Risk Control and the Short-Term
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Short-Term Stock Trends and Risk Control

By
Dr. Winton Felt     

In a volatile market, short-term stock trends can be used to control risk and enhance returns. The amplitude of short-term price swings is often greater than a stock’s appreciation for a full year. Since a person cannot know in advance whether a short-term "dip" will not become a "plunge," it is necessary to pay careful attention to the dips, and to set limits to how much of a decline in stock price will be allowed before selling..

Investors have been dragged kicking and screaming to the realization that buying good quality stocks and putting them in a safe for 5 years is not the way to obtain great returns in the market. That can work with a good mutual fund (if the manager is a good stock-picker who has a good sell discipline), because the manager performs the necessary buying and selling while the investor simply stays put and waits. Though a person might do well sitting and waiting for a mutual fund to perform, sitting and waiting for individual stocks no longer works as well as it once did. On average, the buy and hold approach could net an investor market-level returns or slightly better (market returns range from 7% to about 11%). What’s wrong with that? We must ask ourselves whether that kind of return is worth the risk. We have seen the devastation that can result from this approach in a severe bear market or sudden crash. Unfortunately, we do not have unlimited capital with which to work. For most people, preservation of capital is the prime directive. Let’s clarify what this statement really means. If we say that, "preservation of capital is most important," and then we buy stocks and hold them through their ups and downs, we are not acting in accordance with our stated belief. Acting according to our stated belief means we have to place limits on the behavior of each of our positions. What does this mean in real terms?

One fact that has to be dealt with is that a few years ago the typical "trend" of a stock lasted about 6 months. This was the approximate "central tendency" of the distribution of trend duration measurements, meaning that some trends were shorter and some longer. The curve of probability is skewed because sometimes a stock will trend for well over a year. Recent volatility appears to have shortened the duration of the typical trend. Even if this were not so, there is no way to know in advance which stocks will trend for a year or more. Therefore, to preserve capital, we must be prepared to pull the plug on a position at any time. In other words, issues other than the length of time that we have held an investment must be the deciding factors as to whether we continue to hold or sell. A poor earnings report, the death or retirement of a great company leader, war, a new competitor, and acts of terrorism are all factors that can influence stock behavior. Market behavior tends to anticipate non-random events (insiders, friends, competitors, and other associated persons and their observers often know how companies are doing before those companies release public statements, and all these people buy and sell stock). Thus, changes in the price and volume activity of a stock often precede the news releases and earnings adjustment reports.

Accordingly, if we are to act in accordance with our stated belief that "preservation of capital is most important," then we must be sensitive to the behavior of the stock and set boundaries as to what is "acceptable." Now, think about the implications of what has just been said. In order to incorporate investment policies designed to give the preservation of capital a high priority, we will necessarily tend to have shorter holding periods. In fact, most of our positions will be held for less than a year. This sounds like investment heresy to old-school investors who believe that each investment must be held at least a year, but look at the facts. 1. The market is much more volatile than it has been in the past. 2. It is more subject to plunges of long duration. 3. The average stock trend lasts less than a year.

If company announcements are too slow to generate a sell signal, then we must rely on technical signals. Technical signals are related to the price and volume action of a company’s stock rather than to the status of the company’s financial profile.  Stockdisciplines.com traders rely almost entirely on technical considerations when it comes to selling, because experience has taught them that news pertaining to fundamentals comes out too late. They have found that the stock often responds to the news even before it is widely disseminated. They can "see the announcement" coming in the technical pattern traced by the stock’s behavior. There are thousands of technical systems. A system that is easy to use and that will usually enable a person to be in the stock during most of any enduring positive trend and out of the stock during most of any enduring negative trend, is a simplified 4-week rule. In essence, the system calls for the sale of a stock if it declines so much that it drops below the lowest low reached during the last 4 weeks. Then, when it turns, a purchase is called for when the stock climbs to a high that is higher than the highest high reached during the last 4 weeks. The lowest low for four weeks can be determined by looking at a stock chart at a stock charting Web site. Value Line does not provide 20-day lows, but The Valuator does. Also, using a stop loss tool can be used to get stop losses that are adjusted to the current volatility of the stock. Entering "The Valuator" or "stop loss tool," in Google will provide more information on these. Another approach is to simply go to Google Finance and click on "Historical Prices." There you should be able to get all the data you need for a stock by typing in its symbol.

No investment system designed to protect investment capital while investing in individual stocks can ignore the potential long-term plunges of the market. First, there is no way to know in advance that a "dip" is really not the first leg of a "plunge" (if the dip continues, it becomes a plunge). Since an investor cannot always say, "this is only a dip, so I will keep holding," limits must be set on how negative stock behavior will be allowed to get. This means that though it may sometimes make sense to hold a stock for a year or longer, it is also reasonable to hold many positions less than a year in order to reduce exposure to risk.

 

Get more on this, and see a list of tutorials on disciplines for investors and traders.


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Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com  has a market review page at www.stockdisciplines.com/market-review  has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts  and information and videos about volatility-adjusted stop losses at  www.stockdisciplines.com/stop-losses


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