In the last couple of articles, I wrote a little about issues of
risk. Risk seems to be one of those things that too many traders
consider only after they find themselves facing already existing
losses. Too often, that seems to be the same time that greed may
dissipate and fear increases, sometimes to the point of near
paralysis. As I have written many times and as I emphasize with my
individual coaching students, the time to assess risk is before
entering the trade, not as losses mount or after substantial losses
have already been achieved.
One question that has arisen on the blog relating to the
articles on risk is what is the "best" protection. Some believe a stop
loss order does the job well enough and others contend that the way to
go when owning stock is to buy protective puts. Each of those routes
has advantages and disadvantages (as is true with so many things we do
in the markets) and whatever the choice, there must necessarily be
some compromise.
One may first consider that a given trader might chose to have
no protection and simply buy a stock and take the whole risk that the
position could go to zero. Though I don't know it is the case, I
suspect that most individuals who buy stock take precisely that
approach; they buy the stock and have no protection in place and, in
fact, frequently have no exit strategy whatsoever. Clearly, that is
one approach. Is it the best approach? Who can say. That is an
individual decision and I have little qualms with it so long as the
trader has an understanding that the whole investment is then always
completely at risk. If that trader makes such a choice, he need only
be prepared to live with it. Living with it is that persons decision
and one only hopes that he is not kidding himself into believing that
the stock can't take a precipitous drop, perhaps even to zero. We can
all name instances of that exact occurrence.
More conservative traders might choose other alternatives to
attempt to protect their investment. One such choice for the stock
buyer would be to buy protective puts. In those situations, the
trader pays a premium and buys a put which enables him to assign his
stock to someone else at a specific price anytime before the put
contract expires. In that sense, it is akin to an insurance policy.
For example, I might buy shares of XYZ at $20.50 a share and also buy
the $20 puts. In that case, let's suppose the puts I buy expire in 6
months and they cost me $1 a share. Now, until expiration, I can
force someone to buy the shares at $20 so even if the stock dropped to
$5 a share before expiration, I could still get $20 a share and
therefore lose only 50 cents a share on the stock, but, of course, the
premium for the put cost $1 so I would actually be down $1.50 plus
commissions. Still way better than losing $15.50 a share on the stock,
but in order to achieve a profit in that 6 months, the stock would
have to be above $21.50 a share at option expiration.
Another alternative discussed in the blog is the stop loss
order. If we take the same example of XYZ above, we might place a
stop loss at $19.95. That means if the stock falls to $19.95 or below
our position is automatically sold at the then market price. Suppose
it dropped to $19.90 and our stop was hit and the position sold at
$19.90. There we would have limited our loss to 60 cents total. The
problem, of course, is that stocks can gap down and in those
situations the stop loss only offers a partial protection. Suppose we
had the same scenario with a stop loss at $19.95 and on Thursday the
stock closed at $21 a share, but that evening after the market closed
XYZ released some bad news. What happens on Friday? Presumably, the
stock is down significantly at the open. For our example, let's say
the stock opened at $17.50 on Friday. Well, our $19.95 stop has been
hit, but there is no one there to buy at $19.95 or even close so our
stock is sold at $17.50 and we suffer a $3 a share loss. The really
good news is we are out of the position and will not suffer additional
losses from a continuing drop. We have cut our loss (and could get
back in if it turned back up). The bad news is we didn't get out near
the $19.95 we expected.
These examples are meant to be just that -- examples showing a
couple of ways a trader may attempt to protect a position and cut
losses. Is one better than the other? For each of us, the answer is
probably "yes," but for subjective reasons which we choose will
differ. Stops may be preferable to buying puts because it costs
nothing to place a stop loss order but one does have to pay a premium
to buy a put and the put will expire. On the other hand, buying puts
may be preferable because I don't run the risk of a gap down with the
attendant larger than expected loss that could occur with the use of a
stop loss.
Truth is, we can argue until the cows come home which is better,
but the bottom line is that what is better for me might not be better
for you and your goals, your time limitations, your risk tolerance,
your position size, your trading knowledge and other assorted variables.
I can only suggest that it might be wise to figure out ahead of
time whether you want any protection and, if so, what protection best
serves the furtherance of your own personal trading plan. In fact,
the first step is to create that plan that is specific to you, your
goals, your needs, and your abilities. Plan creation and the elements
I suggest be included as a minimum are set out in detail in my book,
"Trade Your Way to Wealth" .
Incidentally, for those who use TeleChart and/or StockFinder
software, I've been invited to and will do a free webinar on March
16th for Worden Brothers, the publisher of those services.
Good Trading!
Bill Kraft
Success Trading Group -- by Success Trading Team
Our Success Trading service delivers quality trading ideas for the elite investor that has the financial wherewithal and market nimbleness to profit on small moves in a stock's price. Become a member and you will be provided with email and/or mobile alerts intended to provide you with the opportunity to make many, many profitable trades.
Here is a play from the Success Trading Group:
Marathon Oil Corporation (MRO)
Our Success Trading Group members closed two more winning trades this week
including a trade on Marathon Oil Corporation (Ticker: MRO). We have
several stocks on our radar and are looking forward to trading next week.
Have a great weekend and we'll trade next week.
Success Trading Group Team
