Managing Risks

Last night I spoke with a trader who had lost a lot of money. I realized very quickly that he was trading directionally with no hedge. Greed and fear had taken control. This is the worst-case scenario that can happen in trading; you lose money, you try to recover the loss, and you lose more again. You can't pry yourself loose from the computer screen. Going further, the whole process becomes addictive, much like gambling. This is how many traders lose everything and finally have to give up.

There are people who aspire to be full-time traders. Certainly, it can be a rewarding alternative, especially if you have some capital to trade. You can virtually work anywhere that has internet access; you have control of your time and have a steady income (that is if you avoid the above mistakes). It is especially great for me as I live along the Pacific West Coast. So my routine involves waking up at 5.30am, and at 6.30am PST the market opens. I spend some time in the market for an hour or two, watching for reactions to economic data, earnings releases, and trades put in by amateur traders before they head off to their day-jobs. In the middle of the morning I head off for a game of tennis or work out at the local gym. I am back in the market at about 10.30am PST--when Wall Street traders have just returned from lunch; this is when most of the action starts. At 1pm PST, the market closes and I can call it a day!

To become a full-time trader, first make sure you have a clear system that allows you to be consistent and disciplined over time. Initially, you should stay with a full-time job and only trade part-time, on a modest budget. Until you have become consistent and confident that trading can replace your full-time job, you should not resign and become a full-time trader. Before you can trade reliably on a full-time basis, there is invariably a learning curve that involves time, discipline, and dedication. This process ranges from 6 months--if you're particularly quick on the uptake--to even 1-2 years for many people. Before embarking full-time, make sure that you have started off with paper-trading, and then has traded with consistently good results for at least 6 months with a disciplined limit of real money. You should achieve a rate of 80% positive trades before considering trading as your chief or sole source of income. I would consider these to be absolute and minimum requirements.

While it is possible to be consistently profitable in trading, it is not easy. You need a clear system with an edge that fits your personality. By mastering trading, I mean that you need to have core competence that gives you competitive advantage over the majority of traders. Think of the whole exercise like starting up a new business. Draft out a realistic business plan. You do not jump into a pool without learning how to swim, drive a car without passing driving tests or practice a profession without appropriate training and certification. Trading is not simple. Only about 5% of traders consistently succeed.

One primary key to trading is risk control. Control the risk and the profit will take care of itself. Always remember to keep the hedge.

In many ways, trading is a probability game. Contrary to what is taught in business schools, the market is irrational. Effort must be focused on balancing risks and rewards to pursue your target profit. In my case, I use options to manage the risk. At the same time, do not allow any position in the account to get too large. If you need to understand the mechanics of position sizing, some of the best ideas on this can be found in Van Tharp's book.

Respect the market. In my > 10 years of trading, I had been humbled by the market many times. While tomes have been written on how the market is supposed to behave under certain conditions, in practice the market is capricious and is not obliged to behave in any set pattern. Many have learned in costly ways that they cannot pigeon-hole it; it is also almost god-like in its power to consume a person, and put his livelihood and well-being at its arbitrary mercy. Do not ever think you can outsmart the market. Always think of it as dealing with a powerful, live creature with a will of its own, and be ready any moment to admit you had been wrong, to reassess the situation and to change tack accordingly.

Stop-loss is an necessary evil. You have to keep your losses small. One of the commonest mistakes is to allow your losses to spiral to a dangerous amount. The advantage of 'options' is that once you've learnt to use it properly, you will not need to use stop-losses anymore.

Discipline is the key. Know your primary and secondary exit. Plan your trades, and trade your plan.

One of the first things I learned in trading is that “the trend is your friend”. Always trade with the trend. This is counter-intuitive, however. It took me quite a number of years to change the entrenched habit of trying to catch-the-bottom and sell-at-the-top.

Limit the maximum loss in your portfolio. A guideline is that if the portfolio drops below 10%, you should stop trading and re-examine your modus operandus. Never allow any individual position to lose more than 2% of your portfolio. Return to paper-trading for a while until you experience the positive zone of success in your trades, before embarking on real money again.

Protect your profit. A 'collar' is the most effective system for doing this. Once the market is uncertain, add the SC. Do not hesitate to add 'puts' if the trend is clearly down. Normally, I add the SC first. If the stock continues to break up, I will roll the SC up or sometimes just close the SC. If the stock breaks down, add a put. Read the post on how I use puts.

If there is a holy grail for trading, this is it: manage the risks of a portfolio through proper risk-control and management.

If the fundamental is intact, I may average down on shares when there are signals of bottom. A typical signal is when a stock has reached multiple-month or -year support with a bullish formation on candlesticks or MACD. Examine the fundamentals again to make sure it is intact. Only average down if the stock drops more than 20%. If you tightly manage your trades, even if the stock drops 20%, you normally lose only 5%. The SCs and puts will help to reduce your loss. Catching the bottom is a tricky thing. It can be like catching a falling knife. While averaging down, keep the hedge until the breakout is clear.

Finally, do not day-trade. My basis for entering a trade is the fundamentals. I use technicals to time the entry and exits. Options are used to hedge and actually eliminate the rampant emotions generated by day-traders and computerized trading. In this era of automatic trading algorithms generated by super computers, it is difficult to scalp winners against these machines. But with options, you actually capitalize on all the fears and emotions left in the wake of high-frequency trading, and this buys you time to give your trade an edge.

Is the market topping?

The stock market is very bullish. Despite a usually bearish September, we will have a good month. I guess a lot of short sellers are being caught this month.

As I sit back and look at the market, I can hardly build up a bullish case.

There are plenty of reasons for me to be bearish.

· Car sales slumped in August to 11.5 m. It is the worst in 28 years
· In September, Univ of Michigan confidence index falls to 66.6 – worst since August 2009
· Unemployment is still high at 9.7 %. It is stabilizing but high. If it includes those working part time looking for a full time job and those who have given up looking for a job, the percentage is more like 16.7 %
· New home sales plunged 12% in July. This is the lowest ever. Existing home sales plunged 27% to 3.83 m. It is the lowest since 1995. Bank repossessed record number of homes in August. It is up 25% year on year. Home builder sentiments hits lowest since March 2009 in August. Construction spending slumped 1% in July to lowest in 10 years to 805 m dollars.
. Europe is not getting better. Germany reported good manufacturing growth but troubles in Ireland, Greece, and Iceland are getting worst.

· Despite all the cash pumped into the banks that failed, they are not lending. They probably understand the threat of the business environment. Instead of lending, they use the cash to strengthen their balance sheet. Commercial and Industrial loans shrink 16 quarters consecutively. Bank failures hit 119 this month. Altogether, there are still 829 banks that are in trouble.

One very important point is that much of the growth of GDP is inventory building. Once inventory achieves equilibrium but the end of the year, I do not foresee current sentiments that consumers are going to come out and help. We may slight into negative growth.

Finally, major companies warned the last 2 months on their forecast.


o CSCO – cut Q1 sales forecast
o INTC warned about weak sales in semiconductor
o Home Depot and Lowe slashed sales target
o BBYT showed virtually no sales growth
o FDX ( bell weather of economic climate ) missed expectation

If the economy is so rosy, why does the Fed still express so much concerns? Why does the bond market still attractive to many investors?

Interesting to note the stock prices for all the companies still go up in September.

There are of course some reasons for the bullishness.

Most important, the market believes the Fed will do everything to support the market. The Fed has hinted on QE 2. A “Bernanke put” has been bought for the market so it eliminates any fear.

Corporations are accumulating plenty of cash. It is about $800 billion which is roughly equivalent to the stimulus plan. The results are stock buy backs, increased dividends and a big increase in merger and acquisition.

Earnings are also positive so far mainly due to cost cutting, increased productivity and vibrancy of overseas market especially in China and India. According to Thomson Reuters, analysts project that companies in the S&P 500 will earn a cumulative $92 per share in 2011. That's the highest earnings in over 10 years for the large-cap index. This is more more than the bull markets of 2006 and 2007.

Added to the sentiments are the Christmas season and election which are normally positive for the market.

I really think the market is topping. Looking at the chart above on the sentiment indicators. It is extremely bullish. This indicator is a contrarian indicator. When investors are extremely bullish, a top is imminent. The last time, the sentiment indicators are at these level, it was followed by a correction or even a crash.

But it is hard to pin the top. The market can be irrational longer than we can remain liquid. Rationally, there are not enough fundamentals to support such a bullish sentiments.

My inclination is for a correction in October. Stock had risen more than 10% in September. This is the best September in 70 years! Expectations are high for earnings. Once a company fails to meet expectation, the stock will drop like a stone. Look at ADBE for a recent victim.

A friend pointed me out those momentum indicators like Stochastics and RS are greatly overbought. My reply is that the market can stay overbought for a while. It is a lagging indicator.

I have learned from experience that it is important to be patient and wait for signals like bearish candle formation and price breaking the channels and resistance. Meanwhile I am enjoying the ride but exercising vigilance and caution.

Make no mistakes. I am still making bullish trades. Trade with what you see not what you feel. As long as it is bullish, I will continue to ride the trend. At the same time, I am ready to pull off my trigger for hedging my record profits this year when my bearish signals are triggered. The drop will be fast once it starts

Also, I am selectively shorting stocks with synthetic puts ( short stock + short puts ) of fundamental weak companies with some bearish signals. It is my belief in a bull market, there are still more than 50% of companies that will under perform the market. Interestingly, I am making money on 70% of these trades. I believe I will make money on all these trades.

RIMM - update

I decide to allocate a new post to my trade on RIMM rather than just adding a comment to the previous post.

RIMM reported its results on Thursday after market. Shares were up 5% pre-market but ended Friday with only 0.5% gain.

Analysts were mixed on their review; 28 analysts maintain buy, 14 are neutral and 10 recommend sell.

Personally, I believe RIMM is being under priced at the market. Its quarterly sales were up 31%, earnings jumped 76% over same period last year, new shipments hitting the high of 12.1 m units.

OPERATIONALLY, RIMM is on a roll. It is a well managed company.

The ONLY negative is the number of subscribers failed to meet their own guidance of 4.5 m .

RIMM added fire to the negativity by announcing that they will only announce new numbers only when new milestones are passed. Analysts do not like this kind of uncertainty.

Lets discuss more on the results:

The subscribers' is mainly US subscribers. RIMM added only 100,000 subscribers in N. America. However, international subscribers where the real growth will come, is expected to more than double within 2 years. 52% of RIMM sales come from outside US. I like this because it is my belief that growth of US company will come from outside N. America. I will buy stocks of company that has a significant sale outside America.

It was reported that Torch sales were lackluster and weak. But the results show that the sales of Torch shows otherwise. It shows that the ATT $100m advertisement campaign is working. Sales at ATT stores in US tripled after the Torch launched. There is plan to roll out the product to 75 carriers worldwide.

The graph above shows the correlation of earnings and price. There is a big disconnect. Current depressed share price is certainly due to much hyped sentiments of RIMM losing competitively to Apple and Android. The smart phone market is big enough to share. It is a matter of time that powerful operating results will overcome market irrationality. RIMM is currently trading at 8.5X PE compared to Apple 19 X PE. This is a gross mispricing of a well managed company in a competitive market.

In conclusion, RIMM is currently undervalued. Buying RIMM now is a good contrarian play but caution is needed.

My married put did not work out as expected although I made some money. It did not break out as bullishly as I wanted on Friday.

Actually, I add a Oct 42.5 SP at 0.7. At the close of the market, I am losing some money but this is protected by a Dec 42.5 P on the trade.

When market opens on Monday, if the stock goes down, I may just close the trade for some profit as sentiments are overwhelming bearish although fundamentally it is a value stock. I had a discussion in a chat and most people are bearish on this stock. I asked a couple of people holding RIMM phones, most of them agree they will switch to Android or Apple if allowed.

If the stock goes up, I will certainly atdd a SC at around 50 as short term sentiment is bad. Something must happen to change he sentiment in the market for this stock. It could be a winning new product, a buyout or an impressive report of growth overseas. For the time being, these positive news are vaguely or even non existent.

XEC - Covered Call

I closed this trade on August 23rd. I was nervous about the market. It could have broken down.

Fortunately, the market withstood the support and rallied.

I mentioned I will get back to the trade.

I like the fundamentals of this company. It was explained on my previous post: http://zpring.blogspot.com/2010/08/xec-covered-call.html

Today, I see a good set up for the trade. Price has tested support and rebounded. It may test 64 again but there are good support at around 63-64.

Trade:

Buy stock at : 66.95
Sell Sept 65 SC at 2.55

PE: Let SC goes ITM and call out the stock. I will make 1% in 2 weeks. I may roll out the SC before expiry if I remain bullish on the overall market.

SE: If the stock breaks down below 65, roll the call to Oct 65 or lower.

RIMM - Covered call

Background

I initiated a collar trade on RIMM on middle of September 2009 at $76.9. I caught the stock almost at the peak. It has been on a downtrend since.

I continued to trade for almost 10 months with many adjustments. Finally, I gave up and close the trade on August 26th selling it at 48.23 and closed all my options positions. It was a disappointment for me. I put in a lot of effort and yet could not realize its potentials.

Although the stock has fallen from $76.9 to $48.3, I still manage to make a small profit $600 for a position with 500 shares. This is a testimony of the power of options if used properly. I decided to cut as I was disappointed and believe a downtrend was imminent for the stock. My patience had run out. I also made a decision I will buy back when there are signs of bottoming trend.

Now the stock has hit a low of $42.53 and bounce back together with the market, I decided to re-enter the trade.

Fundamentals.

Fundamentally, I still like the stock.

o They are still the market leader with decent margins and growth although shares are slightly eroded by Apple iPhone and Android.

o RIMM is still strongly entrenched in the corporate market

o Recent problems of security in India and UAE are almost resolved. These account for 2% of their earnings

o RIMM is expected to trade under 10 times earnings and earnings to grown > 25% over the next 12 months.

o In April, the company said it will buy back 2 million shares

o It has a strong balance sheet with almost $3 billion in cash and no debt.

o Although the Torch has received lackluster reviews but it will still increase the sales RIMM with ATT $100m promotional campaign on national TV, print and online.

o The stock is clearly oversold. Also, its volatility is almost doubled what was earlier this year. Thus a good time for covered call

o With the current pricing and the cash rich environment of corporations now, I will not be surprised there could be a bid for the company. I rate the probability at around 15%.

Technical

It has shown some signs of short term bottom. The stock has hit support 3 times in the past and bounce up.

However, longer term trend is still bearish. It could still be dragged down to 2008 low and support of around $40-$41

With the rebound of the market, the probability of the stock going down <$41 is reduced. Actually, it should just bounce off from the support line. ( see figure )

Trade:

Covered call:

BTO 500 shares for 44.78
STO Oct 45 SC for 3


Cost : 41.78

PE: Let the short call goes ITM and call out by Oct and make 7.4 percent in about 7 weeks.

SE: As you can see, I am not very bullish on the stock. I believe any bounce will be short term but the support at 42 should hold.

I am not easy about September and Oct for the overall stock market. Thus, I am using a 2 months SC instead of 1 month. A 1 month SC should actually do fine too.

If stock goes below $42, I will roll the SC down to ITM to reduce my cost to around 38.

If the stock cannot maintain support at around $38, I will close the trade at a slight loss, or double up the shares or add a put. It will depend on the market situation at that time. If the environment is bullish and RIMM shows no signs of fundamental breakdowns, I will add to the shares. If not sure, I will add a put to make it a collar and continue to trade until I make money.

If the stock shows fundamental flaws, I will exit the trade with a small loss.