Option Investor
Educational Article

Loyalty To A Stock Or To A Strategy

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By David Popper

Read any message board and you will find a lot of banter about the merits of particular stocks. The bulls claim undying love, while bears will talk about excessive PE ratios and other reasons why the stock will go down. Of course, over time both are right. Stocks will go up and down. Traders welcome the natural rhythm of the market because that is where the money is made. As a matter of fact, almost every article appearing in OIN is specifically designed to assist you in interpreting where your stock or the market should go in the short-term.

The tacit understanding is that forecasts aren't always precise because the market is not logical. Because forecasts are not always precise, it is foolish to put too much of your equity into any one play. Because forecasts aren't always precise, buying options are risky. Because business is always changing, there is no guarantee that the Wall Street darling of today will still be sought after tomorrow. Remember Priceline(NASDAQ: PCLN)? Loyalty to a stock has its risks. Long-term holding has its risks. There is another way.

You can view stock as a trading vehicle within a complete trading system. There may be different systems which fare better in directional markets and others in markets that do not have direction. Loyalty to a system or systems has advantages because when you operate within a sound system, you will not make as many emotional mistakes. I make two common mistakes. First, I have tried to force trades where the odds of success simply were not there. Second, I have expected too much of a return from the markets where the return was not available given my level of expertise.

Trading within a system involves a plan. This plan includes a reasonable return expectation in light of current market conditions. For example, when we are in a 1999 type market, your expectations may be justifiably high and you may achieve these lofty goals simply by being a call buyer. On the other hand, in a March 2000 market, simply stepping aside, or a naked call strategy, put butterflies, etc may have been your choice. Yet, given the wide swings in the market within the downtrend, it may have been prudent to limit the amount of money at risk. Of course, limited risk means limited reward. However, if this is all that is reasonably available from the market at that time, so be it. Better a small gain or loss rather than a major hit. In football, they call this taking what the defense will give them.

Trading within a system involves a plan. This plan should include the notion of trading only the very best stocks which are the gorillas in the industry. This is necessary because if for some reason your play explodes and you did not bail out soon enough, you will be in a stock that eventually will rise again. Trading a stock that has no earnings and no chance of earnings will eventually leave you owning a two dollar stock. One avenue that I have chosen lately is trading the Nasdaq 100 (AMEX: QQQ). QQQ is the proxy for the Nasdaq 100, which is a weighted index of the top 100 companies in the index, excluding financial institutions. I like to trade this vehicle because it represents many companies, so no one company's surprise bad news can fatally kill you, including the gorillas. It still has reasonable volatility so ATM call or put premiums still are in the 7% to 8% range. It also has tremendous liquidity so exits are easy. Finally, if you are inclined to short the market during a downtrend, you can do so immediately because the down tick rule does not apply.

Trading within a system involves a plan. This plan should be implemented in light of at least basic technical analysis and market sentiment analysis. Sometimes I think that limiting myself to a basic analysis works every bit as well because when I get too technical, without the requisite years under my belt, it is easy to begin over analyzing a situation. Most of the time, I have found that sticking to the basics has served me well.

Lynda Schuepp's Option 101 article last Sunday provide a good start in the technical analysis area. Austin Passamonte's market sentiment section provides great information on how the commercial traders are reacting. When there is a strong correlation between the technical and sentiment trends, you have a head start in understanding which direction the market will probably move unless changed by new information. When you have a general understanding of the market's probable direction, it is easier to decide which strategy would be potentially profitable. The technical and sentiment analysis are the tools that give us the potential to beat the returns of the mutual funds. Imposing a strategy without regard to these factors is simply employing a hope game that will lose as often as it wins.

By understanding the times, and adjusting your strategies and expectations within that framework, you will be exercising the discipline necessary to make reasonable and steady returns. It will also reduce the chances of your account suffering any severe shocks.


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