Not Using Stops while Trading
For those of you who follow our trading on our blog at
www.livingonlargecaps,blogspot.com, you will have noticed we do
not enter a stop, when we enter our positions. It is actually
the #1 question we get in our email as well. And in this article
we try to explain our rationale for this.
First off, let us go back to why we trade only large caps to
begin with. Although for many of you this will be review it is
fundamental to our reasoning for not placing stops on our
entries. Large cap stocks, defined as stocks with over $5
billion in market capitalization, have REAL value. Not an idea,
not a scheme, not a, change the world, pie in the sky, plan. But
REAL hard-core, nuts and bolts value. Chances are they have
already changed the world, they have already proven their value
to the world. We are not betting that they will do something, we
know they already have. They might even own things like real
estate, patents, have money in the bank, a steady earnings
stream, proven management etc. etc. Therefore because they are
predictable, reliable, so is their stock pattern. Predictability
and reliability, of course, are relative in the stock market. No
stock price is as reliable as the sun rising, but in the world
of financial markets large cap stocks are very reliable.
However, having said that there are hiccups. There are out of
character moves to the downside, and the upside, but the
downside is always more dramatic, especially when you are
holding a stock while it occurs. The difference between a large
cap and a highly speculative stock when the move comes, however
is; the size of the move and the character of the move. There
are other differences to be sure but these two are of the most
important to the swing trader.
Large caps will rarely plunge more than 10-15% in a single
move. Breath taking to be sure, but nothing compared to a 50%
initial drop, and then continued down ward pressure with no
relief. If your portfolio cannot handle a 10-15% drop in a
single holding, than your money management skills are where you
need to be applying your learning time. The second difference is
after this initial drop, there is almost always a time to exit
your position at a better price. Sometimes it is within the next
few days as bargain hunters move in. Sometimes it takes 6 months
or longer. Not a pleasant experience as our average trades last
about a month. However, we tend to hold 10-12 positions at a
time and at times up to 5 of these could be caught up in a down
ward move looking for an exit. We call these positions our weak
sisters, and have come to learn to accept this as part of our
trading. They are not losses until they are liquidated, remember
this.
For examples of how large caps tend to rebound take the 2005
chart of AAPL. In mid-October it made headlines after dropping
10% in one day. How long did this last? Not long, in fact look
at the chart for the whole year, you will see several such
drops, and they all recovered quite nicely and then some. The
story isn't always so rosy however. Take the chart of HIG for
the same year. We were actually holding this, with stops and
limits in place to lock in profits (yes we do use stops once we
have a profit). And in August the stock fell right through our
stops and limits, and frankly wiped out most of our profit in
one gapping day. And this is with an insurance stock, sometimes
thought of as bastions of safety. We canceled our open stops and
limits, and rode it out. Like an acrobat without a net, we had
to adjust. Just a few days later, the action seemed to good to
be true and we got out. Luckily for us, it was the exact best
time to exit, that HIG has had to date,. (It is 10/23/05 as we
write this.) But the point is there are several places alnog the
way one could have exited this position at better than the spot
of the initial drop. And that is the main reason we don't use
stops on our initial orders. Because there are usually better
places to exit when trading large caps. The sky rarely falls,
and when it does it doesn't fall at once cataclysmic moment.
We have recently begun to place holdings in different
categories to recognize when our trade isn't working out as we
had hoped. We call moves by these stocks out of character. Such
as the move HIG made in August of '05. And our whole goal with
these stocks is to find a dumping spot for them, and get out. If
you notice AAPL's move didn't classify as out of character, it
didn't break the continuity of its pattern that it had going.
But it DID make the headlines, nothing will make you question
your positions faster than a bunch of 'experts' trashing them in
the press. However, once a stock has made an out of character
move, one that changes the very landscape of its chart, looking
for a place to dump it, will not only free up your cash, but
very well might be the best place to rid yourself of a stock
that is heading south for the winter. And when you swing trade
the winter is a very long time to park your cash. But on the
other hand, if you find yourself having to hold a stock that
long, remember there is better places to park your cash then in
a fundamentally sound large cap, waiting for it to come back
into vogue again. You did remember to check the fundamentals
before you purchased it didn't you?