More Volatility Out There, So Let’s Talk About Risk

“Calling the Trend” Column, by George Leong, B. Comm.

The CBOE Volatility Index (VIX) is up, and this could point to increased volatility in the near term. Based on the recent market action, there is a downward bias in place, unless we see some support.

The negative bias is continuing to grip the stock markets. The DOW came close to its third straight day of losing over 100 points. Since the close above 10,000, the stock markets have been moving lower. About 88% of U.S. stocks are above the 200-day moving average (MA) as of October 27, down from 92% last week. Technology and small-cap stocks are attracting the brunt of the selling, which is not unexpected given their run-ups this year.

The near-term technical picture is fragile, with weakening Relative Strength, so we could see further downside moves. The overall market risk has risen, so watch your positions.

I want to talk a bit about risk. If you take the view that managing risk in your portfolio is the number-one goal, you will do well in the long run, no matter how promising a stock market opportunity is.

Even the most sophisticated and experienced investors lose big-time in the stock market. Not only can losing be considered an element of the stock-picking process, but it also really represents the cost of doing business. No one can predict the future and no one can predict future stock prices. Risk should be your top concern in the stock market.

Selling a losing stock position can be a very difficult thing to do. But if one of your holdings drops 30% in value, remember that the ongoing risk to your overall financial position remains the same. Even the investment risk inherent in that same losing position remains the same — it could very well go down even further! This is why management in risk is more important than potential returns. You cannot manage expected returns, but you can manage the amount of risk in your portfolio.

Using stop-loss limits when investing is an outstanding risk management strategy that always pays off in the long term.

When you take on a position in a stock, you should immediately make note of a stop-loss limit from your entry price, say 20%. You don’t have to do this with your broker — you can easily make a note of it yourself.

A 20% stop-loss limit means that, if the stock moves 20% lower in price from your original entry price, you cash out with a loss. By taking this loss, you preserve the rest of your capital to stay in the game. The idea is that your winning stock market positions will pay for your losing ones. Some may question the size of the stop-loss, but in the volatile markets we are seeing, setting a smaller stop loss could take your position out early and you’d miss a potential rebound. Take a look at some of your stocks and you’ll understand what I mean.

If you have $5,000 to speculate in small-cap stocks, put $1,000 into five companies and see what happens. Use a stop-loss limit on all five positions. Very likely, some will go down in price and some will go up. The goal is to cut your losing positions and ride your winning positions. It’s a simple strategy that works over the long term.

Also maintain a moving stop limit when the stock trades above your entry price. If a stock goes up 30%, consider maintaining a 10% moving stop limit from the stock’s most recent high. This way, you can consider taking some profits if the stock pulls back.

Remember, absolutely anything can happen to a stock. There could be a war, a strike, a stock market crash, or anything. So, you have to take steps to protect yourself.