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Greetings, Pro-fundity team members -
08-15-03

At the bottom of the Guidepost, a full listing of this weeks picks are shown, in addition to the Charts via the Pick-link.

As a benefit of membership, you have access to all Guideposts (including Archived GP's) and Picks. If you miss a week or two for whatever reason, you will be able to go into the Historical Guidepost link to catch up with both the weekly guidepost and the 30 picks made for the week.

Greetings, fellow Pro-fundity team members.

1. Last week we punched up the value of using a mechanical trading system for our trades, letting the system make some of the critical decisions. A trading system is a collection of rules providing information and signals where traders should enter and exit positions. The reason lies in the nature of the investing “head-game,” where emotions play such a pivotal role. As we’re able to replace emotion with reason, our trading success will increase accordingly. Don’t misunderstand, emotion is not a bad thing, it is simply human nature. We are wired to avoid loss. None of us ever wants to lose. This means the avoidance of loss is both a conscious and subconscious force in our programming.

2. The trading system must be accompanied by its righteous twin, Money management. From last week’s GP: “A good system without excellent money management is near useless. In its simplest terms, the essence of a winning system is not the steps, the techniques, the signals – that’s just the system. The key is the effectiveness and efficiency of the money management of the system. There are many examples of hot traders who suddenly had a horrendous loss that put them out of business. That usually has little to do with the system and everything to do with money management. Don’t confuse the two. For example, beginners usually have only half a plan, the easy half. They know how much a profit they’re willing to take, but they have no idea how much they‘re willing to lose. Since all trading systems must accommodate losing trades, the first role of money management is to control the losses. That is the function of the stop-loss.”

3. In many investing/trading courses, all of the schemes, entry and exit techniques, fundamental and technical analysis, etc., are covered in detail. Then, almost as an afterthought, we’re told to “always use stops!” Always use stops, good advice. The principle is so important, in our view, that this is where we need to start. This lesson will focus on the use of stops in money management. For example, when our “head” says “losses are unacceptable,” and the price of our latest trade goes south, we hesitate to cut the loss short and allow it to become even a greater loss. That hesitation can be avoided with an automatic stop-loss. This “loss avoidance” mentality can also drive us to exit a trade too soon when we’re afraid of losing the small profit gained. This means we need to focus on rules, not losses. Focusing on losses will guarantee future losses. Remember, our programming - left unchecked - will violate both sides of the first principle in trading; “Cut your losses short, let your profits run.”

4. Your task last week was to focus on a stop-loss by paper-trading the 10 Main picks on 08/08/03, entering each ticker in the PIP and following their daily performance on a price chart. You were asked to execute stops at three different levels (of your choice) and make some conclusions at weeks end about what stop-level feels best. Following is what your PIP should have looked like.
   
   
   Fig. 1 PIP for last week’s assignment.

5. For the paper-trade exercise we invested $1,000 in each ticker and added two columns to show the result with three separate stop-loss levels (-6%, -8%, and –10%). William J. O’Neal of Investors Business Daily recommends a fixed stop level of 8% below our purchase price, under all conditions. In this manner, our risk is never more than 8%. We will see other loss-cut systems, but for this exercise we chose that level and on either side. Look carefully at the pattern of loss levels for each ticker. A comparison of performance, one Friday to the next, is shown on the following Watchlist Tracking table.
   
   
   Fig. 2 Watchlist tracking, from Friday 8/1/03 to Friday 8/8/03.

6. Data in this table simply compares the two dates. Carefully tracking the daily performance, however, we found one occasion where a stop-loss was violated. On 8/14/03, INNO had the following; Open $4.51, High $4.54, Low $4.40, Close $4.51. The 6% stop-loss was $4.43. That means our broker would have sold on that day at some market value near the stop-loss. Notice, it is the low of the day that will kick us out of a position with the stop-loss, not the closing price. None of the other tickers violated any of the three stop-loss levels during the week.
   
   
   Fig. 3 INNO price pattern

7. The black marker is shown on the date of the pick and the violated low price shown with the arrow. Question: Does that low price swing constitute a change in character of the existing pattern? Or is that just normal price variation? Is a 6% stop too tight? We need to understand the relationship between a stop-loss and normal swings in the price pattern. The purpose of a stop is to prevent a small loss from turning into a catastrophe. When the price drops, our intent is to get out before it goes too low. Tight stops, close to the purchase price, will kick us out very quickly, minimizing our loss. However, as we’ve seen with INNO, tight stops can kick us out with small price swings, giving us a bunch of small losses. On the other hand, wide stops, far from the purchase price, will prevent the unnecessary hiccups, giving us a few big losses! You see, there must be some balance here. It is a balance we must find for our own sanity, for our own trading comfort-level. This is not a trivial matter but one that must be studied carefully. This will be a critical brick in the wall of our trading system we spoke of last week.

8. Before we leave the PIP for last week’s picks, notice one ticker exceeded the 10% target price (MESA) and was sold with a 14% profit. The buy date is shown by the black line with price moving up handily. The price on Friday fell $0.03 below the closing price where it was sold. Question: Do we feel good about getting out with over 10% in four days, or is there life left in this pattern?
   
   
   Fig. 4 MESA price pattern

9. Prices in this example did not give us much exercise with stop losses. Let’s go back one more week and look at the Main pick performance on 8/01/03.
   
   
   Fig. 5 Main Pick performance, two weeks out.

10. This week’s focus is on the stop-loss so we’ll look at the worst performer below, MSN. With the marker on the buy-date (8/1/03), we see the expected rise for the next couple of days, but it lost steam and then plummeted on 8/12/03 dropping from $6.68 to $3.35 in one trading session. An 8% stop-loss at the $6.49 buy price was $5.97. The price crashed through the stop on that fateful day. Would it have protected us? There are two ways we can setup a sell safety-net; The Stop-loss order will fill only when the specified price has been reached. Once that price has been reached, it becomes a market order and will be sold at the highest available price. When the stock gaps down like MSN, the actual sell price may be well below our stop-loss price. The second method is called a Stop-limit order where we specify not one but two prices; a stop price and a limit price. Different brokers deal with this in different ways so be sure you understand your broker’s position. In this case, if the price falls to the stop level, it kicks in the limit order (not market order) which will sell at any price down to the limit, but not below. We are telling the broker we want out at the stop but not below the limit. This reduces the uncertainty of the stop-loss, but would probably have left us in the MSN position, at the $3.35 price. (Special Orders are covered in more detail in section 3.1 in our book Provident Investing)
    
    
    Fig. 6 MSN price performance.

11. The Breakout picks on 8/01/03 provides another example for a stop-loss. In this case, CATS brought up the rear with a –15% two-week change. How did our stop protect us here?
    
    
    Fig. 7 Breakout Pick performance, two weeks out.

12. With the marker on the buy-date (8/1/03), this decrease is steady and would have kicked us out with an 8% stop-loss on 8/04/03 near the stop of $5.84. This example satisfies the stop’s purpose. It got us out with a minimum loss.
    
    
    Fig. 8 CATS price performance.

13. To close this lesson lets look at the Quick picks on that same date for yet another stop-loss example. CRY is the culprit here, with over 30% loss in the two-week window. Check the price pattern to see if our stop helped.
    
    
    Fig. 9 Quick pick performance, two weeks out.

14. For CRY, the decrease was rapid but not the large down-gap we saw in MSN. For an 8% stop-loss, we would have been kicked out on 8/05/03 somewhere between $5.90 and $6.90.
    
    
    Fig. 10 CRY price performance.

15. In this lesson we’ve seen examples using the O’Neal default –8% stop-loss. This is but one part of a trading system, albeit a very important part. Unless we protect our capital with stops, we’ll be unable to sustain the losses that are part of the trading business. Careful selection of the stop price is very important to minimize loss. That is, we must use wisdom in knowing how far from the current price to place the stop. The distance between the price and the stop depends largely on the volatility of the chosen stock. Additional stop-methods will be covered in future lessons:
    
    • Trailing Stop – In this technique, the loss level follows price during a trend, remaining a short distance away. This form of stop lets profits run, maximizing gains. We will focus on this method in the next lesson.
      
    • Profit Stop – We saw an example of this in the PIP earlier in the lesson. We had chosen 10% as the target profit, selling then that level was reached. It runs contrary to the trading rule, “Cut your losses short, let your profits run,” we saw that in the MESA example above.
      
    • Time Stop – The exit occurs here after a certain number of days have passed. It is rarely used by itself, but finds utility when a position is not moving, getting you out so you can used the money somewhere else.
      
    • The loss method we have studied in this lesson is called a “Maximum Loss Stop,” getting us out after a predetermined acceptable loss has been exceeded.

16. Your task for this lesson is to paper-trade the Breakout pick list for 8/15/03, repeat last weeks exercise loading all ten tickers into the PIP, select the one stop-loss level you feel best about and record the net percent gain for the week. Submit your results with comments and observations at week’s end to info@pro-fundity.com.
    08-15-03 Pick Selection:

    Main Picks:
    ALSC,CMOS,DGIN,EXEL,FLIR,HYGS,MTLK,NANO,PLXT,SIMG
    Breakouts:
    AAI,BBI,BJ,CGNX,CYD,GTI,GTRC,PCH,PRST,WLDA
    QuickPicks:
    CLZR,CXR,EPIQ,EXLT,IDTI,ITRI,OSUR,RA,SKO,SRNA

    For detail and followup on Pro-fundity Tradescape,
    find the link on "Advanced Trading Tools" on the home page.

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