In case you don\’t read the news (which would make it similarly unlikely that you are taking time to read my blog,) the Dow Jone Industrial Average DOW dropped 299 points jumping right by technical resistance levels at the 7000 point level. Similar the S&P 500 barely stayed above 700 by the end of the day. These are very interesting times that we are seeing, and today was more a surprise I think, because everybody would have expect $AIG to be the stock losing value as it gets more and more diluted by the U.S. government, but instead we saw everything else (especially the financials) down on rumours of Freddie and Fannie future.
Today I\’ll cover a lot on how the trader protects himself from down markets, and eventually sells. In an ideal world the \”investor\” would only sell when the fundamental strategies behind the company change – and continually collect a dividend, reinvest it, and trust that the company will grow over the period of infinite. Realistically, the downturn that we\’ve seen should suggest that everybody follow these guidelines to selling a stock.
Trailing stops are the best hassle-free way to go about protecting yourself. A trailing stop automatically trails the current price by points or a percentage, so as the price rises, your stop order rises. So if during the boom times of 2007 and early 2008 maybe your non-volatile stock shot up from $50 to $70 a share and when you bought it you decided to go ahead and protect it with a 5point trailing stop order. This means that you would never lose more than $5 per share, and assuming steady growth with no $5 down days (like we see in 2008-2009) you would be set until it hit $70 until October 2008 comes and the stock price goes below $65, at which point your broker automatically sells.
What this means is that, if you assume a steady uptrend with no huge spikes in either direction (typically a safe assumption when you want to be standardly long) that your account will automatically switch back to cash when there are major events in the systematic markets… or your company announces in an earnings call that they don\’t plan to be profitable for 5 years.
This is really what a trailing stop is, except here you do all of the work instead of your broker. Now to keep protecting your losses you need to manually adjust the stop loss to a point value at periodic intervals (say every $5 for kicks.) You should also consider switching brokers, as any broker worth having should offer trailing stops most of the time.
Most of All, Don\’t Hold On to Losers
I\’m not a fan of what a lot of people call dollar cost averaging in a down market. If a stock is trending down, then you seriously need to sell it! Don\’t hang on to a sinking ship, get out and re-analyze. Staying in is a purely emotional play.
The GT Student Foundation should have followed this advice with BAC (Bank of America) and probably would have if it were slightly more actively managed and many swaps of positions were not frowned upon. The Foundation bought originally at $24, bought more to dollar cost average at $17, then bought more at $12, and finally, bought more at $5. Instead, drop your losers until the price is more certain (yes, you may miss a big jump) When the foundation was down 35% as the price dropped to $17, all positions could have been sold. Then at either $12 or $5 we could have reconsidered, ultimately giving us more share for the same amount of money.
This is really how Trading works. In the last weeks we have seen Bank of America in major channels between $3.40 and $5.80. This is a huge opportunity, you buy low, and have that stop loss limit (potentially mental) at that 5% as it climbs the next two days. Of course we\’re looking for the end of the channel, but momentum tends to be visible. I\’ve made this tracking trade 3 times now.
As you know, I am a fan of the covered call trade, which means that these orders can not happen as easily as this makes it seem. If you implement both strategies, you will need to have a double legged order to buy back a (cheaper) call, and then sell the stock. Even fewer brokers do this. Tradeking does though, check them out http://tradeking.com