On Risk and Reward

Risk/Reward

Team, lots of convo this morning re/ risk vs. reward.  I think that’s an important concept to consider.  This speaks directly to what I’m often discussing re/ risk.  That is, that simply identifying a “low risk” trade is only half of the equation.

Think about it.  Any time you can buy a stock and place a very tight stop on that position, you’ve got low risk.  Buy Google at $522 with a stop at $521?  That’s super low risk!  But that doesn’t translate to it being a good trade.  Rather, it only indicates that you’re willing to risk a buck per share on a $521 stock.

1.  What are the chances that you’ll get stopped out at $521?  Pretty darned good.  But that’s OK, right?  Because you’ve only lost $1.  But do that enough times and you’ll bleed to death.

2.  You always want to consider the chances that you’ll get stopped out.  That means buying a stock that is as close as possible to definitive support.  E.g., BRCD ($5.26); SLB ($59.75); WCG ($25.68).

You’ll see that support continues to hold on BRCD and WCG.  SLB broke support today.  Not by much…but it did break support.  So the risk of further downside increases.  Perhaps you don’t just outright sell SLB because the market is so abysmally weak today (Hmmm.  The jobs picture is getting worse?  Whoda thunk it!).  But you at least recognize that risk is heightened on SLB versus BRCD and WCG.

3.  Getting to the reward side of the equation: this is where the “I want my money back” aspect of investor behavior comes into play.  Gauging that dynamic is more complex than you might think.  Volume/price is a big variable.  The volume accompanying a decline can tell you a lot.  For example, if a stock declines dramatically on very high volume, it might be safe to say that the high volume sell off was a puke fest (not a technical term, that’s a “Dan-ism”), which leaves few “I want my money back” traders and many “What the heck just happened?” traders.  That often results in a greater potential reward than a situation where a stock declines on light volume but with well-defined resistance closely overhead.  (To my beloved engineer members: There is no definitive formula for “high volume” that differentiates/defines reward.  But if you must, you might use 3.141592653585 x average volume.  That number works for many things.  [Mathematicians will get my weak attempt at humor]).

Summary: It’s important to consider risk…and to consider reward.  Consider them separately.  As a general rule of thumb, my minimum requirement would be $2 of reward for every $1 risked, but I’d sure prefer $3 – $1.  This is why, in this type of market, I think that watching stocks that are near their 52-week highs can be fruitful.  There is little overhead resistance and buying pullbacks has, by definition, been working.  That leaves few traders/investors who just want to get out at break-even.  If a 52-week high stock suffers a BIG breakdown, the aforementioned dynamic has changed.  For example, RINO (a perennial crowd favorite here) is a great example of a stock that had been printing many 52-week highs, but broke decisively back in early January. 

Once that prolonged breakdown occurred, experienced traders were saying “Next.” 

More neophyte traders were saying, “Hey, it’s a great company and I can buy it on the cheap.” 

Wrong.

When a random stock runs from $2 up to $32  in less than a year, I think it’s a pretty safe bet that the big money has exited the stock long ago and is looking for the next 15 bagger somewhere else.  That leaves the weak hands (i.e., the traders who found the stock late, don’t even know why they’re holding it, and don’t realize that there is no one behind them to push the stock up more) as the dominant group of shareholders. 

They’re always the most poorly capitalized and do not have the staying power to stick with a stock that’s no longer going up (nor should they). 

The result is a trade that magically becomes an investment.  I guarantee you that some SMM members are silently holding RINO with a cost-basis of $28-$30, waiting in quiet desperation for the stock to advance more than 50% so they can get out at even money.  That’s an investment that will require more patience than Job.  It was a bad trade, for illusory reasons, and is now a position that sucks the life right out of you.  (And when I’m holding a crappy position like that [which hasn’t happened in a long, long time], I ask myself this simple question: “If I weren’t holding this crappy stock already, would I buy it?”  The answer is always, “Um,…nope.”

I’ve digressed, but I think that the concepts I discussed are important concepts for you to get your arms around if you want to become more profitable traders who don’t constantly have your lives in turmoil because you bought a bunch of pain and refuse to let it go.

Hope this helps.

Dan