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very trader, regardless of the product that he trades or the hours that he trades, has to manage risk. Remember Black Monday in 1987 or the crash of the high-tech bubble in 2000? Those events caused bad things to happen to thousands of good traders. What would happen if the market crashed again? What if some terrorist cell succeeded in a deadly and strategic attack in the United States and a large geographical area or vital economic center was affected? In fact, the attack does not have to be targeted at the United States. In our global economy, a serious crisis or event across the Atlantic or Pacific will have dire effects on the world’s financial markets. What would happen to your portfolio? How soundly would you be sleeping in the aftermath? The best way to protect yourself is to be an educated investor.Trading in the global markets is risky. However, on both a short-term and a long-term basis there are things that you can do to protect yourself.
Expanding your playing field and understanding how to trade 24 hours a day adds opportunities and allows for greater flexibility both on a regular basis and in times of crisis. With that in mind, I offer the following strate- gies that may be helpful.
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Diversify
One of the most basic steps that you can take to protect your assets is to diversify them. As the old adage goes, don’t put all of your eggs in one bas- ket. If the bulk of your assets are in technology stocks and the sector goes south, so does the value of the whole portfolio. Get balance within your equity holdings; do not rely on the success of any single sector to safeguard and grow your wealth. And, do not just diversify equities. To the extent that your assets allow, balance the whole account with various financial prod- ucts. If possible, a portion of your holdings should be in bonds or a bond fund. Bonds, at least under certain conditions, tend to move inversely to equities. If your equity account is ailing, your bonds should be doing better and balancing your losses.
Most of the traders that I know have at least a portion of their wealth in real estate. Investments in real property are another avenue that you might wish to explore. However, with interest rates rising, the real estate market will likely experience a slow down. The particular manner in which you diversify depends on the value of your assets, your comfort zone with various products, and your specific financial needs and plan. At the time of this writing, my personal definition of diversification is cash and profitable stocks. The big idea is that in order to protect yourself from global finan- cial risk, one basic step is to diversify.
A word of caution: Every trader and investor is unique. Asset levels, risk tolerance, and a wide array of factors determine the trading approach that you should take. Therefore, it is not my intent to offer a “one-size-fits-all” plan. Before taking any action, you must be familiar with all of the risks and ramifications including tax liabilities that you may incur.
Those lacking a full understanding of all aspects of any investing strategy should consult a professional to be fully advised of all consequences and risks involved.
STRATEGIES FOR PROTECTING YOUR LONG-TERM ASSETS
Be a Hands-on Manager
Many people like to give the responsibility for managing their money to someone else. It is easier to have Mr. X take care of everything. If the advi- sor of choice is very good, maybe all will turn out well. But, beware! No one is as concerned about your money as yourself. The person who made the funds has the biggest interest in conserving and growing them. Handing over the portfolio to an “expert” might be convenient but unwise. At least, not unless you also keep track of it and hold the manager accountable.
Never trust that someone else will have your best interests at heart and always make the right moves. That is not to say that experts may not be helpful, and there are times when many people need advice. Just remember who the money belongs to and whose final responsibility it is to manage it.
If you do not keep an eye on your own assets, the day may come when there are no assets to watch. That is the beauty of educating yourself about the financial markets. Education translates to power; the power to look out for yourself and your interests.
Use Stop/Loss Orders
If equity prices drop 10 percent during any eight-week period, beware. A serious market correction or crash may be afoot. Should that happen, make certain that you have firm stop/loss orders in place that will take you out of your equity positions if the deterioration continues. When prices fall that far that fast, it creates structural problems for the market. This is espe- cially true with leveraged instruments such as futures and leveraged equi- ties. With equities, the margin requirement is 50 percent (for patterned day traders, only 25 percent) and with futures, it is only about 5 percent (maybe even less). Take, for example, an S&P e-mini contract. The value of the contract is about $70,000, but if you carry the position overnight, a good- faith margin of only about $3,000 to $4,000 is required. If a trader buys one contract at 1,250 and the market falls to 1,125, the loss on that contract is
$6,250. Remember that only $3,000 to $4,000 secures the contract. There- fore, the brokerage house must issue a margin call or liquidate the position.
Additional selling will be forced on the market at a time when buyers are already scarce. The effect of this selling will not only be reflected in the futures markets, but will also effect the equity markets as traders are forced to sell positions to cover margin calls. This selling will accelerate the downward momentum and force prices even lower. Also, remember that if prices fall that far that fast there will be an emotional response; the mass of investors will not rely on rational analysis but panic.
Once the markets enter a crisis mode, it may be too late to take protec- tive action. Prepare in advance. Look at your portfolio and determine the
amount of loss you can afford to suffer. If the market heads south at a neck- breaking speed, how far can you afford to travel with it? Once equity mar- kets drop 10 percent in eight weeks, some traders (this one included) will seriously be considering whether to hold any equity positions. However, for a variety of reasons, many traders do not want to liquidate holdings.
Therefore, you should use firm stop/loss orders to prevent a devastation of your portfolio. As noted earlier, you are not guaranteed to be filled at your stop price. However, at least a stop/loss order should offer some cover and some protection.
After the market has dropped 10 percent in eight weeks, you can adjust stop/loss orders so that you are no more than 10 to 15 percent below mar- ket prices. If the equity markets continue to struggle, you should consider tightening stops by 3 percent a month. In this way, you can limit the bleed- ing. No one likes losing money, but at least with stop/loss orders in place, the extent of your exposure should be limited.
Purchasing Gold or Precious Metals
Gold is the traditional inflationary hedge, and historically it has been con- sidered a safe haven in time of crisis. In the not-so-distant past, faced with soaring oil prices, geopolitical crisis, steady interest rate increases, and fears of inflation, gold prices have posted a 26-year high. Not since the 1980s has the market seen prices like those that have been seen in 2006.
Should equity markets go into a free fall, you might want to purchase gold or precious metals.
Gold is an international currency meriting respect around the globe.
Having a core position in gold should significantly reduce risk during times of market turmoil. There are several ways to purchase gold. You may, of course, buy gold and stockpile it, but few investors want to take that course.
You may also purchase shares of stock in gold mining corporations.
With a little research, the interested investor can find a number of gold stocks to consider. However, you must be aware of mine-specific risk. That is, if you invest in mine AB, and the mine AB floods or is unproductive for some other reason, gold prices may be shooting out the roof, but the invest- ment will be in the cellar.
One way to avoid this risk is to invest in a well-managed gold mutual fund. No gold stock or mutual fund recommendations are made here;
explore the possibilities and do your homework. You may also purchase STRATEGIES FOR MANAGING CRISIS SITUATIONS
gold futures. Gold futures are traded electronically at the Chicago Board of Trade (CBOT). Futures are not for everyone, as they are highly leveraged instruments and you need training and experience before jumping head- long into this arena. However, gold futures may offer just the right hedge for some portfolios.
Another gold trading avenue is exchange traded gold funds. Finally, there are exchange traded gold shares like GLD or IAU, where each share is equal to 1/10 of an ounce of gold. Gold is actually purchased and stored.
If you own ten shares, you own an ounce of gold, but you do not have to be concerned with holding the metal and storing it. The informed investor has many ways to enter the gold market. Regardless of the manner in which gold is held, short of investing in an unproductive mine or a poorly managed fund or corporation, gold should offer protection from market storms.
Using Index Futures as a Hedge
If a crisis hits the market, another possibility is to hedge an equity position with an index position. For example, assume you are holding a diversified portfolio of shares with a value of approximately $180,000. Also assume that the portfolio has volatility closely correlated to the S&P 500. (Many stocks mimic the movement of the S&P or other well-known index.) Once you identify the correlation, sell the appropriate number of index contracts to offset long equity holdings.
Futures contracts on the S&P and Nasdaq are traded at the Chicago Mer- cantile Exchange (CME) and Dow futures are traded at the Chicago Board of Trade (CBOT). Both large and mini contracts are offered. The Big S&P trades for $250 per point, the mini S&P trades at $50 per point. The Big Nasdaq goes for $100 per point, the mini for $10. Finally, the Big Dow trades for $10 per point and the mini for $5.
Here is how the strategy might work on one individual stock. Assume that you own 1,000 shares of stock, and for every five points of S&P movement, the stock price changes by approximately $1.00. You can sell four e-mini S&P futures contracts and mitigate the position. For example, if the stock moves down five points, your equity account decreases by
$1,000. However, the four short S&P positions are making money as the market drops. When the S&P Index futures drop by five points, you have recouped $1,000.
Again, futures are not for everyone. They have particular risks but the rewards can also be large. Education is essential before trading them. Being an educated and informed trader is the key to being a successful trader.
Also, a margin account and a trading platform are required, so you must be prepared before a crisis hits.
Hedging with a LEAP
The Chicago Board Options Exchange (CBOE) defines a LEAP (Long-term Equity Anticipation Security) as a long-dated put or call option on common stock or ADRs. These options allow the holder the right to purchase a call or sell a put (for a specified number of stock shares) at a predetermined price until the expiration date of the option. With LEAPS, the expiration date may be three years in the future.
In a down market, I recommend strictly a long DELTA approach to options. That is, only buy calls or buy puts. Options and LEAPS may allow you to hold your equity positions while also protecting your downside. For example, assume that you are holding a portfolio worth $200,000. You could buy October 2007 Dow Jones or S&P LEAP puts with a strike price approximately 7 percent below current market prices. If the market drops severely, the LEAPS will go up in value offering protection for the dropping equities.
The cost of the LEAP is the purchase price and the commission, and that is the risk that you face. In case of a strong market downturn, that would be a small price to pay for some portfolio insurance.
These are only a few strategies that you might want to use to get pro- tection for your portfolio should the markets head south. Investigate the range of possibilities available to you and be prepared to act in case Iran or South Korea or some terrorist organization aims torpedoes at your port- folio. The bottom line is, you must educate yourself and be prepared. You never know when that education and preparation will really pay off.
What if the market crashed tomorrow? Would you be prepared? Play the what-if game. What if Osama Bin Laden were captured? How would your portfolio suffer? What if there is an oil crisis and fuel is unavailable?
What will happen on Wall Street and across America? What if equity prices drop by 10 percent? Or, 50 percent? Do you have any plan in place to pro- tect yourself ?
The most important thing that you can do to protect yourself from a market meltdown is to be prepared. You must think in advance and develop a strategy. If you are going to execute any of the above trading tac- tics, you must have the right kind of account, the right trading platform, ESSENTIAL STEP: DEVELOP AN ACTION PLAN
and the education to know how to use them. Once disaster hits it is too late. Therefore, you must investigate possibilities and opportunities now.
As a trader, I take risks every day. However, I take calculated risks and put the odds on my side. Years ago I traded like a cowboy. I threw caution to the wind and took unnecessary risks, and I lived to regret it. I paid far too little attention to the dangers of the market and spent my time dreaming about the pot of gold that waited for me at the end of the rainbow. I managed to do well for a number of years by using that approach. Then there was Octo- ber 19, 1987, and my life flipped upside down. All of those great trades that I had made meant nothing. All of those profits that were acquired during the course of many, many trades and several years were gone in a day. I had fearlessly faced the traders of Wall Street and I lost everything because I took an all or nothing approach—and I got nothing.
I realized that if I wanted to continue to trade the global markets, I had to change my style. I had to be smart and avoid unnecessary risk. If I could not or would not do that, I had to give up trading. That sobering reality fun- damentally changed the way that I do business. Today I analyze the risk involved in every trade first; only if the risk is acceptable do I consider making the trade. To stay in the day trading game for the long term, do the following:
Protect Your Trading Account
Simply stated, I trade to make money. Just as the profits from the shop down the street provide the proprietor with his income, my trading account and my market skills and acumen bring home the bacon for my family.
When I put my hard-earned cash on the line and take a market risk, it is not a game; it is a serious venture. Consequently, I manage my account like any good businessman manages his business’s capital. I watch every penny and I am careful to take steps to protect my assets. Otherwise, money that is made on one trade or investment is lost in the next one.
You must keep up with both your profits and your losses. If losses get too great during any week, day, or session, you must stop trading. Some- thing is wrong. One or more of several things is happening: The strategy is not working, the strategy is not being executed properly, or the market STRATEGIES FOR MANAGING RISK WHILE
DAY TRADING
is too unpredictable. In any case, wise traders get out of the market and go to the sidelines until they analyze the situation and rectify it.
Worry about Risk First, and Only Then Consider the Rewards
The risk involved in a trade must be your primary concern. Forget about the rewards. If the risk is managed and controlled, the rewards will come.
Putting risk management first seems so simple, but it is not. I learned it the hard way. When I consider making a trade I calculate the risk involved.
Only if I am able and willing to take the risk, will I make the trade. The mar- kets offer many good trading opportunities; why take bad ones? You must wait and be patient, and winning trades will come.
Calculate the Risk of Every Trade
If you do not know the risk involved in a trade, you should not take it.
Therefore, before clicking the mouse, calculate the risk. Here is how I do it. I determine my entry price and my stop/loss placement. The stop/loss placement is the point at which you place a protective stop to pull out of the market if you are wrong. There are several ways to determine stop/loss placement. The first and most inefficient way is arbitrarily. Determine the amount of loss that you are willing to endure and place a stop at that point.
For example, on an equity position, if you are only willing to lose $1.00 per share, place a stop-loss order $1.00 below the point of entry. Assuming that the system works correctly, you know the maximum risk to which you are exposed, because when the loss is suffered, the order is executed and the trader is removed from the market. An arbitrary stop is not ideal, but it is better than no protective stop at all.
A better way to determine your true risk is to use key numbers and charts to identify support and resistance levels. Support is the point at which prices have difficulty falling below because buyers step in and pull prices upward. Resistanceis the point at which prices have difficulty ris- ing above because sellers step in and push prices down. If you are selling or shorting the market, a protective stop or stop/loss order should be placed just above resistance. If enough buyers come into the market and the bulls are strong enough to break resistance, you want to be removed from the position, because staying in is just too risky. Likewise, if you are a buyer and long in the market, you want your protective stop or stop/loss order to be just below support. If the bears are strong enough to break sup- port, a further sell-off may be in the cards and a prudent trader does not want to be along for the ride.