Stock Trading Techniques

Due to a lengthy vacation, I was not able to update this blog for a month. For that I apologize. So, after all this time, a portfolio review is in order.

The first big news is the CROX disaster. Crocs makes popular plastic shoes. For months their management has been saying that everything is fine and they’d meet their earnings projections. On July 24 management announced horrible earnings and gave very poor projections for the future. In other words, management lied to its shareholders. This resulted in the stock losing more than 50% of its value virtually overnight. Since this was one of our covered call plays, we did not have a sell stop order in place (which is OK as we would have taken the maximum loss if we had entered one). What I did was immediately buy back our September $12.50 calls for $.05. Then, on August 18, when CROX had a quick run up, I sold our position for $5.25.

There probably will be shareholder lawsuits resulting from this, as frequently happens. We may eventually get back some of our money from these lawsuits, but they are not relevant to this blog so we’ll just put this trade behind us. There is no defense against lying management when they lead you in a positive direction then negatively blindside you.

The next major item is that on July 24 FXI split 3 for 1, meaning that for every share of stock we owned, we now had 3 shares. It also cut the stock’s price by two-thirds, resulting in the same overall value after the stock split and causing our sell stop price to be reduced by two-thirds too to $39.85. Unfortunately, on August 19 FXI dipped below our sell stop briefly and we were stopped out at $39.75. the stock is now on the way back up, but we are out of it.

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I’ve been researching more ways to make money in this bear market we are experiencing. As a result, I have not been very timely in my posts lately, so it’s time to go over the stocks in our portfolio.

Earlier today I did write a post relating to FXI (click here to see the post).

On July 2 we were stopped out of GEX. our alternate energy ETF.

However, our other positions are doing well with Constitution Mining hitting a series of all-time highs and Crocs moving up along with FXI and PRW. Our only loser (besides being stopped out of GEX) since our last review is DBA, our PowerShares Agricultural Fund.

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Our China 25 ETF (FXI) has struggled lately, almost reaching our sell stop before rebounding slightly. However, two different advisory newsletters I receive are now pointing to a possible rebound in the Chinese stock market. Following is a reprint (with permission) from today’s Money and Markets. It’s entitled “What China Wants, China Gets!” by Tony Sagami. As requested, I have included the following notice:

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For the first time since I started this blog in early January, our portfolio has gone slightly negative, based on June 20 closing prices. Of course, in the U.S., no sector has been immune, except oil. In the last 12 months, out of 159 market sectors, a full 156 of them have lost money. Still, we are trying to be conservative while  attempting to grow our portfolio with a variety of stocks, all selected to make us money while also teaching specific investment techniques.

As I review our portfolio, I believe we should stick with our current selections. Our covered call play (CROX) has been hit hard, with the stock losing $880, but the call we sold has increased in value by $425 offsetting some of this loss. Still, CROX was cheap when we bought it and it’s cheaper now. Not long ago (November 2007), it was priced at over 100 times earnings at $75/share. Crocs recently reaffirmed 2008 earnings guidance of $1.50 to $1.70 per share. So, at Friday’s closing price of $9.17 per share, CROX trades somewhere between 5 and 6 times forecasted earnings. The company also has no debt and trades at just one times revenue. It is now a value stock.

As for our other stocks, the portfolio review I did on May 31 still applies. To see it, click here.

If you are going to be a profitable trader, you have to ignore the news. Very few successful traders or investors watch any news shows during the day. If you want to watch these shows, watch them in the evening, but when the markets are open, the commentary you find on these shows will more often than not just confuse you, frighten you, or mislead you. This results in emotional trading, which virtually guarantees losses.

Remember, news does not dictate the major trends in any market or security. Rather, news flows from the trends! For instance, how often has a stock reported better-than-expected earnings, and its share price tanks? Or it announces worse-than-expected earnings, like Citibank did recently, and the share price soars?

The same holds true when economic stats are released by Washington like unemployment numbers, CPI, trade deficit numbers, you name it — they are all backward-looking statistics and do not create or change trends. Rather, the statistics are the result of trends already in motion, and if you follow them, or rely on them to trade, as I said previously, you are virtually guaranteed to lose money.

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Our covered call play (CROX) is slightly negative. We bought 500 shares of CROX and sold 5 September $12.50 calls. This is called a “covered call” because we own the stock we are writing the calls against. A “call” gives the purchaser the right, but not the obligation, to buy our CROX shares anytime up to the third Friday of September for a price of $12.50 a share.

If CROX is selling for less than $12.50 on that date, we get to keep our CROX shares and also the premium we received from selling the call contracts. Each call contract is equal to 100 shares, so we received $650 ($1.35 * 500 = 675 - 25 commission = $650). After that September date we can sell our calls again (although they may not be $12.50 calls, depending on the price of CROX at the time), if we still have the shares. We can do this over and over until eventually our CROX shares get called away.

If CROX is selling for $12.50 or more, our shares will be called away, but we then make a profit on our shares (the difference between $12.50 and our buy price of $10.88 or $1.62 per share * 500 shares - $810) plus the premium from selling the calls ($650). That’s the good news. the bad news is that if CROX is selling for $50.00 at the time, we still only get $12.50. But we knew that going into this trade and the fact is that 85% of all options expire worthless, so this strategy is a way to generate income into our portfolio. If you think a stock is going to rise rapidly in the near future, you would never sell calls against it until it hit what you considered a peak, then you could sell calls to protect against a sell-off (but if its a volatile stock I’d just as soon enter a trailing stop).

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How you exit a trade is as important, if not more important, than how you enter it. This may seem odd, but if you think about it, if controlling your risk to small, predetermined amounts is the key to successful trading and investing then that, by definition, tells you how important the exit is.

Your trading strategy might well turn an initial stream of profits into a flood of wealth for generations to come, so exiting with a small loss — the 2% rule —is critical. But knowing how and when to exit with profits is equally as critical. After all, what good is it if you give back a majority of your profits before getting out?
Or, what good is it if you get out of a winning trade prematurely, when a big trend is about to emerge, and you caught it early on?

So how do you exit a trade with locked-in profits? By always using a trailing stop to reduce both the risk and the odds — as well as the amount — of profits that you can potentially give back. It is critical that when your trailing stop is hit to immediately get out of the trade.

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When Wall Street’s darling growth stocks start reversing course, they become beaten-up value stocks.  Growth-stock investors have no patience for companies that fail to meet inflated earnings expectations and value investors are too timid to step up and buy for fear of getting into a declining situation too soon.

When the former stars of Wall Street crash and burn it creates a buying opportunity. Right now we have that opportunity with Crocs (Nasdaq: CROX), the former highflying maker of brightly colored plastic shoes. This stock, which once traded north of 100 times earnings, is now a value stock.

Crocs recently reaffirmed 2008 earnings guidance of $1.50 to $1.70 per share. So, at its Friday closing price of $11.01 per share, CROX trades somewhere between 6.5 and eight times forecasted earnings. The company also has no debt and trades at just one times revenue.

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Always use protective stops! This is an absolutely imperative action you must take! It is also the way to limit our risk as per Part 2 of this discussion. Once you’ve defined your 2% risk in terms of your account equity, always place a protective sell stop to get out of that trade at a maximum 2% loss, no matter what.

You can always get back in. You can always trade another market. There is always another opportunity. But if you don’t religiously use stops to limit your risk to 2%, it is almost a certainty that you will never make any money on a consistent basis.

You might get lucky once in a while by not using stops. But be assured, without a hard and fast rule of using stops, you will give back any “lucky” profits you make in no time, guaranteed. I have experienced this myself many times (OK, so I’m a slow learner). Back in the 2000 tech stock crash, I let the biggest profit I ever had to that point become my biggest loss ever when I removed a stop from Cisco. It was at $76 or so and started dropping. I had a stop at $66. As Cisco’s price approached $66, I decided I didn’t want to sell it so I removed the stop (and, afterall, this was a “healthy correction” as Cisco could never go anywhere but up over the long run, right?).

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Never risk more than 2% of your account equity on any one investment, trade, or recommendation.

Make this a “golden rule” for any trading you do on your own. The only exceptions to this would be long-term core positions where you are not using any kind of leverage or margin.

However, for short-term investing like day-trading or swing/position trading, you should never risk more than 2% of your account equity on any one trade.

Let’s look at some examples. Let’s say you have $100,000 to trade with. If you risk 10% of your equity on every trade and you experience 10 losers in a row, you’re wiped out. You are out of capital, and out of the game. Even if you lose nine in a row, you’ve lost 90% of your equity and you then have only one chance left to be right. In that case, just to make back all the losses and break even you have to hit one heck of a windfall profit on that 10th trade.

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