The Stock Market Cash Flow

by Andy Tanner

  Other Risks to Consider

  We’ve addressed some of the major risks that stock market investors typically face, but those are by no means the only types of risks that are out there. It’s vital to do your homework for a particular investment to know what risks might stand in your way. Some of these risks are obsolescence risk, geographic risk, interest rate risk, political risk, longevity risk, legislative risk…the names alone give you an idea of what dangerous waters might await you. But with the right education, you can navigate those waters successfully.

  Controlling Your Risk

  Remember when we discussed how most investors put their money into investments and cross their fingers that everything goes their way? That’s not investing, it’s hoping. And when you put your money behind that hope you’re not investing, you’re gambling.

  Life is already full of so many things we can’t control. First of all, we can’t control the market or the direction of a stock. We can’t control natural disasters—a tsunami in Japan, an earthquake in Mexico, Hurricane Katrina in New Orleans. We can’t control the outcome of events we know about in advance—earnings reports or FDA approvals. As individuals we certainly can’t control sovereign issues, like debt and fiscal policy.

  If you are in a mutual fund, all of these things affect you yet there’s nothing you can do about them. You’re taking a lot of risks, betting on a long-term diversified portfolio, and hoping that everything will work out and it will all be rosy. And often, even though your account statement shows you that it’s not really working out the way you envisioned, you still keep hoping.

  On the other hand, there are many things in our lives that we can have control over.

  •You can’t control the weather, but you can control where you build your house to hopefully avoid hurricanes, floods, and tornadoes.

  •You can’t control the market going up and down, but you can control how you position yourself in that market.

  •You can’t control if your house burns down, but you can take precautions to minimize the chance of it catching fire and control whether or not you purchase insurance.

  Insurance

  When we possess things that are important to us, such as our homes, cars, and investments, one of the best ways to protect them is with insurance. And even with precautionary measures, sometimes accidents happen. If we just hope that our house doesn’t burn down, it may still happen and we’ll be out of luck. Yet if we buy insurance on that house, at least our investment is protected. It may be inconvenient, but it’s nice to know that we can be back in a newly rebuilt home within a matter of months. When we buy insurance on our investments, we know what the outcome will be. We have control over the situation. That gives an investor a lot more peace of mind than does hope.

  That’s how professional investors maintain their ability to grow wealth no matter what happens. They plan for the best, and also plan for the worst. Since they can’t control the market direction, they insure their investment with a hedge.

  Whenever you have something you can’t control, you can usually insure it. You can’t control Hurricane Katrina, but you can have insurance on your house. You can’t control a tsunami, but you can have insurance on your business. You can’t control a market crash, but you can have insurance, or a hedge, on your portfolio. That’s the big secret. If I can’t control it, I need to hedge it or insure it. I can’t do anything about the sovereign stuff, but I can control my personal fiscal policy. If you want to gamble, go to Vegas—and never bet more than you are prepared to lose. Because gambling is entertainment; it’s not an investment.

  Exit

  Another way to manage risk in an investment is to plan an exit strategy. This is a pre-determined plan to get out of a stock when it hits certain levels. This can be tough to do in other asset classes such as real estate, because they’re not as liquid as the stock market. There are even some paper assets that lack liquidity and where having an exit strategy might be difficult. However, for most large companies with highly traded stocks, an exit strategy is a viable risk management tool.

  Before entering a trade, you can set the price points at which you want to automatically exit the trade. If it does poorly, you don’t want to sit on that stock for a long time—you want to get out as quickly as possible to minimize your losses. That’s one of the great advantages of owning stock: If you don’t like the trade, you can just click a button and exit it instantly. In fact, most exit strategies these days can be programmed into your computer and you can give precise instructions to the brokerage. These instructions can be very specific and detailed with many “if/then” statements that allow you to go about your life rather than babysitting your investments all day long.

  It’s no surprise that the best investors are those with the best financial education. When you know how to plan for virtually any investing scenario, you can structure your plan in your favor. Every investor makes the decision on whether they will invest in ignorance or if they’ll become educated. It’s a choice. Trust me, doing nothing…being ignorant? That’s a choice too. And it’s the most dangerous one of all.

  Whether you are interested in either cash flow or capital gains investing, having a good understanding of the different risk-management strategies available to you is a very smart move. You’d be surprised how far ahead of the novice investor you are just in knowing about hedging and exit strategies. But there is a lot more to get excited about when it comes to risk management.

  Risk/Reward Ratio

  In our study of technical analysis, we learned a little about how to look at the price movement of a stock on a chart to set a price target, an entry point, and an exit. To help us evaluate the potential attractiveness of one trade over another we can use these price targets and entry/exit points as a way to measure each trade. We call this measurement the risk/reward ratio.

  •Reward = The amount of money you expect to profit when entering the trade. This is usually shown as the price target you expect the stock to reach while you are in the trade.

  •Risk = The amount of money you are willing to risk losing in order to be in the trade. This is usually shown as the price at which you pre-set your exit point when entering a trade.

  We can show this mathematically as:

  Risk/Reward Ratio = Anticipated Profits : Anticipated Losses

  For example, let’s say we are considering buying a stock that is currently at $10 per share. After doing our technical analysis, we think that a target price of $12 is realistic. On the risk side, we understand that the stock might drop slightly on its way up to the target level so we’re comfortable putting our stop-loss exit at $9 to give a dollar’s worth of wiggle room. In this scenario, our risk/reward ratio looks like this:

  ($12 - $10) : ($10 - $9) = 2 : 1 ratio

  In other words, we think this trade has the potential to earn twice as much in profits as we stand to lose.

  But what does this mean if we compare it to another potential stock buy?

  As you analyze other potential stocks in the same way, you can quickly find and compare the different risk/reward ratios. A stock investor who is seeking a capital gain might establish criteria of having a minimum of $2 in reward for every $1 risk that they take. The idea here is that if the investor makes ten trades and half are winners, that investor can still come out ahead because of the risk/reward ratio.

  For options traders this ratio can be significantly less because of the amount of leverage available in those instruments.

  For cash flow investors this ratio is based on the amount of cash flow they received for the amount of money placed at risk.

  There’s no magic number where one size fits all when it comes to a risk/reward ratio. Investors will develop their own criteria based on tolerance for risk and other factors such as age and investment goals. It is an individual process.

  Exit Strategies

  You may be asking the question, “Why have an exit strategy? Why not just buy a stock and hold it until it grows?”
That’s what most of us have been taught—that smart investing is to buy and hold for the long term. Like I said before, it’s a matter of control and risk management. Since you cannot control how a company manages itself or what will happen to its stock price, you need to be very careful in how you invest with that company.

  For example, take a look at the following list of major companies that have gone bankrupt in the recent past. This is just a small list, yet we can see that the combined value of these losses is more than $1.6 trillion. That isn’t funny money. That huge amount represents losses experienced by real investors like you and me. And it’s the best reason I can think of to have an exit strategy every time you make an investment.

  Even though some of these companies were able to restructure and are back in business, the shareholders still lost their money.

  Another reason to have a good exit strategy is to avoid big losses to your trading account that can take a long time from which to recover. Whether they realize it or not, buy-and-hold investors have made the decision to hold onto their stocks through bad times and good. They hope that in the long run, everything will go in their favor.

  Let me show you a simple illustration of how this line of thinking can be very detrimental to your long-term success plans. Suppose you hold a particular stock that is worth $100 per share today. If something unforeseen happens, such as when British Petroleum had the Gulf oil spill, that stock could lose half of its value almost overnight. Suddenly, you have lost half your wealth in that stock. In order for that stock to return to its previous value, it needs to double itself—it requires a 100 percent growth rate just to get back to even. For a stock that grows at perhaps 6-7 percent annually, that can take a long time.

  This is not a far-fetched scenario. Let’s take a look at how Microsoft dropped after the dot-com bubble burst in 1999. At the beginning of that time period, Microsoft was trading around $51–$52. In 2011 it had dropped to around $25. That’s a 50 percent loss for an investor holding that stock. Now it has to achieve a 100 percent run to get back up there.

  As we have seen, it’s much easier for stocks to drop quickly than to rise. That’s why it can be wise for us to have a smart exit strategy in place to get out of stocks before we lose much. Then we’ll be better positioned to take advantage of prices when they’re on the way back up. Smart investors take advantage of this knowledge to keep their profits rising.

  Entering Trade Orders for Protection

  Now that you can see that buying and holding isn’t a surefire way for you to grow wealth, how can you protect yourself from dangerous price drops? And how can you lock in your profits to maximize success? It’s actually very fast and easy to build in these safety factors when you place your trades. Thanks to today’s computerization of the entire trading process, it’s simply a matter of knowing the terms and entering the values into your software.

  To show you how this is done, let’s look at a sample trade, ACME. As we look at the chart on the right, we decide that a target price of $45 is realistic. Currently, ACME is moving down a bit, but we don’t expect that to continue very far. We’ve drawn a support line on the chart that’s slightly lower than the current price of $38.83. So we’re comfortable waiting a day or two to make sure the price bounces off that support and comes back up. If it continues down past the support level, we don’t want to be in the trade. The ideal is to enter the trade at $39 as it rises.

  If the price does as expected and we enter our long position on the way up at $39, we need to recognize that it could also reverse and begin dropping back down. So we want an exit point slightly below the support level at $37. If it hits that point, we will lose a couple dollars on the trade, but we’ll be protected if the stock slides lower over time. For this trade scenario, that gives us a reward of $6.00 for a risk of $2. The lowest reward/ risk ratio you should ever consider is 2:1. Since this trade gives us a 3:1 ratio, we’re in good shape.

  For our trade transaction, we want to put in an order for an entry point at $39 and an exit point at $37.

  On the left is a broker’s order page. Each broker’s page looks slightly different, but they all have the same components. Online order forms help you give instructions to the brokerage regarding what you want to do. You can put in orders to open a position or orders to close a position. In this case, you are going to buy 100 shares of ACME. This is an entry order to open a long position.

  Brokerages allow you to specify exactly how you want to enter your positions. As you will see, you can have as much control as you want when entering orders. When placing an order, you usually have at least four different order types to choose from:

  Market Order: This means the trade will go through right now at the current price or at whatever price the market opens at if you place the order outside of trading hours. But since we have a specific entry point we want, we won’t use the market order option. In fact, I rarely use market orders when I trade because it requires that I give up an amount of control, which, of course, is not always a good idea.

  Limit Order: Many people make a mistake here. If I fill in $39 here, I’m saying I want to buy this at $39 or higher. But I don’t want to buy it at $40 or $41 because that screws up my reward/risk ratio. I want it at exactly $39.

  I could say I want it at $39 or lower, but that might put me in too early. It’s at $38.83 today so this order would trigger the trade now, while the stock is going down. I don’t want to automatically buy a stock that is going down. This is one of the most common mistakes people make when they enter orders. They think they’re really smart because there is a chance they will get it cheaper. But they are buying stocks that are headed the wrong way.

  I want stocks that are headed up.

  Stop Market Order: The next order we can select is the stop market order. Now this is an interesting order. This brings in a window for a stop price. It means, “Stop and don’t do anything until it reaches $39.” I think this is confusing because it really means “Go” since the order will be triggered when the stock reaches $39. But again, soon after it hits $39, it might go to $39.05 or it might go to $38.06. The order will be triggered as soon as $39 is reached, even if the price then drops down or gaps up. I don’t use this type of order much either.

  Stop Limit Order: To get very precise control over entering a trade I most often use the stop limit. This requires you to enter two prices, the stop price and the limit price. I am now giving an order to buy when the stock reaches $39, but I am also limiting the price to $39 or higher, so that if it suddenly gaps up to $41 and reduces my reward, the order will not trigger. Once the order has been triggered and I’m in, I need to put in an exit order to limit my loss and manage my risk. Controlling this risk, limiting losses, is what this is all about.

  With practice, all this can become second nature.

  For an exit order you can put in a stop market order, an order to sell if the stock hits $37. So, the stop limit is the very specific point where I want to enter the trade, and the stop market is where I want to bail out for safety.

  Protective Put Options

  Is it possible that a stock price could ‘jump’ over your exit price? Absolutely. This can happen around earnings announcements or other newsworthy events such as a pharmaceutical company failing to gain FDA approval for new a drug. This is another place where an education in options will be valuable.

  At this point, you know how options can be used to generate cash flow. For serious investors, options also can be used as insurance on their investment positions. For example, if you are investing in a company that has an erratic stock price that jumps around a lot, a good insurance policy can protect you in the event those jumps don’t go your way.

  A good example of this kind of stock was Research in Motion (RIMM), makers of the Blackberry phone and other electronic devices and services. This particular stock had a tendency to gap, meaning its stock price made huge jumps or drops in price that appear to leave gaps on a chart. Much of the time investors can see
these coming on the earnings calendar. If you happened to have a long position in a stock like this and have your safety stops in place for protection, what would happen if the stock gapped right over your stop? Suppose you entered a stop at $34.50, but the gap meant that your stop triggered much lower at $29.50 (the next price after it gapped). Suddenly, you are facing a loss you didn’t expect.

  To protect ourselves against a situation like this, we can buy a protective put option on the stock in order to insure it until after the earnings announcement. We can enter into an agreement with another person where that person agrees to buy the stock at a certain strike price within a certain period of time, and we have the option to sell it.

  On the left here we have the October option chain for RIMM. Suppose it’s now September 4th, so we have about five weeks before the October expiration date. As we look at the puts we see the ask is $3.40 for the option, meaning that for a premium of $3.40 we can insure $30 worth of stock for the next five weeks. At 10 percent of the stock price, this insurance policy may seem expensive. But the reason for the higher-than-usual option price is the frequent gaps in RIMM’s stock price.

  After we purchase the option to sell the stock at $31, what happens if it gaps down to $26? The protective put option guarantees that we can sell it for $31. Even if the stock were to somehow fall to zero during the life of the option, we could still sell it for $31.

  Sure enough, RIMM went down once again. By the option expiration date in October it was trading in the low $20s. The put option certainly would have helped soften the blow.

  Protective put options can be an effective way to protect against stocks and markets with extreme volatility. Many of the high-flying stocks like RIMM have fallen to trade in the single digits after being worth well over $100 a share. These dramatic falls have cost many investors much of their fortune, while other savvy investors used insurance and hedges to mitigate the risk of such meltdowns.