the 4 pillars of investing risk management: module 2 4 2 t tr ll a eserved. this is the basic risk...

Risk Management: Module 2THE 4 PILLARS OF INVESTING

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The 4 Pillars of Investing | Risk Management : Module 2

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This is the basic risk management toolbox. When you get it further along, it will go from a toolbox to a tool chest, intermediate. Then you will go to a whole garage full of tools like Home Depot. We’re going to be the Home Depot of risk management. Alright, beautiful.

So risk reward ratios: we’ve talked briefly about it, we’ll talk about it a little more in depth. Stop loss orders: how are you going to put those in? We better do some order entry. Protective puts or call options, yeah. That’s an ironic thing really because everyone is saying, “Oh, options are risky” and “Oh, they’re risky, everybody is losing money on options.” Do you guys know that a lot of investors will use options solely for risk management, that options actually can reduce risk rather then enhance risk? Some people use options for speculation, but some people like me…man, I use options all the time to limit and manage risk. All the time. So maybe I’ll show you some trades or something like that. Give you some examples.

I’m in a trade right now that’s one of the most conservative trades in the universe. In fact, it’s the most conservative trade I think I know. It’s called a “Collar.” So maybe I’ll show you an example of one of those. Maybe I should in a manner that you’ll take it as financial advice and do it. Maybe we’ll find a new one.

Non-correlating assets that can be a big risk management tool. Position sizing that can be a risk management tool. So those are in our toolbox and basic box. Then we move on to delta hedging, delta neutral trading, stuff like that. Rebalancing, stuff like that. Very cool.

So let’s talk about risk reward ratio. So in the last session, remember…if you remember, we talked about this idea of setting a target, right. And setting an entry, right. And then setting, what was it, an exit. Remember those three points right here. And that way we had two scenarios that could happen basically. Let’s say it goes up as the target wants, well that’s wonderful. Let’s say it goes down and hits the exit, well we control that. So it’s a lot like the Titanic analogy we used, isn’t it? Saying, “Look, we are going to make sure there’s a lifeboat on here and do this.”

RISK MANAGEMENTMODULE 41 2 3

A transcription of

The 4 Pillars of Investing

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Well another thing is is let’s say our risk reward ratio is 2:1 or better: 3:1, 4:1, 10:1, whatever it is. If we can get 2:1 or better, let’s say we go out and we make twenty trades like this and we don’t know whether going to go up or down. We flip a coin and let’s say over time, if we do it enough; if you flip a coin three times, you’re going to have 2:1, one or the other, or all three. That’s all you can really have is two to one or three. But if you flip a coin a million times, it’s going to be about 50:50. So the more you trade, the more whatever your win/loss percentage will come to bear. Casinos depend on that. Remember I talked about the roulette wheel, how they’re trying to get their win/loss percentage up.

So as you trade with fundamentals and technicals and good management, but mostly fundamentals and technicals, your win/loss percentage…you’d like to see it above 50%, 51/49 would do it. And so you’re winners and you’re losers here. In fact with options, you win so big and cut your losses so short; you could actually in this one…what if we did 60. We do $60, right, and we make $80. So you could literally lose more than half the time if you’re managing and cutting these up.

Again, it’s not about picking these winners so much as it’s about cutting your losers. Let the winners run, there’s no limit to how high. It hits a target, maybe it goes higher, move your exit up, lock in your profit, but let the thing run.

So if we do 10 winners, we make $100…or 5 winners, we make $100; 5 losers, we make $50. So this is a risk management tool to say, “Hey, I’m going to have a bigger upside of stuff then a downside. I’m going to put the odds in my favor by trading with the trend and doing good fundamental analysis. I’m going to learn about doggies. I’m going to learn about higher highs then our lows. I’m going to use MACD. I’m going to use all these things to help my win/loss percentage to get above 50% if you can.” And then we’re going to make sure that our winners pay us more than our losers. Very cool concept: risk reward ratios.

Well, why should I use one of these exits? Why not just buy and hold? Look you have to do what you’re going to do. Everyone’s been taught, “Buy a stock, hold it till they die.” Why did they teach you that? Think about it for a second. Two sides to every coin. Do you think they’d like to have your money for a long time? I think they would. I think they’d like to have it for 65 years if they could, because that’s how they make money. It’s called “assets under management.”

So check this out. Why an exit strategy over buy and hold? Let’s sell ourselves on this idea. First of all, this is a small list. I mean we could add Circuit City this or we talked about Blockbuster, but there’s 1.6 trillion reasons why right there. Delta Airline, United Lines: these guys, a lot of them are still in business. General Motors, they just finished, stock goes to zero, and what do they do? They just do another IPO, make even more money, and have investors give them money again. So

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all the investors that put money in these, it dies. Those that…like Enron, WorldCom they’re dead. But Chrysler, General Motors, Texaco, United Airlines, Delta Airlines they’re not dead, they just rebooted. But the shareholders lose everything, and then they just do another IPO and people say, “Oh, okay, we’ll get in again.”

I mean I’m telling you. I’m not going to hold one of these to the bottom. It’s just too much money, it’s too tough. So there’s 1.6 trillion reasons just on the board there and think of all the others we could have put on if we had the room. Bankruptcy, that’s number one reason. I don’t want to be victim of that. And some of these are big, Lucent Technologies. If memory serves, that was one of the most, if not the most, widely held stock in the world at one point. Every fund in the world had Lucent in it. It was huge. Every investor held Lucent it seemed like. All kinds of guys doing this.

The other thing is is when a stock loses a lot of money; it can take a long time to get back to even. And there’s this little mathematical glitch that you have to have. I mean if your average growth is 6-7% a year that could be devastating to try to come back.

Look, here’s the year 2000, whim of the Dot Com crash. Microsoft is trading up here $51-$52. We’ll call it $50. They go down here to $25 today. That’s a 50% loss, but think about it, what does Microsoft stock have to do now to get back to even to its high here? It’s got to double. So that’s kind of a weird mathematical glitch isn’t it? It’s not a glitch, it’s a phenomenon. You lose half, you’ve got to make a run, you’ve got to double your money and make a run.

How often do stocks double? When’s the last time you saw a stock double? I had one double the other day. It’s called a “Vix.” But look at that, how often do they really double? It’s easier to fall. The other thing is is when they fall, they fall fast. When they rise, boy it just takes so long to build up. Falls fast and its going to take a long time to build it up. Look at this, fall, and to get back to here that’s what one…two…there…four…five…six years. Then it falls again one…two…three, it’s not even back up there yet. This is 1999 to 2011, this is twelve years. That’s going from age 50 to age 62 and you’re down half.

Why exit strategy instead of buy and hold? That’s why! Oh we could do more. We were friendly with Microsoft. How many people in Microsoft, everybody? How many funds are with Microsoft? S&P has got it in there. S&P 500 Company.

Oh, CitiGroup. CitiGroup falls in 2000. First it didn’t go anywhere from 2000; one…two…three…four…five…six…seven years of doing nothing. And then kabam eight…nine…ten…eleven… twelve years it’s gone from $550 to $27. That’s probably had some reverse splits to get the numbers. Lot of these have because they’ve fallen so far.

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Well think about this, you’re going from $550 to $28. That’s 95% of the money gone. I’m not going to stick with my hands in my pockets, diversify and hope this doesn’t happen to a lot of them. I don’t want it to happen to any of them. Am I going to go out and buy a hundred houses and when one burns down say, “Well at these the other 95 worked out. At least only 5 burned down.” Or would you have insurance on all of them? I think we have insurance on them all.

But look at the run. Now this gets kind of interesting. Once you get past 90%, it gets kind of crazy. Check this out. That sucker has to make an 1800% run to get back to where it was back here for the industors.

Oh yes there’s more. How about this one: Sirius Satellite Radio. Obsolescence risk. XM Radio, Sirius Satellite Radio, Apple comes out with the I-pass. Killer. Boom, you’re dead. What, you hire Howard Stern right here. Whoop, that’s it, that’s all the power Howard’s got man and he’s on the decline. He’s a little bit old. Kind of passé. Howard. I don’t know, I don’t like Howard.

So look at this. I don’t know, enough about Howard. But look at this, this is going from $60 to, that’s probably a reverse split too, $60 to $1. That’s a 98% loss; got to make a 5900% run to get back to even. AIG, 99% loss, got to make 9900%. That’s 10,000%. When’s the last stock you had that did that? And you know what kills me; people are buying this right now because it’s trading. There are people buying this at $23. And you talk about reverse split, it wasn’t in 2000. It was what it was but it wasn’t in 2000. That’s reverse split stuff. That’s a big deal, big big deal.

So how long is going to take for this to come back? And this is the trap you get into. Okay, you buy it in here and it makes a nice run. Okay, great. Oh well, you know I’m even. I’m okay. Okay, I’m down a little bit. Now I’m up a little. I’m just riding it. Then all of a sudden, well I can’t sell it now because I don’t want to lose any money. And that’s the trap, “I can’t” and you get trapped mentally. I can’t sell it now because I…Oh, now I really can’t sell it because I’ve lost everything. Well now I have no choice but to just hold it.

See how that trap goes? Without a line in the sand, without an exit strategy, next thing you know you have one of these and you feel like, “Well I can’t sell it now, look at how much money I’d lose.” Hey, here’s a secret: The monies gone baby. It was gone the moment this happened. It’s gone. Toast. Poof. History. But people hold hoping it will go back up. And how much control do you have to make that go up? Oh I would say zero control to make something go up. I’d say worse then zero. So, not to belabor the point, but why exit strategy instead of buy and hold? That’s why.

Well, it goes on. What about your time? I love this Nikkei example because they have the same policy. Look, housing boom with low interest rates, right. Everyone can get a mortgage causes

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demand for houses because everyone can buy one. If everyone can buy one, they buy them. Big demand. Up goes real estate. Finally it’s unsustainable. Can’t keep going higher and higher and higher. Then the price of the homes outpace the loans or the amounts, and boom.

Look at this. You go up and down, golly I wish I would have known technical analysis when I was in high school right here. This is where I was in high school, right here. I could have gotten in on this. So look at this. Boom, down it goes. That’s 27 years ago guys. 27 years ago and just worse and worse. Times gone. You can’t get that back.

So what if a guy is to diversify in the Nikkei. Well it hasn’t been like it’s been much different over here. I mean we’re already 10 years in. This is 27 years. This is 12 years. Alright, 98. One… two…three…four…five…six…seven…eight…nine…ten…eleven…twelve…thirteen…fourteen; fourteen years since 1998. We’re up, what, 20%. 14% is what we’re up. From 2000, around in this area, to 2400. That’s a 14% gain. What is that divided by…that’s a little over 1% a year. Inflation is 3% a year.

So even if you get your money back, the time is gone. We’re going from, what’s that 13 years; we’re going from 50 to 63. We’re going from 63…or 60 to 73. I mean that’s long term to me. This is long term to me, 27 years to me is a long term. 100 years is not long term, that’s too long term. You have got to have this money in 20 years, 15-20 years.

I mean that’s the NASDAQ. These are major companies: Microsoft. This is not representing one company. This is the whole. This is the technology of the deal. Nokia is in here. Nokia, well Nokia is in the Nikkei as well. So there you go. This is the S&P 500, about the same, 1% a year if you go over that 13 year period. If you go from 2000 to now, you’re down. And it’s not looking real good right here. Okay, this is looking very similar to me. If you ask me, these look, that looks, and that looks very similar.

So times gone. So you get the message. Why do we buy and hold? Because we’re dumb I think. That’s just my opinion. Talk to your fiduciary, I can’t give financial advice. Hey, time can be gone forever.

Okay, so if we’re going to put in a stop order. Okay, something that will stop this from having this happen. I don’t want to buy this $100 and have it at $50. So I’ve got to draw a line in the sand, and in this case it’s $90. Okay. So let’s talk about how this can be done. And I want to say, this is all woven in together because got to have technical analysis. In fact, this is just a basic class on showing basic concepts but in reality, this wouldn’t be my favorite trade. Why? Well look at this, I got support right here and my exit here. I would like almost to have my exit below the support in case it bounces off of it, right. But we’ll get into some of that stuff later.

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So, border entry. This is a real stock. It’s actually an ETF. It kind of mimics silver. It has its risks too. But here I look at the trajectory of this; I mean there’s so many things to do technically on this. We just as well do them since we’re together. Is here I see a point of resistance, right. Where it pops above that baby and look at that. Now the resistance becomes what? Support. So we cash this here and up it goes. That would have been a nice catch. And now it’s come back down. We draw this trend line here and we see it’s come back down and it hit the trend line. That’s close enough to call it a hit.

So this stock, who knows what it’s going to do. Maybe it hangs in here for a bit, comes off this, and then goes. That’s fine, but it’s down far enough now, in my opinion, that we can put in an entry. Target of $45, absolutely realistic. Absolutely. But here’s the thing, we looked at that Microsoft that went from $50 to $20. Do I want that to happen here going from $40 to $20? No I don’t. I mean this thing was $17.50 a year ago. So do I want to be in this and just all of a sudden turn it into something I’ve got to hold and wait for 20 years for it to come back up? I don’t think I do.

So I’m going to draw a line in the sand and say, “Look, this is it. That’s all I’m going to risk in this thing. I’m not going to let half of my money be gone. I’m not going to let this thing die on me.” Silver is precious metal. It probably wouldn’t go to zero, it never has. But even if it’s one of these companies that go bankrupt, if this is Enron, hey if it heads down there. The chart is the bottom line. And if I let the chart get away from me, then I’m holding it like we talked about before.

So we’re going to enter right here. Let it take us into this stock. If it goes down, we won’t be in the trade. But if it takes off then reverses, that’s when we get out. Right. So we’re going to let it come up first and establish this line. Let this stock prove to us that it really takes the support lines seriously that we’ve drawn here. So there we go.

Now, target $45 realistic, rewards $6. So on these right here, I like to see you have as a beginner just testing things out with your paper trading; lets make sure we have $2 reward for every $1 we risk. $2 or more, okay. $2 or more. This one is even better; it’s got 3:1. Alright, 6:2 which is 3:1. So pretty nice trade right here. I would do that trade actually.

So how do we enter this? Well if you’re trading for the first time, you’ll need to learn how to put in orders. I’m going to do the long side. Short is just the same, you flip it over. And rules are the same, so you’ll be able to do both.

So orders to open long position. What we’re going to be buying here. I thought I’d do the whole thing. So how are you going to put in a stop, unless you’re going to buy? So the first thing you’ll do is you’re going to click this. Now every brokerage sets theirs up different, but it will have basically the same components. This is a lot like driving a car. You hop in a car, it’s got its steering wheel, got your

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blinkers, but the windshield wiper thing is sometimes in a different place. Then the radio might be a little different. So it has all the same parts, it’s just you kind of get used to where things are in your car, right. Well same thing here, it’ll have all these parts but just might be in a different format. Some use, these are called “radio buttons.” But some use a drop down or check box or whatever.

So we’re going to buy. It’s going to have you list the quantity and the symbols. So the symbols can be SLB and we’ll buy 100 shares here, what have you. So we’re going to buy some of this. Now it’s going to have a drop down box that’s going to select the type of order. Okay. And this is going to be in order to open a trade. You can order open or you can put an order to close a trade. Since we’re just starting on this one, we’re doing an entry. This is going to be an order to open a trade.

And it’s going to give you several; these are the four main types of orders. So let’s explain these and why we choose the ones we do to help us with our odds and manage our risk. So here we go.

The first one we could do is called a market. And that means buy the thing right now. Okay. If I click on market, it’s not going to bring anything else up. This is buy it now. We don’t want that one. Why? If we buy it right now, my blue, that means I’m going to buy it right here where it closed today. Right. And again I want it shooting up through this right here. If I buy it now, it could go down tomorrow and now I’m losing money. So I only want to buy it when it hits a certain point. Right. I want it bouncing up through this area here. I want it where it is now and then boom. I don’t want to buy it at this exact point. I want it to have to go up through my enters.

Okay, now notice that when we click the limit order that things change. See on the market, there’s no additional box. But when we do a limit order, it will put in an additional field up here. It’ll appear and say limit price. What this mean is if I put $39 in here, that tells them that I want this at $39 or better. Now I don’t want it at $40 or $50 because that starts screwing up my risk reward ratio. Right. So a lot of people say, “Look, I want this at $39 or better.” And this is a very common mistake because people like to shop at Wal-Mart, they like cheap stuff. So they want to be getting a better price.

Well the problem is is if I say $39 or lower, it’s at $38.83 today. Does that qualify as $39 or lower? Yes it does. So it’s going to put me in now as well too early because it’s at $39 or lower. Well it’s lower right now. It’s right here at the bottom of this candle. It’s $38.83. I don’t want in yet. And besides, this is a terrible thing. If I tell it at a price at $39 or lower, that’s going to force me to buy stocks that are going down isn’t it? It’s going to force me to buy things more likely that are going down.

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So this is one of the most common mistakes people make when they enter in orders. They say, “Look, I want this price or cheaper.” And it forces them to get in stocks that are going the wrong way. So they think they’re really smart, “I’m not going to do a market order.”

The reason people don’t do the market orders, is the stock…see how it goes up and down during the day. Well if you put in at $39 and hit in market, you might get in at $39.05 or $39.08. You spend $.05 to $.08 more than you want to by the time it triggers. And so you don’t get a chance to shave spread, especially in the options market. Market orders cost you a little bit to have too much money.

Limit orders, people think, “Okay, not going to pay too much.” But again, they’re buying stocks that are going the wrong way. Because $39 or lower means that it could be getting lower. I don’t want to have that; I want stocks getting higher as I buy it. Right.

So the other order I could do is a stop market. This is an interesting order. It’s going to create another window called a stop price or another field. So look at this. Markets have nothing additional, limits put in a limit price, and then stop market puts in a stop price.

Now what this really means is stop, don’t do anything until it hits that. And I got all confused because to me, it should be go. And it really should, but they call it stop. So what that means is don’t do anything until it hits what? Till it’s $39. So if it hits $39, buy it. Now again, once it hits $39, you might be at $39.05. You might be at $38.06. Whatever. But I don’t use those either.

So here’s the one we use. Now watch this. You put in a stop limit and watch what it does. You get both boxes. So let’s say that you say…and I’ll just put $39 in both for this example. But it says, “Look, buy if it hits $39 and then buy it at $39 or better.” Which means, what is it going to have to do? It’s got to be going up doesn’t it? It’s got to be going up and then once it hits $39, boom you got to get it right at $39. Because I don’t want it to go up a gap above and screw up my risk reward ratio.

So when we enter orders to buy, when we enter it to open an order, we always use the stop limit order. That’s the same with shorting too. If we’re opening the order, we use a stop limit order.

Now once that triggers and we’re in, bam…now we’re in. What do I need to have now to limit my loss and manage my risk? That’s what we’re talking about, managing risk. I got to have an exit order here, right.

So again if I put in a market order, right then it will sell it right away. If I put in a limit order, it will sell it at there or better. So what I really want to do is I want to use the stop market. Now here’s why. I don’t want to be picky with stop limits because if thing starts falling apart and it hits it, by the

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time my order is ready to go it’s below $37 and I’ve said I want $37 or better. That’s not going to do. So I use a stop market and say, “Look, stop limit to get in. Stop market to get out.” Remember that: Stop limit to get in. Stop market to get out. At least that’s the way I like to do it. I’ve walked you through the logic in how it works. Okay. So this is how we do it.

Now there’s something else we have called an OTO. An OTO means one triggers the other. So in other words, I can actually set it up to once it hits this enter, boom it triggers this one to be set. Now as this is climbing, if something bad happens and it hits here…I’m out because this is set. Because one order triggered the other order. And you want to learn about those for sure. So, very cool.

Notice my stop price is at $37. If it hits that, then I’m out right away. So that’s how to order to exit and how you set it in what, how you do this right here. Get this risk rewarded. So, very cool stuff.

Okay. Let’s talk about what happens though if something bad happens. There’s a little gap up right here and another gap up right here. Not a real serious gap down here. But we can have these gaps. So let’s talk a little bit about what we do if we get a gap.

END OF RISK MANAGEMENT – MODULE 2

the 4 pillars of investing risk management: module 2 4 2 t tr ll a eserved. this is the basic risk...

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