Process: Managing the Trade
In my previous article we discussed the process for identifying the stocks you want to own (link) and now it is equally, if not more, important on how to manage these trades. Once again, preparation is 90% of the battle. Not only does it require having expected price levels for entry and exit points but also important to have a time-frame in mind which will dictate the parameters of the trade. More advanced traders can utilize options to further enhance returns and protect gains during the lifecycle of the trade. It is essential as a trader to develop a systematic approach to eliminate emotions from the trade process. Each individual needs to develop his/her own process and set of rules that fits the trading style and return/risk parameters but I can outline it from a broader view.
Part 1: The Entry
After determining the stock you want to own entering the trade is next on the agenda. One can use technical methods, fundamental methods or a combination of both to come up with what I often refer to as the “ideal entry level.” You can also look at entering a position in partial increments at multiple levels to allow for slippage and in order to get a better net entry. Further, more advanced traders may want to consider opening put sales that define a level (strike) at which you are willing to buy the underlying stock while collecting premium. Without getting overly sophisticated I can provide some examples of these methods with the goal once again being to come up with a systematic trading plan tailored to your specific style and financial situation. There are broader portfolio decisions that also have to be mapped out such as the allocation weighting to each stock and whether you want sector diversification.
First, looking at technical methods there are various technical strategies to identify important levels of support and resistance on a chart. I find it helpful to make notations directly on the charts and also keep a table of important levels. One popular approach is using moving averages to define entry levels into stocks and evidence has shown using the Fibonacci sequence of moving averages tends to be the best method on daily and weekly timeframes, so I use 8, 13, 21,34,55,89,144 and 233. Price patterns and trend lines are another technical method I tend to favor as most stocks follow trend/channel support/resistance fairly well. Volume profiles are also a good way to identify key levels on OpEx cycle timeframe preferably while VWAP levels are also important. Lastly, one may want to use an indicator like RSI (Relative Strength) and target entry in favored names when hitting oversold levels, I tend to use 30 and 75 for oversold/overbought on daily timeframe and 35 and 70 on the weekly view. There are countless technical methods and like everything else I prefer to use a combination of techniques. We are in an investing age with more data, resources and tools than ever before so developing a systematic approach can be improved via back-testing.
On the fundamental side if you are using valuation analysis to determine an entry point it is important to keep in mind overall market and sector valuation percentiles while also looking at an individual stock’s historical (3/5/10 years) valuation bands. At this point you have already determined the best of breed name and compared the most important industry-specific metrics. You can then apply a multiple to your expected metric to determine a valuation range, one approach is utilizing a bear/neutral/bull scenario weighted to the probability of achieving that number to come up with a blended number. Your expected holding time period will play a major role in how precise you are to a specific entry level because you may be willing to pay a multiple at an estimated metric five years out today that you would not pay at the current metric. Other important factors to keep in mind are cyclical vs non-cyclical and where on the growth cycle a company is which determines to compression/expansion of the multiple cycle.
Valuation plays a much more important role the further out in time you go, so if you are a long-term (5+ years) holders it will influence entry to a higher degree. If you are more of a swing-trader looking to hold positions for a few weeks or months, utilizing a technical approach makes a lot more sense for entry as it is more reflective of real-time market sentiment.
Part 2: Modifications
The main modifications I think of when owning a stock involve using options to either protect the position or to enhance the returns. Developing a systematic approach is again the way to go, one example would be to use an overbought/oversold indicator such as RSI and if it hits your overbought level, say 75, and then proceeds to contract under another level, say 68, you sell a 25-Delta call option 30 days out. This allows you to collect premium with the risk of having your stock called away at a higher level. It allows Theta-decay to work for you if a trending stock you own needs time to consolidate. There are other more advanced strategies such as stock replacements and ratio spreads, but for this initial approach best to keep things simple.
On the protective side it is necessary to always be aware of upcoming event catalysts for the stocks you own, typically earnings reports. Into these reports option premiums tend to rise to elevated levels so if looking at a protective put position it is best to plan ahead and buy five or more days ahead of the event. One approach I prefer, mostly in a stock that has gained since entry, is using a collar strategy (selling an OTM call and buying an OTM put) that will not only define your risk into the event but also define a profit target while being more cost-effective than simply purchasing the downside put protection.
Modifications is not the only part of the middle stages of a trade’s life-cycle as staying informed is always vital. This ranges from the broader Macro perspective down to following news, analyst reports, earnings reports, and other details out of the stocks you own. This can also impact the last part of the process, the Exit, as Winston Churchill said “When the Facts Change, I Do Too.” In other words, if a company you identified as high quality starts to have missteps, management changes, increased competition, or economic-sensitivity then you always have to be willing to adapt to the new information and come to a new conclusion.
Part 3: The Exit
The two obvious scenarios to keep in mind for the exit strategy are preparing to take a loss and preparing to take a profit. First, to tackle the taking a loss risk management side of the equation it can be as simple or as methodical as you see fit. A simple approach such as a strict percentage drawdown stop can be quite effective and eliminate “paralysis by over-analysis. Conversely, a technical method that identifies important price levels can be used keeping in mind that price often over-shoots so either using a percentage cushion to a level or a multiple of a time-frame (30/60 Minute or Daily) cloud under (candlestick) approach often keeps you away from stop-runs. Volatility-based indicators like ATR (Average True Range), Chandelier Exits, or Moving Average Bands are something I find as an effective systematic approach that can be applied to all positions. Taking the time to get familiar with the indicators, figuring out how best to use them with your trading style and then back-testing results can go a long way in improving returns and minimizing drawdowns.
In the taking a profit scenario the same kind of approaches can be used as stops that are locking in a gain while options can also be used via puts or collars to lock in a profit. The fundamental analysis comes back into play here to a greater extent with setting an upside price target. It is so difficult to precisely determine a target because stocks often overshoot so I rarely set exact targets and instead apply momentum based indicators. Moving average crossovers are a great indicator of inflection in momentum, so on a longer time horizon I find utilizing the 8/21 weekly EMA crossover as a great sell signal while a shorter term trader may use a 5/13 crossover on the daily, or any combination of the aforementioned moving averages.
If using a fundamental model that has given you a fair value of a stock you can take a much more patient approach. Taking profits too early has been the hardest obstacle to overcome personally and think it applies to most traders. The market often takes a lot longer to price in new information and attract incremental investors creating a “momentum begets momentum” scenario. I find it a bit naïve and presumptuous to believe one can determine exactly what level a stock can rise to and peak which takes me back to something I was taught long ago. It is highly unlikely to catch the bottom 10% of a stock move and exit in the top 10%, but there is a lot of money to be made in the 80% in-between. Perfection cannot be attained as a trader, neither in the win/loss ratio nor in capturing the maximum profit of a move, but taking a systematic approach and not falling into the trap of the “woulda, coulda, shoulda” thinking can make you a highly successful trader.
It is why using a more on the fly adaptable approach with both price action indicators (volatility-based stops) and staying informed on the fundamentals willing to change your view when the facts change tends to work out the best. Opportunity cost is also something to weigh, if a better opportunity is found in the identification process, one should always be willing to replace positions with lower reward/risk ratios to position the portfolio optimally.
In an effort to keep this fairly general and basic, hopefully this article provides some ideas for you to develop your own systematic approach to stock idea generation and trade management. In the short future I will provide a real example following this process which I often find to be the best method of educating.