in that three-monthperiod. This new weighting is far greater than your original 20% goal.Figure 4.12 shows how a portfolio can remain unchanged stockwise, but theweighting can shift to a more aggressive weighting on its own. The portfolio beginswith a technical stock exposure of around 20% and a blue-chip Dow stock makesup the remaining 80%. After the quick run-up, the weighting in the technologystock is approximately 50%, tipping the scales to a more aggressive tone. Now, a50–50 mix of technology to blue chips is still prudent, provided your time horizonis sufficiently long to ride out any downturns in the tech sector. But if retirement isless than a year or so away, perhaps it’s time to reduce your exposure to the techsand shift more toward something a bit more stable.A word about betas: A stock’s volatility is measured against the overallmarket. If it is more volatile than the Dow, it will have a beta greaterthan 1.0. If the stock has less price volatility than the Dow, the beta will beless than 1.0. Some web sites will provide you with a beta reading. Thishelps the investor understand the overall volatility of his or her portfolio.
There’s a host of financial web sites with the capability to track the stocks and/orfunds you own. I like the Optionetics Portfolio Tracker (www.optionetics.com) fora number of reasons. First, it’s free (always a nice feature), but most importantly itallows you to track a wide variety of stocks, funds, options, even money market accounts, so that you’re constantly abreast of your portfolio’s performance. You caneven check in to see the recent news that pertains to your investment, and the siteoffers the ability to do technical and fundamental analysis on the stocks you own orare thinking about owning.Besides price, it makes a lot of sense to monitor the sectors your stocks are in. Acool web site that tracks sector performance is SmartMoney’s Map of the Market(www.smartmoney.com/marketmap). It’s a graphic display that’s easy to read and understand. Another good one that’s a little trickier to maneuver around in but offers amuch more in-depth look at sector performance and how the stock you own rankswithin that sector is John Bollinger’s Equitytrader.com (www.equitytrader.com). It
%Portfolio
NewPrice
NewValue
New %Portfolio
20%80%
$73$74
$36,500$37,000$73,500
50%50%
Stock
# Shares
Price
Value
RMBSGMTotals
500500
$18$72
$ 9,000$36,000$45,000
Figure 4.12
Sample Portfolio Weighting Changes
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takes some time to learn his proprietary system of charting and ranking of stocksand sectors, but it’s well worth the effort.If you’re in the correct sector for current conditions, review the fundamentals asbest you can. Chances are good the company has its own web site. If you’re not yeta denizen of cyberspace, call the company up and ask for annual reports, quarterlyreports, anything. Your brokerage firm probably has research that’s current, andthere’s always the library. Many public libraries have the Value Line InvestmentSurvey—a publication that’s bigger than the New York phone book. The layoutcomes in easy-to-follow sections with understandable ratings for both the sectorand the company. But if you are online, just surf over to Value Line’s web site(www.valueline.com). I’ve read Value Line’s stuff for years, and have found it to bea veritable treasure chest of information.
Dealing with LossesI’ve been investing and trading for a long time now, and have learned that it doesn’tmatter who you are or how careful your investment choices are—you’re still goingto pick a loser now and again. That’s just how it goes. A huge danger we all face isour own ego, the part of us that is so certain the market is wrong and we’re right asto why our stock pick is certain to rise. So we hang on, and a small loss turns into amajor source of pain as the loss keeps increasing or the stock goes dormant well below our entry point.Cut your losses! Investor’s Business Daily’s William O’Neil recommends sellinga stock once you’ve incurred a 7% to 8% decline from your purchase price. Sometimes I just know in my heart I made an unwise buy or that the market isn’t actingright, so I get out. There’s no law that says you can’t repurchase that stock later,when conditions improve.On the other hand, what if you sell too soon in a rising market? Seller’s remorse,or the fear of it, keeps many people in a stock or trade, because they’re afraid thestock may continue moving up, seemingly forever. No matter who you are, the market will humble you. You’ll sell too soon, and the stock will continue on to make amonster-sized move. Or you’ll buy at the top, and take an embarrassing (and painful)loss. Or you won’t buy, trying to outsmart the market, and it’ll leave the station without you. If you invest long enough, all of these circumstances will beset you.You’ve probably heard the saying “Cut your losses early.” Preservation of capital isthe most important thing you can master. Another great idea is just around the corner,so take your lumps and follow Mr. O’Neil’s advice (and that of every other trader whohas been around awhile): Control your losses. Here are some guidelines that can help:• If you own a stock that has lost value from the time you purchased it, how hasthe overall market performed during the same time frame? If the market hasdone better than your stock, do not double down! (To double down is to buymore to lower your price basis.) If a stock is down 7% or 8%, dump it.• Know before buying a stock what your parameters are: If it drops this much,I’m selling. Write down your purchase price and the date you bought it in a
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• Study Chapter 9 on technical analysis. A stock’s charts can often tell you theprudent entry points.
Chasing the Hot StockSomewhere along the way, perhaps when tech stocks began creating millionaires ona daily basis, many traders began to seek immediate financial gratification. They began chasing stocks that had already attracted the attention of institutional buyers tosuch a degree that their trendlines went vertical. Greed overcame good sense, andthe greater fool theory worked until the fat lady started singing. Value investors buya dollar for 50 cents; the hot stock chaser is usually buying something that’s worth$1 for $1.25 in hopes of reselling it for $1.50. Chasing a train that’s left the stationis not practical because the odds are high that the person who bought it 20 pointslower than you’re buying it now is probably selling it to you. Wait for these rocketstocks to cool off before getting into the game. And if a stock goes to heightsheretofore unknown, so what? For every one you missed by not chasing it, there aredozens that fell back to earth. Stick with being a chooser, not a chaser.
Harboring the Fallen StockNo matter how good at investing you get, there’s going to be a loser in your account.As I mentioned before, if a stock falls off 7% from your purchase price, get ready todump it. If it’s down 10%, sell, period. Don’t become a religious investor—someonewho prays for his or her stock to come back up. Don’t ever let a small loss turn into abig one. If it turns around after you sell it, you can always buy it back. Just don’t arguewith the tape, because you’ll lose that fight every time. The market is the Great Humbler. Just when you get to thinking you’re smarter than everyone, you’ll get whacked.Stick to your stop-loss levels. If you take a loss, take it, and then get over it.
RULES OF THE TRADEI don’t mean to be harsh, but it seems with so much information around today, people believe their own malarkey. Nasdaq support, Dow trends, and on they go, fooling no one but themselves. If you’re a novice, these rules may help you to stay inthe game long enough to get good at it.1. Stay away from chat board recommendations. The Net has brought us a lotof wonderful things, and some destructive things, too. Chat rooms that offerhot tips are not one of the wonderful things. If this is where you’re gettingyour education and investment strategies, stop! Tips are the single most
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destructive thing going, especially when they involve micro-cap stocks.Stranger or best friend, steer clear, or you’ll end up learning the hard way.2. Avoid stock tips from magazines. Don’t get me wrong; I’m not saying don’tbuy financial magazines. They offer good information and certainly help educate people. It’s just that if you pick up a magazine and it gives you the “10Best Stocks to Own Today,” what happens next month when a new listcomes out? Then another? There’s no strategy involved, at least not a consistent one that I can see. Plus the articles are written in advance, detractingsomewhat from their freshness. Read for big picture topics and strategyinsights, but do your own stock picking.3. Use education not magazines. Take the time to investigate stock sectorsand their cycles, and if you read only one thing a week about the market,read Barron’s. The publication riles some people due to its viewpoints onthings like technology, but it’s current and pertinent, and offers useful information.4. Be selective in the counsel you seek. Once you have a plan (or think youhave a plan), use one or two people to bounce your ideas off (besides yourspouse). Money discussions and financial decisions as they pertain to investing are serious matters, and too many people offering opinions can be adangerous game. Find an old hand in the market, preferably someone youalready know. You are the one who will live with your decisions, not the adviser. Right before you conduct any transaction, discuss it with your spouseif possible. There may be something you overlooked, some nuance thatmight affect the outcome. Look before you leap.5. Prepare your plan of action the night before you expect to trade. Don’t alter your plans during market hours and/or if you have an open position. If itisn’t working like you thought it might when you made your plans withoutany stress, why on earth would you dream of altering your plans in the heatof battle?6. Know your competition. Remember that you’re playing against legions ofhighly skilled and well-funded professionals, overachievers with talent andexperience. They’re trying to beat you, period.7. Predetermine your exit point prior to opening a trade. That means predetermining the maximum loss, and sticking to it.8. Use caution when you average down. Pouring good money into a bad trademay succeed every now and then, but it’s not worth it in the long run.9. Be a gracious loser and take your losses easily. Never try to justify a badtrade by trying to convince yourself it will probably turn into a winner atsome point. A losing trade is to be viewed as overhead in your trading business. There’s no way around the occasional loss, other than quitting tradingaltogether.
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10. Don’t fight the trend. You may win occasionally, but don’t get sucked intobelieving you’re smarter than the market. It’s arrogant and costly to makethis mistake.11. Missed opportunities exist only in your mind. A market opportunity is likea city bus: Another one will be along any minute. If you chase a trade youhad mapped out the night before, you’ve compromised yourself already.Learn from it without learning the hard way.12. The human side of every person is the worst enemy to successful trading.The successful trader has to fight two powerful instincts: Fear and greedcannot be avoided, but they can be minimized by planning your trade, andtrading your plan.13. Never risk more than you can afford to lose. This is the heart of low-risktrading.14. Become a proficient computer geek. As investors wade through the financial markets, it is imperative that they harness the power of the personalcomputer and the software that is currently available. The competition thatyou will be facing is using this technology to its fullest potential, and in order to be successful, you will need to do the same thing.
ROADMAP TO SUCCESSObjective
Course of Action
PersonalEvaluation:What Kind ofInvestor Are You?
How you invest will determine your approach:What is the time frame you’re dealing with?• Before you invest, think about how long it will be realisticallybefore you begin using the money.–Retirement: supplementing your pension, Social Security, andother income.–A major purchase or expense: college; travel, a new home.How much risk can you tolerate?• Risk is another word for volatility.• Can you stand to watch your investment fluctuate? A little ora lot?• What is the most risk you can take and still be able to sleepat night?–You may surprise yourself!–You may be more or less risk-tolerant after you begininvesting.Sites for assisting with your risk profile:• Mutual Fund Investor Center (www.mfea.com): There’s a lotof information here, and a risk profile questionnaire from aleading mutual fund company.• Investor Financial Corporation (www.investfinancial.com/ais1.asp): A site that includes a questionnaire that can help.
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• Investor Guide.com (www.investorguide.com): Check outthis site’s risk profile guide.• Investor Home (www.investorhome.com/asset.htm): Awealth of links designed to assist you in your investmentplanning and assessment.Selecting the ToolsYou’ll Need toBegin
Factors to consider before you begin:• What system do you currently use?• Will it be able to track a new type of investment?–Where are your assets currently?–Do you track their performance?Get started on the right foot!• Put a system in place that can grow with you.• Quicken (www.quicken.com/myfinances): This site offers avery easy-to-use online system.• Kiplinger.com (www.kiplinger.com/magazine) This site alsohas some useful tools you can use—free!Know Where to Look for Information!• Find out what you don’t know. Here are some places to get youpointed in the right direction:–Financial Engines (www.financialengines.com): “Your PersonalOnline Investment Advisor.” Very informative, and free!–CyberInvest (www.cyberinvest.com): This site offers atremendous amount of information in an easy-to-use format.Definitely check it out!–Invest Smart (library.thinkquest.org/10326/index.html): Thisis a terrific site. Try Market Simulator and play with$100,000 of play money to see how the market actuallyworks. Lots of good basic information, too.–Armchair Millionaire (www.armchairmillionaire.com): Thissite offers a lot of help for just getting everything together;saving, debt reduction, and so on.
DeterminingTrends: TheEconomy
• Determine interest rate direction; up, down, steady.• Briefing.com does a good job of explaining economic events(www.briefing.com/intro/i_markcal.htm).• Treasury Corner.com is also a great place to research bonds,the economy, and a whole lot more (www.treasurycorner.com).• CNBC’s Kathleen Hayes does a tremendous job of explainingthe mysteries of the bond market, and how the economyinfluences it (www.cnbc.com/bond/bond_main.asp).
DeterminingDetermining the direction of the market is half the battle withTrends: The Market investing. Here are some sites I look at to get a better idea ofhow things are going:• Optionetics.com (www.optionetics.com): Daily commentaryand other useful information, daily commentary and articles,plus a huge library of past articles.• Investor’s Business Daily (www.investors.com): I look atsentiment indicators, read IBD’s thoughts on the latest inmarket levels and volume interpretations. Bookmark it.
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CRITICAL TRADING APPROACHES• Signal Watch Light (www.signalwatch.com): Ed Downs is amarket technician who offers a free daily service that can behelpful. Sometimes he’s spot-on accurate; other times hemisses badly. Still good to read to get a better understandingof technical analysis.• The Street.com (www.thestreet.com): Jim Cramer is a wellknown trader on Wall Street. He and his staff offer someintriguing insights and commentaries worth reading.
DeterminingTrends:Sector Watch
Being in the right sector is a very important ingredient to makingmoney in the market. Find out what sectors are doing well.• Look for sectors with the most new highs.• It’s a very good idea to read the Wall Street Journal and/orInvestor’s Business Daily to become familiar with what thecurrent buzz is all about.• Barron’s is often opinionated, but very good to read. It comesout weekly, on a Saturday.Various sectors/industry groups have free online newsletters thatcan be a bit too technical, but still worth reviewing. Here aretwo I like for tech stocks:• The Internet Analyst (www.theinternetanalyst.com/default.asp).• TheStandard.com (www.thestandard.net): At last countTheStandard offered 18 different newsletters on differentsectors under the “technology” heading. Free!HOLDRS are being used to buy the strongest stocks in a sector,and more are coming out all the time. Merrill Lynch hasdeveloped them, and they trade on the AMEX. For a current listof what sectors are represented in HOLDRS and the stocks theycover, go to: www.holdrs.com/holdrs/main/index.asp.
Determining Trends: Once you narrow down the sector or sectors you want to be in,Stock Researchbecome a specialist in those sectors. Know what stocks theyconsist of and their relative rank within the group. There aresome sites I’ve already mentioned but are worth listing again:• Investor’s Business Daily (www.investors.com): Online or inprint, a great place to find stock information and sectorrankings.• Market Guide (www.marketguide.com/mgi/home.asp): Agood site with lots of good insights and research, too.• Zacks Investment Research (www.zacks.com): If you want toknow everything about a company and how it ranks within asector, bookmark this site.• John Bollinger’s Equitytrader.com (www.equitytrader.com):No commentary here, just hard technical data that interpretsvolume and price information.Building a Portfolio How are you going to do it?• Lump sum.• Monthly deposits.• A mixture of the two.
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Lump sum• Don’t invest it all at once!• Be patient when evaluating entry points.• Find support and resistance levels (see Chapter 9 ontechnical analysis).• Look for breakouts—stocks moving up and out of a tradingrange. (Investor’s Business Daily has a good list every day ofstocks and sectors with the most new highs.)Monthly deposits• Go for a mutual fund to begin with.• Check the track record.• Fund description (does it meet your risk profile?) Do yourresearch at these sites:–Zacks (my.zacks.com/funds/index.php3)–Morningstar (www.morningstar.com)–Money.com (www.money.com/money/fundcenter)—Amixture of both.Write down your asset allocation mix.• Funds may overlap in terms of their portfolios. Look for their10–20 top holdings, and use Zacks to determine their riskcharacteristics.• Don’t get too concerned with the minutiae. Set an allocationof cash, stocks, and bonds–Aggressive: 80% stocks, 15% bonds, 5% cash–Moderate: 65% stocks, 25% bonds, 10% cash–Conservative: 50% blue chips, 35% bonds, and 15% cash• Silicon Investor has a pretty decent stock screen feature youcan use to help screen for stocks that will match yourportfolio’s objective (big caps, small caps, etc.), plus a goodnewsletter. Free! (www.siliconinvestor.com)Check fund families for monthly deposit features.• Do an MSN search for “mutual funds.”• CyberInvest (www.cyberinvest.com/guides/sharebuilder.html)offers a feature called “Share Builder.” Click on site to reviewdetails.• For further help with building a portfolio, go to: InvestorHome.com (asset allocation—www.investorhome.com/asset.htm.)• Read William O’Neil’s How to Make Money in Stocks. Thefounder of Investor’s Business Daily offers sound advicewhen looking for winners.The ThreeApproaches toEvaluating a Stock
Growth Investing: A growth stock is a company whose earningsand/or revenues are expected to grow more rapidly than theaverage earnings of the overall stock market.• Look at five-year earnings record.• Look at rank within its industry. How did it farecomparatively? (Zacks has a good tool for this, as doesInvestor’s Business Daily.)
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CRITICAL TRADING APPROACHES• Look at annual and quarterly earnings. Any surprises, good orbad?• Do you understand the industry group enough to becomfortable?Momentum Investing: Momentum investors like to find theprimary trend of a market and invest with that momentum inhopes of profiting from it.• Technical analysis is a requisite for this type of investing.• Look for breakouts into a higher trading range.• Look for price increases or decreases of 20%+ in the past 60days.• For shorter-term ideas, look for price increases or decreasesof more than 30% since yesterday.–Is momentum strengthening or weakening?–Check for strong volume.–Is it optionable? (May be able to take advantage of shortmoves with less money.)Value Investing: The primary objective of a value investor is touse fundamental analysis to buy a company for less than theinvestor thinks it is really worth.• Market may take time to discover this.• Buy-and-hold strategy is required.• Patience is a virtue, because the market will move and thistype of stock won’t.• Warren Buffett is the best-known value investor.• CyberInvest has a great site for this (www.cyberinvest.com/buffett.html).
Tracking YourPortfolio
Once your portfolio is in place, don’t micromanage it!However, check it regularly.• Keep a journal of all transactions. Make it convenient, safe,and organized.• Record the name of the security, the date you bought or sold it,the price paid (including any commissions), and your exit price.• There are software programs and web sites that enable you totrack performance:–Optionetics.com (www.optionetics.com)–Zacks Investment Research (my.zacks.com/index.php3)–Quicken (www.quicken.com/myfinances)Rank your portfolio.• Who’s doing best, worst?• What is the annual return? To calculate your annual return,take the amount of all securities at the end of the year (orquarter, if you so choose), subtract the beginning balance,then divide the answer into the beginning balance.Revisit your original plan.• Are you still comfortable with it?• Is it meeting your expectations?
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Rebalance the portfolio.• Look at the weighting of your holdings.• Is the portfolio still within your original parameters?• If not, are you more or less comfortable with the new risk?• Are you overexposed to one sector?–Overexposure can lead to painful drops in account value.–Rebalance quarterly!The Initial PublicFirst time a private company offers its stock to the public.Offering• Often it’s a liquidity event for the original investors.• Lots of hype surrounding it initially.• Quiet period causes hype to die down.• Stock can move sharply in the beginning, only to fall off afterthe quiet period begins.• Shares are offered through Offering Syndicate. The onlyplace to purchase them is through a brokerage firm that’sinvolved in the syndicate.• Pre-IPO prospectus is called a red herring due to the redprint on the cover. Final prospectus issued on date ofoffering.–Prospectus offers full disclosure of all pertinent financials,management profiles, business objectives, and risksinvolved.–Offering made only by the prospectus. If you intend to buythe stock, a prospectus must be in your hands prior to or onthe day of the offering.For a listing of upcoming IPOs, go to:–CyberInvest (www.cyberinvest.com/guides/ipodpo.html)–Alert!-IPO (www.ostman.com/alert-ipo/ai.exe?cobrand=ostman)–IPO.com (www.ipo.com)• Many insiders own restricted stock; they cannot sell it until alock-up period ends. This often involves employees,directors, management, and venture capitalists. The end of alock-up period can have a negative influence on the price ofa stock. For a list of all companies with lock-up periods andthe dates they come out, go to: www.ipolockup.com/may00.htm).Dealing with Losses What do you do when you’ve made a mistake? Either youbought too early or the stock has changed somehow,fundamentally.• Before entering the trade, accept the fact everyone takes aloss on occasion.• Calculate the maximum loss you’ll accept—usually it’s as littleas 5%, or as high as 7% to 8% less than your purchase price.• Keep your losses small! A small loss is less painful, maintainsyour confidence, and keeps you in the market so you can findanother winner.
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CRITICAL TRADING APPROACHES• If you hold onto a loser, it will distract you from findinganother winner. It’s too consuming and demoralizing.• Never double-down. You made a mistake, so don’t arguewith the tape.• If you’re making regular monthly deposits into a mutual fund,the market will rise and fall. When it’s down below yourpurchase price, determine if there’s been a change in fundmanagers. If not, keep putting money in. The lower NAV willenable you to purchase more shares. Not every investmentmanager’s style will work in every market.
Don’t Chase aStock!
If a stock has moved up and you were thinking about buying it,don’t wait until it’s moved up for a week before getting in.• Check its trading range. If it’s breaking out, what was thebreakout price?• If it’s more than just a few points above that level, forgetabout it.• When you sell a winner, don’t buy it back if it keeps goingup. Seller’s remorse could quickly turn into buyer’s remorse.• New opportunities come along daily; if you miss one,another one will come your way soon enough.
Other Good WebSites
Quote.com (www.quote.com/quotecom): Undoubtedly, one ofthe best web sites on the Net. Great charting and quotes as wellas commentary and analysis tools.Russell Investments (www.russell.com/us/home/default.asp): Alongtime institutional Investment firm; value-oriented.Whisper Number (lycos.whispernumber.com/index.cfm): Thissite is looked at for what the true earnings number will be forpublicly traded companies. If a company meets the estimates butmisses the whisper number, it can really make the stock sell off.Equis “Free Stuff” (www.equis.com/free): A good glossary fortechnical analysis explanations. From trend lines toretracements, this is a great site.Open Fund (www.metamarkets.com): The world’s first (andonly) interactive mutual fund. These guys post their trades asthey make them. You get to look over the shoulders ofinstitutional traders buying and selling. Very cool.ClearStation (clearstation.com): Nice site for observing whatothers are thinking. Also spotlights stocks with notabledevelopments in their technicals.
5The Versatility of Options
The last decade of the twentieth century fostered an explosive bull market. Everyone wanted to jump aboard and participate in the meteoric rise in U.S. stocks. Asvolatility rates soared and overnight high-tech sensations became the mainstay ofthis so-called new age of investing, online trading and investment-oriented Internetsites further changed the nature of the game once and for all. But for all the hype,newly created channels of information, and advancements in trading technology,making money in the market still proved to be an exercise of skill.A divergence between the new economy tech stocks and old economy Dowstocks rang in the new millennium, and volatility soared. Investors who had onlyknown bull markets and temporary pullbacks received some tough lessons as first theDow rolled over, dropping over 17%, followed by the Nasdaq, once believed to beimmune to such carnage. Good buying opportunities got better, and by May 24,2000, the Nasdaq had dropped a whopping 40%. A drop in the market of that magnitude served as a grim reminder that successful trading requires a comprehensive understanding of all the trading tools and instruments available. Hence, those traderswith the foresight to use options and hedge their positions had the last laugh after all.If in the old days, finding a broker who could spot winners was essential toincreasing your capital, these days survival can be found through the use of anincreasingly popular trading instrument: the option. An option gives you the right todo something. One of its uses is as a hedging instrument, to protect against suddenor prolonged downturns in the market. But options are much more than a hedge;they are often used in creative ways to reduce risk while enhancing a trade’s profitpotential.Options are a contract between two parties—a buyer and a seller—conveying theright (but not the obligation) to buy (call) or sell (put) a specified underlying security at a fixed price within a predefined time period for a specific premium. Let’sbreak this statement down.117
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THE VERSATILITY OF OPTIONS
Option: A trading instrument that represents the right to buy or sell a specifiedamount of an underlying stock at a predetermined price within a specified time.The option purchaser has the right, but not the obligation, to exercise thespecifics of the contract. The option seller assumes a legal obligation to fulfillthe specifics of the contract if the option is assigned to him or her.
“An option serves as a contract between two parties—a buyer and a seller—conveying the right (but not the obligation) to . . .1. “buy or sell . . .” There are two types of options: a call, which gives theowner the right to buy the underlying security, and a put, which gives theowner the right to sell the underlying security.2. “a specified underlying security . . .” Although options are available onstocks, indexes, bonds, currencies, and futures contracts, we are going to concentrate on the dynamics of stock options. Each stock is unique—some haveoptions, while others do not. If options are available, they can be bought andsold at a fraction of the cost of the underlying stock. But remember, you arenot buying or selling actual stock, just the right to buy or sell the stock at aspecific price within a specific