|Posted by bulldogtrading on June 15, 2009 at 12:50 PM|
Last time I discussed the use of a team's playmakers in order to get ahead in a game. Strategies for investing and trading should beused to actively push your capital further. This time we complete our team withthe building of our defense.
Playing Defense: Protecting Your Capital in the Market
Just like in football, or any sport for that matter scoring points alone will not win you a game. In the market it is no different; we needto make sure our points, or gains are greater than our losses or our opponentspoints. This is done by playing defense to suppress the other side. We can do this in several ways.
First we need to have a system in place to guide our investing or trading activities. Our system needs to be tested and should berobust enough to withstand the test of time. This system should be found to beprofitable consistently when practiced with paper trading and or forwardtesting (Forward testing would be a great topic for a future post).
Next in our defense is probably the most important thing aninvestor can do. That is to have a stop in place on every single trade. This iscontrary to what most people believe should be done. Most will say ?Oh myinvestment has gone down about 15% since I bought it, I?ll just hold until Iget it back?. This is a very naive thing to say. For one lets say you have $100 and you loose 5% you need 100/95 = 5.25% to get to break even. Now lets seeabout 15%, 100/85 = about 17%. Do you see what I?m getting at? The farther yourinvestment falls the greater the percentage gain you need to recover to getback to even. What are you going to do when that 15% is now a 50% loss? Willyou wait for your investment to double to get back to break even? Stops willforce you to keep your losers to a minimum. If we have many small losers but afew rather large winners we will come out on top.
One of my last pieces of defense is to know when not to getin the game at all! Many people invest with a Buy & Hold approach. This isn't really a strategy because all you're doing is buying in hopes of it goingup?eventually that is. Let's do another example. Let's say you made a $1000 investment in a stock and over the course of 10 years you made 100% profit. Younow have $2000 (assuming no dividends and not taking into account commissions) let?ssee what you could have by consistently making about 15% per year for 10 years. After 1 year you would have $1150, after 2 years 1322, 1520, 1749, 2011. Catching the trend here? Hoping for a one time big move is a childish dream. The real money is obtained by constantly growing your capital.
Now getting back to playing defense if you were to be a B&H investor during the last bear market (2007 approx. to today) you wouldbe down about 40%. Now by being an active investor you could have realized thata DOWN Trending market is not what you want to be investing in. When the marketis in a downtrend your best move is to stay out completely. If you look at achart of SPY the ETF that tracks the S&P 500 you could have seen thatsomething was obviously wrong as far back as December of 2007 (when the marketfell below its 200 EMA and failed to rally above it). Once you see a change inthe trend your best option is to stay out. What would you rather have to startwith when the next bull market starts, 60% of your capital or 80%? Don't let anyone fool you by saying your going to miss out on the market recovery, trust me there will be plenty of upside profit for you when it does turn around. Inthe mean time let your friends and your idiot investment advisors pretend theycatch a falling knife without getting cut.