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?