Tactical Execution

Hello and welcome to Financial Audio, an information series providing listeners with detailed and tactical guidance on today’s complicated financial world. My name is Patrick and I’m your host. You can find written versions of these podcasts at FinancialAudio.com and I encourage your candid feedback at the same location. Today, we’ll be talking about one of the most important disciplines for investors and that’s money management – so let’s get started.

One of the biggest problems investors encounter when they first start trading is that they learn how to select an attractive security and they learn when’s a good time to buy in. But after that, they’re lost and have idea when to sell. In many cases, the security they chose appreciates nicely but then it breaks through its trend line and starts coming back down again. The investor misses the top and never pulls the trigger on the way back down and ends up losing all the profit in the process. It happens all the time. It’s happened to me a bunch of times and I’m sure it will happen to you, at one time or another.

Just a quick note to explain I’ll be referring to investments as securities from now on. During the first few chapters, I referred to them as stocks but in the last chapter, we discussed Exchange Traded Funds and they’re NOT stocks. Listeners may be interested in investing their money in individual stocks or Exchange Traded Funds – that’s none of my business – so I’ll refer to all investments as securities going forward.

So anyway, you can read dozens of books on stock market investing and the authors will always plead with their readers to use the strategies we’ll be discussing in this chapter but the fact is; most people don’t. It’s amazing sometimes. You can tell people horror stories and everyone will be nodding their heads but then they’ll go home and never utilize the easy and FREE solution you proposed. I’ve never quite understood that. People will spend real money and devote real time to learning this stuff but they’ll ignore the most important piece of advice. Well, I’m going to take my shot here today and I truly hope you’ll listen to the advice and use the strategies will be discussing.

Let me start at the beginning. Years ago, when you wanted to buy or sell a security, you’d call your broker and arrange the trade over the phone. Of course, all that’s changed today and the vast majority of individual trades are entered over the internet. The platforms provided by brokerage companies include a variety of functions you can utilize in your trading strategy. For example, you can put a buy order into the system and walk away, knowing the system will execute that trade when the price you specified becomes available.

Think back to the example we used early in this series. It involved a stock that was trading between $20 and $25 for quite a while. Seeing the stock was clearly in a trading range with strong support and resistance, an investor might put a buy order in at $26. So as the stock trades sideways, the buy order sits there unexecuted, allowing the intended investment amount to remain available for other potential investments. However, as soon as the stock breaks through the resistance at $25 and crosses $26, the system would automatically execute that trade for the investor.

If the investor wanted to sell the stock short, he or she could put a sell order in at $19, allowing the stock to trade sideways until it finally breaks through support at $20 and crosses $19. Only then would the trade be executed. But the order could’ve been programmed into the system for weeks or months before. Of course, an investor could put a buy or sell order in wherever he or she wanted – I’m just using these two examples because we’ve referred to them throughout this series.

These platforms also provide a number of other automated trading options and one of these is called a Stop Loss. When you buy a security, you can program in the price at which you want to sell it if things don’t go as you want. Obviously, you WANT the stock to go up in value and you can hold on for the ride but if something goes wrong, you need to get out as quickly as possible. And the best way to do that is to program the worst-case sell order right at the time you buy the security. That type of sell order is called a Stop Loss and it’s absolutely mandatory EVERY time you purchase anything.

Using our earlier example, assume you had a buy order in at $26 and it got executed. Now, you would EXPECT the break-out above $25 to result in an upward price move and you’d expect new support to form at $25. If something happened and the stock breached back BELOW $25, the pattern is broken and you no longer know what will happen. The whole point is you want to stay in the trade as long as the pattern remains intact and you understand what’s going on. If the price breaks back below $25, the pattern is broken and anything can happen. As a result, I would put a Stop Loss at $24.75. That way, I’m risking $1.25 per share and I don’t have to feel paranoid after I’ve bought my shares. I already know what my exposure will be.

Now running the example, it’s important to realize you could be in this trade for an hour or less in some cases. The pop up to $26 could’ve been some bizarre anomaly and the stock could’ve come right back down again. Or, the break-out could’ve been legitimate but an unusually strong pull-back pushes it temporarily below $25 before it resumes its upward momentum. Either way, the whole thing could play out in less than a single day. But on the other hand, the trade might hold and you can ride the wave as the stock begins trending upward.

The good news is never the problem. If the trade works out the way you want, it’s time to celebrate. The problem comes in when the pattern breaks and goes against you. You ALWAYS want a Stop Loss in place so you can limit the downside right from the start. Now, we need to speak about the good news as well. If the trade works out the way you want, you don’t want to keep your Stop Loss at $24.75 forever. You want to move it up, locking in your profits, as it moves. There are a number of different strategies for doing so and we won’t have the time to cover them all but a few definitely warrant discussion.

When securities are trending upward, they rarely do so in a straight line. And this relates back to our discussion about oscillators back in the third chapter. The securities will tend to trend smoothly upwards, then pull back a bit and then advance again, breaking past the previous high and pushing slightly higher. Then, after another advance, the stock will pull back again but the low THIS time is higher than the low LAST time. So you get this pattern of higher highs followed by higher lows. As soon as the security is unable to break to a new high, you’ve got problems. And if a low drops down to where the previous low was, that spells trouble as well.

We spoke about trend lines and the fact that they are drawn to connect the periodic troughs of an advancing security. That’s what we’re talking about here. The trend line should be drawn to connect the periodic pull-backs as the stock pushes higher and higher. So if you drew the stock’s price movements in a simplified way on a piece of paper, it would look like a lightening strike – long diagonal upwards lines separated by short pull-backs – and the trend line would connect the bottoms of the pull-backs in an upward direction like a crooked floor following the stock price as it trends upwards.

In terms of moving the Stop Loss for the first time, I would wait until the first pull back. You’ll know its taken place because the security’s price will noticeably pull back for a few days, erasing part of the early gain. Then, the price would stop at some point and resume it’s upwards movement and PASS the earlier high. That’s the most important part. Until the earlier high has been exceeded, the security’s upward trend has not been confirmed. As soon as the security sees new highs, you can move that Stop Loss to the BOTTOM of the recent pull back. That’s right. You would move the Stop Loss to the bottom of the recent pull back, maybe even 25¢ below it. And when the price pulls back again, wait until it resumes its upward movement and breaks into new highs and then move the stop loss up to the bottom of the NEXT pullback.

Once you’ve established a trend line by connecting the first two pullbacks, you can move the Stop Loss more regularly along the trend line, just slightly below. That way, you don’t have to wait as long before locking in your profits. You can move the Stop Loss up every single day. It also allows you to retain more of the total profit when the security finally breaks out of its pattern. In other words, you won’t have to sit there and watch the price fall from grace until it finally crosses below the most recent pullback. You can follow the security’s price upward along the trend line and have the system sell you out automatically when the breach finally takes place.

There are other people who put their Stop Loss a certain number of percentage points below their purchase price. So, for example, if you bought a stock for $20, you might automatically put a Stop Loss 5% below that – that would be $19. That way, you always know you’re only risking 5% of your money on a single trade. I know many people adhere to rules like that but I just don’t think it’s the best approach. You have to read the stock’s chart and put your stops where they need to be to facilitate the pattern. Your stocks should only be stopped out if the price-volume action confirms the pattern has broken.

There are other guidelines people use that employ a bit of both mentalities. For example, they’ll put their stops 2% below the trend line or 2% below the moving average. Or they’ll require the security actually CLOSES below the trend line or moving average. These rules try to eliminate the false breaches that sometimes take place when the stock is approaching the line and may get whipsawed briefly before being pulled back to its pattern. These are reasonable rules in my opinion and can stop a winning security from getting stopped out prematurely.

I’ve mentioned before that you can sell securities you own as they break out of their patterns and replace them with the new up-and-comer securities. And I really believe a process like that can form the foundation of a very sophisticated investment strategy. But it’s unrealistic to think there’s a constant revolving door with a ready supply of new up-and-comers every time an old security falls from grace. The fact is; you’ll quickly notice that a ton of securities all break out on heavy volume at exactly the same time … and, on the other hand, a good number of the securities you’ve purchased in the past might get stopped out all at once.

This further supports the fact that the whole market moves in tandem. All boats rise in a rising tide and all boats fall in a falling tide. While individual securities may perform better or worse than the market as a whole, the overall trend often overlaps everything else. Back in late 2002 when the stock market finally hit a bottom after the dot-com bust, we saw some huge volume days and hundreds of stocks broke out all at once. The whole market turned the corner in a single day and it affected everybody.

If it turns out that all your stocks get stopped out in a day or two as the market takes a turn for the worse and the moving averages are all pointing down, don’t force it. Don’t try to find securities that don’t exist. If the stock screener isn’t yielding any attractive candidates, so be it. In fact, now that you know about the Exchange Traded Funds that reverse the market’s movements, you might consider moving your money into one of those and profiting while the market corrects. Just keep in mind you always need to put a Stop Loss in place when you enter the position.

Bottom line; protecting your money is the most important thing you can do in the stock market. You have no idea how many people get all excited when they check their computer and see huge profits, only to see those profits vanish because they didn’t sell at the right time. Take the emotion out of it. Leave the decision in the hands of your online investment platform. Make it a practice to adjust your stops every morning and then let the platform carry it from there. It might only take you 10 minutes but it could save you endless amounts of frustration while preserving your hard-fought profits.

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Again, you can find written versions of these podcasts at FinancialAudio.com and I do offer workshops, seminars and keynote speeches as well as a variety of more advanced information products so please email me at Patrick [at] FinancialAudio.com for more information. I’m also doing a series on innovative marketing and strategic business positioning. That series is called Tactical Execution and you can find it on iTunes.

Stay tuned. There’s a lot more to come. In the meantime, think big, take action and invest strategically. Bye for now.