F
inancial publications generally tout their stock picks. Especially dur- ing December or January, they print those eye-grabbing headlines directing readers to articles about “The Top Ten Stocks to Own” or“The Must-Have Stocks to Add to Your Portfolio.” The stock-picking game is a lot of fun; I like to play it myself. However, by the time the holiday bells ring in December, some of the picks that looked so good in January have generally lost their luster. During the course of the year, some of them did well and others did not. After all, no one has a crystal ball, and much can happen during the course of a year.
Therefore, a better strategy is to approach the markets without any bias or preconceived notions. You should never adopt someone else’s list of stocks and simply phone your broker to make the purchase. Maybe the stocks on the “best picks” list were once good equities to own, but now the economic picture has changed. Or, perhaps those stocks are not the right stocks for your particular portfolio.
Although I do a good bit of short-term, intraday trading, I also make some long-term plays. I like to reevaluate my equity positions when each year starts. Here is the general strategy that I use. I identify 10 high per- formers by studying stock performance during the last quarter of the previous year. Then, as odd as it might seem, I eliminate those stocks from my list. So, after identifying the stocks in the top 10 percent for the final quarter of 2006, I scratch them from my list for 2007. The reason is
139
simple—experience has taught me that many of these stocks have ex- hausted their upward momentum.
One good historical example is eBay. In 2004, eBay was flying high and I loved it. I regularly traded it, and it proved to be very profitable for me.
When 2004 came to an end, eBay was in the top 10 percent of stocks dur- ing the final quarter. Then 2005 began. Per my parameters, I did not trade eBay in 2005, and eBay proved to be a marginal performer. I scratched Apple from my list for 2006 because Apple was in the top 10 percent in 2005. Maybe a stock will continue its upward climb, but I will not be climb- ing with it. I will bet on another rising star for my long-term plays.
Now that the top 10 percent of performers from 2005 are eliminated, I focus on the losers. I eliminate the bottom 50 percent of performers during the final quarter of the year. That leaves me a nice list of stocks to trade.
Once I have my stock trading universe, I follow the same procedure previously outlined. That is, I select stocks with liquidity (two to three mil- lion shares traded per day). I want some price movement in the stock, and I focus on equities that have an average true range of at least $1.00. I like volatility, because that is the only way that I can get paid. So, a beta of 2 or better is good for me. I also check to see that the stock is in a bullish sec- tor and that the sector is in sync with a bullish market. I study the stock’s personality and identify its particular trading patterns. Now, I am ready to select the stocks that I want to buy.
Each year I track the stocks I plan to trade. I begin my yearly tracking process by recording the yearly opening price. That is the place where the first big battle of the year between the bulls and the bears will be waged.
The bulls will struggle to pull the price higher while the bears will do their best to push it down. After recording the yearly opening price, I track its monthly opening. From month to month, I want to know if prices are mov- ing up or down. I use these monthly prices to form a trend line. In addition to tracking the monthly opening prices, I also track each weekly open. By following this simple procedure, I can look at my trend line and get a good idea of the overall health of that particular stock.
Now I use the numbers that I gathered. I will not buy a stock unless it rises above the yearly open. I may sell it, but I will not buy it—at least not on a long-term basis. If a stock is following an upward path, I will check its progress. In relation to the last month or two, how is it doing? On a weekly basis, are the bulls winning the battle? If so, it may well be one of my plays.
As with other products, I look at resistance. I do not want to go long just before a strong resistance level. I wait for resistance to be broken before I risk any capital. If this month’s opening price is $52.75, I will wait to be sure that the market is strong enough to get above it before I lay my money down. I know that the monthly open will be a point where resist-
ance will be strong. If it is too strong, the bears may be able to take charge and move prices down. Another big resistance level will be the yearly high.
If the stock is trading close to that level, let the bulls get it over that level of big resistance before taking a long position.
When I make a stock purchase, I always know my stop placement and my profit target. I determine my profit target by viewing a chart of the stock and identifying the points of resistance over a three- to six-month period. As prices rise to the next strong resistance level, I will probably take at least some profits. Then I will adjust my stop closer to the current trading price to reduce my risk and lock in some cash. As the stock trades in my favor, I will continue to lighten my load by taking out more profits.
As long as the stock keeps paying me, I will probably stay with it, but as each new resistance level is broken, I will tighten my stop.
I identify my stop placement in a similar manner. I look at a monthly chart for a three- to six-month period. I note the areas of key support. I place my stop just below the first big support level. As prices move up, I adjust the stop placement accordingly. I may stay with the stock for months. It just depends on its movement and whether it is paying me.
Regardless of what you trade, it is never a good idea to make an investment and fail to track it. Check the market on a daily basis and look at equity holdings. If you respect your money and want to keep it, you need to take some personal responsibility for your assets and follow prices.
Exchange traded funds (ETFs) may also be good long-term plays. Each of the major indexes has a fund. These are actually stocks that are much like a mutual fund. The QQQQ is an index stock for the Nasdaq. It is traded on the Nasdaq exchange. The Spyder is an index stock for the S&P 500 and it is traded on the American Exchange. The Diamond is an index stock for the Dow Jones. It, too, is traded on the American Exchange. I am par- tial to the Diamond because it is generally very volatile, and I like that characteristic.
Exchange traded funds have a number of advantages over common stock. First, they are less news sensitive. If a trader owns IBM and IBM NEVER ADOPT A “BUY IT AND FORGET IT”
STRATEGY
EXCHANGE TRADED FUNDS
reports bad earnings, or he owns XYZ and the CEO goes to jail, the stock price sinks. But, with ETFs, the problem is minimized because the stock is a combination of all stocks on the index. Just because one of the holdings in the fund goes south, does not mean that the entire fund will take a dive.
That aspect of ETFs offers some protection.
Another approach you might wish to consider is selling a covered call.
Assume that you want to hold a long stock position, but also want to make some cash on the play. If the stock is not paying a dividend, you are out of luck. However, there is another approach you may consider. You can try to keep the stock while letting it generate some income by selling a covered call. Here is how it works. You own a stock position. You sell a call that is out of the money. That means that the agreed strike price or price at which you will be forced to sell the stock is above the current trading price. You receive a premium for the option sale. If the stock reaches the strike price, you must sell at the agreed price, but you still make money on the rising stock price. You also make money on the sale of the option. If the strike price is not hit, you have the premium and you still have the stock.
TRADING OPTIONS
Call Option
Selling a covered call option is an option strategy whereby one is long stock and writes an option against the shares on a one-to-one basis.
Here is how the play may work. Assume that you own shares in the Board of Trade (BOT) and you want to hold onto your position. The shares are trading at $120 per share. You sell a $130 call. It is a near-month call so you do not have a great deal of time before expiration. Assume it is July and the call expires in August. If the strike price is not reached, the option expires, and is worthless to the buyer. You pocket the premium of $130 (100 shares at $1.30). Now you have the premium and the stock. If the strike price is hit, you must sell the shares at $130. That means that you
have made a profit of $10 per share and have also received a premium for the option. One of my friends and students, Russ, holds a position in XLU, a utility exchange traded fund. Russ has used this strategy a number of times and has experienced great success with it. Translation: Russ has made a good bit of money selling covered calls.
One of the secrets to executing this strategy is trading only near-term options. You are literally banking on the fact that the strike price will not be reached. Therefore, time decay is working in your favor. You do not want to sell a covered call more than 45 days out; the greater the time, the greater the risk that the strike price may be reached.
If executed correctly in the right market conditions, this strategy is a good way for you to really have your cake and eat it, too. Always know the risk of any trade before taking it. Ask your broker about the specific risk of trading options.
I like to buy and hold mutual fund positions. Let me explain my approach. I identify the top-10 performing mutual funds for the previous year. Then I elim- inate the top two performers. Then I allocate 80 percent of my mutual fund account balance to the remaining eight funds. At the end of the first quar- ter, I close out the worst three funds. I allocate that money to the top five of my remaining funds. At the end of the second quarter, I reallocate again.
I close the worst two funds and add those monies to the top three funds. My profit goal is 10 percent on any given fund. If I have achieved that goal at the end of the second quarter, I either close out the fund profitably or exit half of my funds to lock in the 10 percent profit. At the end of the third quarter, I eliminate the worst performer of my remaining three funds and ride the funds that I have left to the end of the year. At that time, I go to cash. When the New Year begins, I start the process all over again.
There are many ways to make money in the financial markets. I prefer to make a lot of short-term plays, but some traders are more comfortable with a buy-and-hold strategy. If the broad market is bullish, I too take some long positions and hold them for a period of time. If you wish to be a long- TRADING MUTUAL FUNDS CAN BE
ANOTHER GOOD LONG-TERM PLAY
REVIEW
term player, you should select your stocks carefully. I evaluate stock prices at the end of each year. I make a list of stocks that I will trade in the upcoming year. I strike the last year’s performers that are in the top 10 per- cent; many of them have run out of steam. Then, I also eliminate the bot- tom 50 percent. I do not want to risk buying a stock that has historically performed so poorly. The remaining stocks compose my universe of poten- tial stocks for my upcoming year’s trading.
Now I consider other factors such as liquidity, volatility, beta, and how the movements of the stock correspond to price movements of the major indexes like the S&P 500 or the Dow Jones. The charting patterns of a great number of stocks exhibit a close price correlation. That is, when prices on the S&P 500 Index rise or fall, so does the stock price. I like to trade these stocks because the S&P futures can guide my path. You can easily do some investigating and identify some of these stocks.
I use the yearly and monthly opening prices for stocks as key numbers for my purchases. I will not go long on a stock that is trading below its yearly open. I also want the stock to be bullish on a month-to-month basis.
The yearly and month opening prices for the stock are key numbers that can be used for determining stop/loss placement.
Even with my long-term plays, if a stock moves up in price and offers me an opportunity to take some good profits off the table, I will do so with a portion of my position. As prices rise, I will also move my protective stop closer to the market price and lock in profits while reducing risk.
If you own a stock position and want to make a little cash off of it, you may want to consider selling a covered call. The strategy requires that you sell a near-term call with the expectation that it will expire out of the money. Then you will have the ability to keep the shares and also pocket a premium for the sale of the call.
I also trade ETFs like the Diamond and the QQQQ. These funds are traded like stock but have less risk in that they are composed of all of the stocks on a particular index. Also, they are less news sensitive than one individual stock.
Trading mutual funds is yet another way to make a long-term play. As with stocks, I generally go to cash at the end of the year and reevaluate my specific strategy for the next year. I find the top10 best-performing mutual funds. I eliminate the top two and distribute 80 percent of my cash in the remaining eight. At the end of the first quarter, I close the worst three and put that money in the best five funds. At the end of the second quarter I repeat the process. My goal on this entire play is a profit of 10 percent. If that goal is reached on any single fund, I will close it and take the money to the bank, or at least exit half of the position. I keep follow- ing the process of selecting the cream of the crop. At the end of the year I again go to cash, reassess, and start all over again.
Regardless of the trading strategy that you use, you must always watch your money and take personal responsibility for it. Even if you have a financial advisor or manager, you should keep your eyes open so that your assets can be protected and grown.
M A R K E T I N S I G H T M A R K E T I N S I G H T
Always keep an eye on a stock’s yearly opening price. That price will be an important number throughout the year and can be used for determin- ing anticipated support and resistance.
C H A P T E R 1 0