yet.
For Monday, there are tons of gold charts that look good to me. This time, I'm going to take on a more reasonable number. After all, they could all gap down Tuesday. Learning from my mistakes; it's the only way I'll get better as a trader.
