Martin Zweig Winning on Wall Street
Page 26
Remember, if a stock drops right away—which is about the worst thing that can happen after you purchase it—I’m stopped out with a moderate loss, but I’ve got most of my money left. This gives me the opportunity to find a better stock. That’s right. A small loss, when realized, becomes an opportunity for profit elsewhere. It gives you the chance to turn a liability into an asset, instead of just sitting there praying that your old stock will come back.
So, when I was stopped out of ASA, Sanders, and St. Jude, I took my moderate losses and had the capital left to redeploy into much more promising situations, and happily so, especially since those three stocks were pummeled after I was stopped. Even in the case of MCI, which soared spectacularly shortly after I was taken out, I at least had most of my money left to use elsewhere. I had bought the MCI on July 21, 1982. I did not buy another stock until August 18, the day after the market began to shoot upward. I bought thirteen stocks on August 18, about as many as I’ve ever purchased in one day. Five days later, as the market continued to roll, I recommended the purchase of another six stocks, and three days later I added three more positions. Some of the money used to buy those stocks came from the proceeds of the MCI sale, plus a few other issues in which I had been stopped in July.
Chart Courtesy of Trendline, a division of Standard & Poor’s Corporation
One of my purchases on August 18 was an OTC stock in the computer area called Emulex, mentioned in the last chapter (graph S). I paid 15 for it and sold the last of it in April 1983 at the equivalent of 66½ (it had split 2-for-l, so it was 33¼ on the new stock) for a huge 343.3% profit. I don’t know exactly what I might have done on August 18 had I not been stopped out of MCI. Certainly, at least one stock I bought that day would not have been purchased. Because Emulex, like MCI, was a volatile, high-tech, OTC stock, it was in some sense a good substitute for MCI. Most of the stocks I recommended that day, including the golds and utilities, were not at all good substitutes. Indeed, Emulex was the only one having those characteristics.
It’s a fair probability that I never would have purchased Emulex had I not been stopped out of MCI, and I actually did better in the latter than I would have done at the former, even if I had somehow managed to sell MCI at its exact high in 1983, a most improbable event. Thus, I never look back when I’m stopped, even if that issue turns around on a dime and soars mightily. Rather, I focus my attention on what to do with the proceeds. Granted, there aren’t many Emulexes to be found, but there’s no point in moaning about the fish that got away. One is best off simply trying to hook the next fish.
LOCKING IN PROFITS
As we’ve seen, the first use of a stop is to protect against losses. If the stock goes down shortly after you buy it, the stop forces you to take a moderate loss while keeping the bulk of your capital intact. The second use of the stop is to lock in profits after the stock has begun to rise, obviously a more pleasant task. The idea is to let your profits ride as the stock keeps rallying. As it continues to climb, you keep raising what is called the “trailing stop.” Finally, at some point the market will turn down, and you’ll be taken out with your trailing stop, often showing big profits.
Let’s take a theoretical example. You purchase XYZ at $20 a share, setting a protective stop at $17, 15% below the purchase price. Happily, your stock begins to rise. There is no precise point at which to raise the trailing stop; it’s an art. If I’m still very positive on the market as a whole, I’ll be a bit slower in raising the trailing stop. If general market conditions begin to deteriorate, I am quicker to lift the trailing stop. Occasionally, the stock might rally only a fraction and I’ll still raise the trailing stop because of concern over market conditions. Once in a while I may even become cautious because of something negative about that particular stock. It may not be quite enough to cause me to sell it outright, but for added protection I will tighten the initial stop.
Another factor to consider is the trading behavior of the stock itself. As noted in chapter 11,I favor buying stocks that are generally strong to begin with. Suppose the XYZ was in an uptrend when we purchased it at $20. Suppose that earlier the stock had made a couple of minor downticks from $21 to $20, our purchase point, but had risen from $15 prior to that. Let’s also assume that the stock went no lower than about 19½ on the small reaction after we originally bought it. Now let’s say that XYZ climbs to about $24 a share, giving us a 20% paper profit. This is about the time we should think of raising the stop. One logical spot to put our trailing stop would be around the 19½ area, the low of the previous minor reaction. If all is well with the stock, it ought not break below that point. So a logical stop might be 19 3/8, a fraction below the previous minor low.
Another possible way to determine where to place the trailing stop is to construct an upward trendline connecting the last several low points of the stock. Let’s assume that the upward-sloping trendline currently is at about $20 a share. So an alternative logical point for placing the stop is a fraction below that upward-sloping trend, at about 19 7/8 or 19¾.
Sometimes there is no logical place to put the stop, especially in the case of a breakaway stock. Suppose XYZ suddenly zooms to $30, having never gone higher than the low 20s in its history. At the new price, there’s a very limited trading pattern to analyze. There are no minor bottoms below which to place the trailing stop, and the upward-sloping trendline is so steep as to be useless for this task. This is where it becomes totally an art. I’ll generally attempt at least to raise the stop above my purchase price in order to make sure I don’t lose any money. However, at $30 XYZ would have a 50% profit, and that’s far too much of a gain to lose all of it back.
I would then try to determine how much of a percentage loss would be a “reasonable” reaction without doing any major technical damage to the stock. Suppose I estimated that a 25% reaction, while harsh, might be within reason for a volatile stock. That implies a 7½-point drop to the 22½ zone. So I might set my stop at, say, 22¼. That would lock in a gain of at least 12½% on my purchase price and give me more than enough room to handle a relatively normal reaction. Of course, I wouldn’t ordinarily allow as much room as a 25% drop unless I were still very bullish on both the stock and the market as a whole.
Let’s assume that we raise the trailing stop to 22¼. Now the stock begins to back off the 30 level down to 27. From here it rallies, breaking out to a new high and reaching 32. At this point the drop from 32 to our trailing stop at 22¼ is far too much, so it’s time to raise the stop again. At least here we have a logical point to which to raise our trailing stop, namely the 27 zone, which marked the low of the last minor decline. Giving the stock a little bit of extra room, we might raise our stop to, say, 26½. This is about 17% under the current 32 price and 32½% above our purchase price, locking in a very nice profit.
Now suppose XYZ begins to falter and eventually breaks down and triggers our stop. We’re out, but we’ve taken a 32½% profit and we haven’t given up an extreme amount from the peak. We’ve protected ourselves by, first, putting in a protective stop at 17, 15% below the purchase price. Next, we raised our protective stop to just under the purchase price at 19¾ when XYZ began to move upward. Third, as the stock continued to climb, we raised our protective stop to 22¼, locking in better than a 12% profit. Fourth, as the stock advanced further, we raised our protective stop one more time, to 26½, locking in our final profit of 32½%. It would have been nice if our theoretical stock had kept on climbing, and if it had, we would have kept raising the protective stop. But all good things come to an end, and the final result, a 32½% profit, is certainly nothing to be upset about.
I suggest raising stops to points that will make you most comfortable, and you are the only one who can choose those levels for yourself. If your protective stop is 25% below current prices, you may find that that’s far too low for you to feel relaxed about. Certainly, it’s not pleasant to see a stock drop a whopping 25% before you sell. On the other hand, if you raise your protective stop to, say, 5% or
6% below the current price, it would be very easy to have it tripped on just a minor reaction.
The main idea is to make the best guess you can about what an ordinary reaction in the price would be, as opposed to a drop commensurate with bad news or lower expectations for the company—or perhaps more negative general stock market conditions. You’re trying to separate the random and normal short-term sell-offs from the nonrandom and abnormal sell-offs inspired by more negative conditions. No one can do this correctly all the time, but with reasonable judgment you can stay ahead of the game by judiciously setting both the protective and the trailing stops.
Here are a couple of actual examples where I used trailing stops. The first is USAir, a stock I recommended in The Zweig Forecast on August 24, 1982. The market was in the early days of its strong bull run and USAir had just broken above the previous minor high of around 17¾. My purchase price was 18½. At that time I put in a protective stop at 15¾. As you can see from graph X (p. 246), the last minor low was about 14¼, which might have been a more natural protective stop point. However, 14¼ would have represented a loss of 23%, which I felt was too large. I decided to use the 15¾ price as a compromise. It was, however, about half a point below the trading high set in the spring of 1982, which I thought would offer reasonable support.
USAir surged to 21 and then retreated to about 17¾. In that initial jump I raised the protective stop one point to 16¾, which was about one point below the previous trading high at 17¾. That 17¾ region proved to be the support point in early October, after which USAir and the whole market began to surge once again.
As the stock rose I lifted the stop to 17¾, and then, as the stock shot up to 25 in October. I raised the trailing stop to 19¾. That locked in a gain of about 7%, or 1¼ points above my purchase price. I felt that at 19¾ it gave me more than five points, or around 20%, of downside on a normal reaction. Also, it was 1¼ points below the last rally high, which seemed reasonable. In fact, I might even have set the stop slightly higher, at, say, 20½, which I did rather quickly when the stock rallied about another point.
Chart Courtesy of Trendline, a division of Standard & Poor ’ Corporation
As USAir began to climb even further, reaching the 28 area, I advanced the trailing stop to 22¼ and then in November to 23¼. No sooner had I done that than USAir broke above 30, prompting me to raise the stop once more, to 25¼. It was rising so quickly that it was difficult to find the most reasonable points to place the trailing stops. But I didn’t want to lose more than 20%-25% or so back from the top at that time. I kept the stop at 25¼ for a couple of months, during which the stock reached 36.
I could have raised the stop again, but I decided not to do so because I felt that a normal reaction could take me out. Normal, in that case, would have been an enormous reaction because the stock had more than doubled in just a few months. Sure enough, in January USAir was hit all the way down to 26, a 10-point decline from the top. Because my stop was at 25¼ I was fortunate not to have been taken out. Quickly, USAir turned around and raced toward the 36 level again. At that point I felt it should not drop back below the 26 area again, since it had already undertaken its major correction and the stock market as a whole was off and running toward new highs.
So in January I raised the stop to 26¼, with an increase in February to 27¾ . The next reaction carried down to 29½, again failing to take me out. I didn’t touch the stop again until May 1983, by which time USAir had finally managed to break above the 36 zone. As it ran to almost 40, I raised by stop to 29 5/8 in May, and again, to 30¾, in June.
In all I had raised the stop eleven times after first having set it at 15¾ With 20/20 hindsight, perhaps I should have raised the stop somewhat more. It’s easy to say after the fact, but somewhere around the 34 level the upward trend was broken, and just below 33 the stock dropped under its last minor trough. With the comfort of hindsight, I would estimate I should have raised the stop again, perhaps to 32¾, but I opted to leave my stop at 30¾, namely because the stock was extraordinarily volatile. Finally, on August 16, 1983 I was stopped at 30¾, nailing down a gain of 66.2% in just under one year.
The main regret is that I was only a week or so away from establishing a long-term capital gain (since that time the holding period for long-term capital gains has been reduced to six months and one day). Actually, that is why I left my stop at 30¼ rather than 32¼, figuring that I was so close to the long-term gain that I was willing to sacrifice a couple of extra points to have room to make it. Unfortunately, I was stopped shortly before I achieved that objective.
The stock immediately dropped toward the 26 area, and it managed to have a rally in the fourth quarter of 1983 that finally carried USAir back to 35 in early 1984. But after that it was downhill to $22 a share in mid-1984. That was nearly 29% below where I had been taken out with the trailing stop, enough of a decline to make me feel rather good about having sold the stock about a year earlier.
Let’s try one more example. In August 1984, a sharp market rally began, prompting me to recommend, among others, an OTC issue called First Data Resources (ticker symbol FDRI), a company involved in the data-processing field. The purchase price was 15, and the initial protective stop was set at 13¼ . You can see on graph Y that First Data Resources fit my criteria of a stock acting well, because at that point it was breaking to a new high. The earnings were also excellent. At 13¼ my protective stop was only 11.7% below the purchase price, somewhat on the tight side. However, I was n’t a roaring bull on the market then, and I didn’t want to take much of a loss in case prices turned down. The 13¼ stop was a hair below the previous minor reaction low in June.
First Data Resources immediately rallied to the 16 area, and I followed suit by raising the protective stop to 14. It had traded between 14 and 14½ for a few weeks during July without going below 14, so I figured that if the stock and the market remained in a positive trend, there would be no valid excuse to break below 14. In September, First Data Resources climbed to 17½, and I elected to raise my stop to 15½. Once again, this was a rather tight stop. However, it enabled me to lock in a half-point profit, or about 3%. The market as a whole had stopped going up, and I was, at best, neutral on the trend at that time; hence, the continuance of the tight stop. (Later that fall I would turn bullish.) The 15½ point was also used because it was just below the bottom of a tiny trading range in which the stock had traveled in August, after the original breakout.
Chart Courtesy of Trendline, a division of Standard & Poor’s Corporation
I could have gone to sleep for a few months after that as far as FDRI was concerned. Finally, in the last couple of weeks of 1984, FDRI began to break out, making a new high at 18 and continuing to climb to about 19¾ in early January. I quickly raised my stop to 16¾, roughly the bottom of the trading range since September. Once again, I deemed that there would be no sound reason for the stock’s dropping below that point if it were truly in a major uptrend. I really cut it close that time, but luck was on my side. FDRI dropped to exactly 17. I was a scant quarter point away from having been stopped. But the stock market as a whole turned around mightily in the second week of January and took off like a shot, with FDRI following suit.
By February, FDRI was above 24 and I had raised my trailing stop to 18 and then to 19. Nineteen was still a good fraction below the minor trading peak in January, and I felt that FDRI would not break below that point unless something serious was brewing. The stock retreated to just under 22½ in late March and early April, still comfortably above my trailing stop at 19. Even if I had been taken out, I would have shown a 4-point profit, or some 26.7%.
In mid-April FDRI once again began to rally, breaking through a new high above 25. That prompted me to raise my trailing stop once again, to 21¾ . This was about half a point below the reaction low set in March and April. No sooner had I raised my stop than FDRI shot ahead to over 27. So, once again I faced the pleasant task of raising the protective stop, this time to 22¾ . I did this because I
didn’t feel like giving up as much as 20% should the stock decline from the 27 area, which would have been the case with the previous stop at 21¾ . Also, a rough upward trendline drawn between the last important lows, at 17 and at 22½, showed the trendline cutting through at somewhat above my 22¾ stop. Recall, it’s often a reasonable idea to set your stop slightly below an upward sloping trendline.
First Data subsequently was taken over by American Express for $38.25 a share in cash. I advised my Zweig Forecast subscribers to tender their stock, establishing a long-term capital gain of 155%. The fortuitous takeover made my last stop point academic.
I can recall numerous stocks in the past on which either protective stops or trailing stops prevented disaster later on. It hurts when you’re stopped right near the bottom of a minor reaction, but you have to make a finite decision at some point. Occasionally, I miss getting taken out by a fraction, as I did in FDRI when it retreated to 17 on a minor dip and my stop point was 16¾. So I had an element of luck then, and perhaps the next time I won’t be as lucky. However, I’ll always continue to use stops. In the long run they enable me to cut my losses to reasonable size and to let my profits run. I can’t think of anything more important in managing money.
CHAPTER 14
Selling Short It’s Not Un-American
No discussion about making money in the stock market would be complete without some attention to short selling, a subject that many traders do not truly understand. The idea in short selling is simple—you’re betting that a certain stock will go down. So you sell it now and hope you can buy it back later at a lower price. When you think about it, this is similar to any transaction where you try to buy at a lower price than you sell. The only difference in this case is just that you ’re selling first.