|
Home, choices, Barometer, timing, backtest, signal, buy, SELL, watch Selling Stocks and OptionsSell stocks and options to preserve capital, to exit an acquisition or a downtrend, to rebalance, or to raise cash. Do not take profits and do not respond to news.For call options the rules apply to the underlying stock, not the option itself. Call options that are near expiration can be sold, exercised, or allowed to expire worthless. Preserving capitalContinuing an aggressive strategy is dangerous when the January Barometer gives a negative signal. Diversification will not provide adequate protection because almost all stocks, even defensive stocks, fall in a weak market. The easier way to implement a defensive strategy is to sell everything and stay out of the market until the negative January Barometer expires. The way that would probably be more profitable is to moderate the aggressive strategy by hedging with short positions or put options. Protection is advisable for call options that are deep in the money, as well as for stocks, because they will track their underlying stocks closely. Funds should be sold because there is no practical way to hedge them. The hedges must be carefully chosen. If the hedges underperform, there can be a profit even if the securities being protected decline. However, if the hedges outperform, there can be a loss even if the securities being protected rise. Puts versus optionsIn my opinion, puts make better hedges than shorts. Losses on puts are limited to their premium. However, puts tie up capital and the premium reduces profit. Shorts do not tie up capital and there is no premium, but losses are unlimited, dividends are charged against your account, a negative cash balance with the concomitant exorbitant interest charges can occur, and the daily marking to the market makes your account statement difficult to understand. Another problem with shorts is that shares must be borrowed. You might not be able to short or you might be forced to cover after you short because shares are not available. Hedging strategiesOptimally, a portfolio has the number and volatility of the hedges equal to the number and volatility of the securities being protected. Hedging long stocks with shorts and hedging deep-in-the-money calls with deep-in-the-money puts provide the best volatility matches. But because of the disadvantages of shorts and because deep-in-the-money puts are rare, hedging with near-the-money puts is more practical. To compensate for the poor volatility match, the put option tranche size should be double the tranche size of the security being protected. After the initial hedging, additional hedging will be required for subsequent monthly purchases. Whether hedging with shorts or puts, additional hedging should be made on the following selling day—the first trading day before the 3rd while a negative January Barometer prevails. All hedges must be removed unconditionally on the first trading day before October 28, when the negative January Barometer expires. In traditional hedging, a stock is hedged with a put option on that stock. It defies logic to buy a put option on a stock expected to outperform. If the stock is not expected to outperform, it should be sold. In individual hedging, each security is hedged with a related security that is expected to underperform. A stock is suitable for an individual hedge, either as a short or a put, if it is a direct competitor of the security being protected. In individual hedging, a hedge is closed when the security being protected is sold. In mass hedging, there need be no relation between the hedges and the securities being protected. Hedging is done with shorts or puts on stocks that are expected to underperform the market. Just as with the securities being protected, the hedges should be diversified. In mass hedging, any of the hedges is closed when any of the securities being protected is sold. Exiting an acquisitionWhen a planned acquisition is announced, the stock of the company to be acquired immediately plateaus. There need be no rush to sell, but do not wait too long because there is no more upside potential and the stock will become increasingly difficult to trade. Exiting a downtrendActing immediately on a trend reversal sell signal will ensure that the position is closed out before the downtrend can do much damage. Do not be tempted to use stop loss orders to make the process easier—they have an uncanny way of being executed at an intraday low far from the stop price. When a stock develops a downtrend, as determined by the closing price, sell on the next trading day with a market order. One way to find trend reversals is to create a portfolio at finance.yahoo.com with columns for closing price, high limit, and low limit. The high limit is the highest uptrend closing price and the low limit is the high limit divided by 1.35. The high limit can be determined at finance.google.com or finance.yahoo.com from historical daily closing prices or from stock charts. The high limit and the low limit must be updated each time the uptrend establishes a new high. RebalancingIf one of your positions has increased enough to reduce diversification, the amount held should be reduced. A good rule of thumb is that you should sell half of any position that is more than twice the tranche size. Raising cashOne of the advantages of owning stocks is that they are more liquid than real estate. You can sell them to meet an emergency or take advantage of a rare opportunity and have the money in hand in a few days. This is not generally possible with real estate, although in some circumstances it is possible to obtain money quickly with a home equity loan. If you do not hedge in response to a negative January Barometer, you must sell all stocks. If you hedge, you might need to sell some stocks to avoid exorbitant interest charges by maintaining a positive cash balance. Do not take profitsSome people take profits because they want a high percentage of winning trades. But even though winning percentage is important in sports, in investing you should aim to maximize portfolio gains. If you have large gains and small losses, you can be a winner even if your winning percentage is less than 50%. People who are satisfied with a small profit will never have a large profit. People who refuse to sell declining stocks will have large losses—paper losses are just as destructive as realized losses. If you have small gains and large losses, you might not be a winner even if your winning percentage is more than 50%. Jim Cramer recommends taking some off the table when you have a profit because you are then "playing with the house's money" and "hogs get slaughtered." But it is possible that the best use of the money is to leave it on the table, as Peter Lynch and Warren Buffett have shown. Karen Finerman has a different reason for taking profits. She says that a gain in a stock increases its risk potential and decreases its reward potential. She does not seem to know that stocks move in exaggerated trends. I respect Cramer and Finerman highly, but I have to disagree. There are two contradictory Wall Street sayings—"You can't go broke taking a profit." and "Cut your losses and let your profits run." The latter is correct. In a similar vein, do not protect profits by selectively hedging winning securities. The purpose of hedging is to preserve capital, not to preserve bragging rights. Do not respond to newsDo not respond to local, state, national, or international news. Do not respond to news about a company, industry, or sector. Do not respond to news about wars, popular uprisings, or natural disasters. There is no way of knowing how a security will react to news. There might have already been a reaction because the news was anticipated. If not anticipated, there might be a reaction that plays out before you can act. Any reaction could be partially or completely reversed if consequences are overestimated, or could be followed by a continuation if consequences are underestimated. Manipulators can leak good news to boost stock they own or leak bad news to drive the price down because they are short or wish to buy at a bargain price. Even worse, the "news" is sometimes nothing but a false rumor.
|