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Exits: Know When To Hold ’em, Know When To Fold ’em

Originally published March 29, 2016 We all focus a lot of attention, perhaps too much attention, on where to buy and sell a market, on where to enter trades. Today, let’s spend some time looking at the other side: where are you getting out? Some categories are useful here, and they are not complicated. First, we have exiting at a loss, or at a profit. (This is not necessarily the same as saying exiting on a stop or at a profit, because a (trailing) stop can often be a profit-taking technique.) Both of these can then be divided into two more categories: Exiting at the initial loss or a reduced loss, and profit taking against a stop or at a limit. Let’s spend a few moments thinking about each of these. Initial stops The most important think about initial stops is that you have one. Though so many trading axioms and sayings do not apply universally, one that does is “know where you’re getting out before you get in.” For every trade, you should have a clearly defined maximum loss, and you should work hard to make sure that loss is never exceeded. In practice, bad things will happen. You will have the (hopefully rare) experience of a nasty gap beyond your stop, and sometimes will see losses that are whole number multiples of your initial trade risk. (I remember one lovely -4.5x loss in Yahoo (NASDAQ: YHOO ) years ago. Though these events are rare, they are also a good reminder of we do not, for instance, risk 10% of our accounts on a trade. A 45% loss on a single trade would be a disaster, but 4.5x a reasonable risk (1%-2%) is merely annoying.) Initial stop placement is an art in itself, but, in general, I think too much of the material on the internet probably uses stops that are too tight. I’ve never seen anyone trade successfully with stops that are a few ticks wide. For me, initial stops usually end up somewhere around 3-4 ATRs from the entry. These stops are wide enough that many traders find them uncomfortable, but simply reducing position size to manage the nominal loss is an obvious solution. Taking losses is perhaps the most important thing you will do as a trader, so do it well and do it properly. Click to enlarge Reduced stops We have defined that initial “never to be exceeded” (ideally) stop at trade entry, but many traders find it effective to move that stop rather quickly. Another possibility to consider is the time stop, in which we take steps to limit the position risk if the trade does not move in some defined time. There are many possibilities here, ranging from tightening the stop, to reducing the position, to exiting completely. I have made a good case for not reducing the position at a loss because it effectively “deleverages” your P&L in the “loss space.” (See the chart above, which is drawn from pages 242 and 243 of my book.) Personally, I’ve found that simply taking whole, but smaller than initial, losses is more effective, but your experience may be different. A key point here is that all of this – entry, exit, position size, moving stops, taking targets, re-entries, adding to positions, partial exits, etc. – all of this must work together. You change one piece, and the whole system will change. This is why some techniques may be effective in some settings but not in others. To simplify, think of reduced stops as being moved when the trade does not immediately go far enough in your favor, and consider the use of time stops. Profit targets Profit targets are usually limit orders, as opposed to stops (which, not surprisingly, are usually stop orders). In general, I find that it makes sense to have profit taking limit orders working in 24-hour markets, though we may not wish to work stops in the same after-hours environments. People sometimes make mistakes or do silly things in after-hours, and I’m always happy to provide liquidity at the right prices. There is a school of thought that says that all trades should simply be exited at profit targets, while there is a conflicting school that says we must let our winners run. How to reconcile these two approaches? I think the answer lies in trading style. For trend traders, we must let our profits run. As countertrend traders, we must take quick profits, usually at pre-defined areas. I have not found chart patterns or points to be any more effective than simply setting a target 1x my initial risk on the “other side” of the entry. Many people like to use pivots or trendlines, but I’ve executed well tens of thousands of trades (one of the advantages of spending years as short-term trader) and have simply not found these to be that effective. (For intraday traders, highs and lows of the day do deserve respect.) Consider the tradeoffs in simplifying your approach. Trailing stops Trailing stops can be managed in many ways, and I have found these to be very effective in many types of trading. We can trail at some volatility-adjusted measure, and there are even times we trail a very tight stop, effectively hoping to be taken out of the trade. This is a good problem to have: sometimes you may trail a stop at yesterday’s low, and be shocked as the trade grinds in your favor week after week – there’s nothing to be done in these cases but be forced to stay in the trade and make more money, but guard against hubris: many of the times this has happened to me; I have been properly positioned into a climax move. When these moves end, they often end dramatically, so simply ring the register and step away from the market. Putting it all together This is certainly not an exhaustive list of all the possible ways to exit trades, but it will get you started in the right direction. I find that combining these techniques, using a pre-defined target for part of the trade, trailing the stop on the rest, and moving quickly to reduce initial risk on my rather wide initial stops, this works very well for swing trading the markets I follow. Consistency certainly matters, but consistently doing something that works will, not surprisingly, lead to consistently losing money. Make sure you have a well-designed system with an edge, and that the system is one you can follow in actual trading. Make sure you trade with appropriate size and risk, and that you monitor your performance accordingly. With these guidelines, you can be a few steps closer to developing your own system and approach to trading.

Best And Worst Q2’16: Energy ETFs, Mutual Funds And Key Holdings

The Energy sector ranks last out of the ten sectors as detailed in our Q2’16 Sector Ratings for ETFs and Mutual Funds report. Last quarter , the Energy sector ranked ninth. It gets our Very Dangerous rating, which is based on aggregation of ratings of 22 ETFs and 100 mutual funds in the Energy sector. See a recap of our Q1’16 Sector Ratings here . Figures 1 and 2 show the five best and worst rated ETFs and mutual funds in the sector. Not all Energy sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 144). This variation creates drastically different investment implications and, therefore, ratings. Investors should not buy any Energy ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off. Figure 1: ETFs with the Best & Worst Ratings – Top 5 Click to enlarge * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Four ETFs are excluded from Figure 1 because their total net assets are below $100 million and do not meet our liquidity minimums. Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 Click to enlarge * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Rydex Series Energy Service Portfolio (MUTF: RYVIX ) is excluded from Figure 2 because its total net assets are below $100 million and do not meet our liquidity minimums. Market Vectors Oil Services ETF (NYSEARCA: OIH ) is the top-rated Energy ETF and MainStay Cushing Renaissance Advantage Fund (MUTF: CRZZX ) is the top-rated Energy mutual fund. Both earn a Neutral rating. iShares US Oil & Gas Exploration & Production ETF (NYSEARCA: IEO ) is the worst rated Energy ETF and Saratoga Advantage Energy and Basic Materials Portfolio (MUTF: SBMBX ) is the worst rated Energy mutual fund. Both earn a Very Dangerous rating. 178 stocks of the 3000+ we cover are classified as Energy stocks. LyondellBasell Industries (NYSE: LYB ) is one of our favorite stocks held by CRZZX and earns a Very Attractive rating. Over the past five years, LYB has grown after-tax profit ( NOPAT ) by 10% compounded annually. Over the same time period, Lyondell’s return on invested capital ( ROIC ) has improved from 17% to a top-quintile 22%. Additionally, over the past four years, LYB has generated a cumulative $14.8 billion in free cash flow . Despite the strength of the business, LYB is undervalued. At its current price of $88/share, LYB has a price-to-economic book value ( PEBV ) ratio of 0.8. This ratio means that the market expects LYB’s NOPAT to permanently decline by 20% from current levels. If LYB can grow NOPAT by just 4% compounded annually for the next decade , the stock is worth $139/share today – a 58% upside. Hess Corporation (NYSE: HES ) is one of our least favorite stocks held by IEO and earns a Dangerous rating. Contrary to GAAP net income, which has fluctuated wildly over the past decade, Hess’ NOPAT has only worsened by declining from $1.7 billion in 2005 to -$859 million in 2015. Over the same time period, Hess’ ROIC has fallen from 11% to -2%. In a large disconnect from reality, HES has risen over 50% over the past three months, which has made shares more overvalued. In order to justify its current price of $57/share, Hess must immediately achieve positive pre-tax margins (from -22% in 2015) and grow revenue by 20% compounded annually for the next 20 years . In this scenario, 20 years from now Hess would be generating $254 billion in revenue, which would nearly equal oil giant Exxon’s 2015 revenue. The expectations already embedded in HES are unrealistically high. Figures 3 and 4 show the rating landscape of all Energy ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs Click to enlarge Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds Click to enlarge Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Declining Housing Starts Equals Big Profits

Since peaking at 2,111 on April 20, 2016, the S&P 500 has rolled over. The broad market index now sits at 2,050 – nearly 3% lower in just a couple of weeks. The S&P 500 chart below has a distinctly negative look to it. Click to enlarge As the S&P 500 peaked, the moving average convergence divergence (MACD) momentum indicator showed significant negative divergence. This is a strong warning sign that the current rally is exhibiting exhaustion and could be vulnerable to a reversal. The S&P is well-below its 9-day exponential moving average (EMA) of 2,068, which means the market could test its 50-day moving average at 2,035. But given recent negative readings on a host of economic reports here and around the globe, there’s a real possibility that a much deeper move is in the cards. And should the market pass through the 2,035 level, there is no real support until roughly 1,980. That’s another 3.4% from current levels. For this reason, traders should use any strength in the market to unload long positions, while also adding short positions. One possible short position is the S&P Homebuilders Fund (NYSE: XHB ) You see, the homebuilding sector is vulnerable here to a sharp pullback. Below is a chart of XHB… Click to enlarge This chart looks eerily similar to the S&P 500 chart. It shows that XHB has also fallen below its 9-day EMA, while also sitting at its 50-day moving average. This means the $34 level effectively becomes XHB’s new level of resistance. This provides an excellent opportunity to short XHB. With the close proximity to the new resistance level at $34, we can quickly exit the position if resistance with a small loss if resistance breaks. On the other hand, if the nine-day resistance holds, XHB should fall to one of the lower support lines at about $31.20 or as low as $30.20. Now, we hold that the $30.20 price target best aligns with our expectation of a moderate pullback (~3.4%) in the S&P 500. This make $30.20 a reasonable target over the next few weeks. XHB closed at $33.29 today. Now, by taking a short position at this level, we’re risking $0.54 per share if the stock moves higher. Conversely, we stand to pocket $3.00 per share if we’re right and XHB moves lower. That gives us a good risk/reward setup. But we can mitigate our risk even further by purchasing put options on XHB instead of shorting the stock. Here’s how… Let’s assume you’d typically short 500 shares of a recommended stock. At today’s price of $33.29, you’d pony up about $16,650 to short the shares. Now, most investors are willing to absorb a 10% drawdown on shorted stocks should the stock run the wrong direction. This would limit your loss to $1,665 before you exited the position. But, because $1,665 is the most you’re willing to risk, you could instead use the $1,650 to buy the puts. But let’s reduce our risk even further by cutting our maximum loss in half… The XHB June $34 puts closed Thursday at $1.15. With $825, you can purchase seven put options on XHB. Since each option contract covers 100 shares, that gives you control of 700 shares of XHB – versus the 500 shares you would have shorted with the $16,665. You’ve reduced the risk on this trade, while also increasing the potential reward by controlling more shares. This is the right way to speculate with puts. Of course, if we’re wrong on this trade, you could lose 100% of the money you used to buy the puts. But it’s far better to lose 100% of $825 than to lose 10% of $16,665. And if we’re right on this trade, you can make more money by owning seven puts than by shorting 500 shares. So, by purchasing puts instead of shorting the shares, we reduce our risk and increase our potential reward. It makes for a more intelligent trade for managing risk/reward. Here’s the trade in a nutshell… Buy the XHB June $34 put options (XHB160610P0003400) up to $1.25. This option closed yesterday at $1.15 when XHB closed around $33.29 per share. You should be able to get into this trade as long as XHB is trading above $33.30 per share by the time you enter your order. If the stock falls and the option moves out of range, or if the option spikes higher as a result of this recommendation, give the trade a day or two to come back into range. Going forward, if XHB falls to our downside target at $30.20 per share, the June $34 puts will be worth at least $3. That’s a 161% gain on the trade. Once the options have double in price, sell half the position. This will eliminate any chance of a losing trade. Then focus on maximizing profits if XHB moves lower. One caveat…. It’s important to remember this is a speculative trade. We’re buying short-term options in anticipation of a stock market pullback. There’s no guarantee the market will fall or that XHB will decline even if the broader market falls. You can lose everything you put into this trade. So, please, limit your risk to less than half of what you would normally be willing to lose on the stock. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.