Weekly Commentary – January 5, 2008 – Let The Games Begin

by JDH on January 5, 2008

After watching my portfolio decline by 34% in 2007 (my second worst year ever, as noted on the Portfolio Performance page), I am pleased to report that the first three days of 2008 have produced a 4% gain in my portfolio. Not a fantastic start, but considering that the Dow fell by 2% on Friday, and was down for the week, that’s a good result to start the year.

So now, my dilemma: Do I sell everything I own, move to cash, and guarantee myself a 4% return for the year? That’s as good as you get investing in T-Bills. In fact, I could put the money in T-Bills and be guaranteed an 7% return or so for the year, with no risk.

If I did that, every week I could write that “My T-Bills are doing fine; no change.” In 2007 we had a few hundred thousand page views on this site and the Forum; if I invested in T-Bills the readership would quickly drop to zero. The blog would be boring, but I wouldn’t lose any money.

Needless to say, I have no intention of crawling into a hole and hiding. There is no doubt that I made some mistakes in 2007. (You can read all about them in my post called JDH’s Stupid Mistakes of 2007). I have decided to learn from my mistakes (which is, of course, the whole point of posting my thoughts each week for all to see) and follow three simple rules to prevent the mistakes of 2007. You can read the rules on my new Investment Rules page, or you can just read them here, since there are only three of them:

JDH’s Investment Rules:

  • Buy high, sell higher. Don’t try to catch the exact bottom; wait until a stock has started to move up, then start buying. The perfect time to buy is at the end of a period of consolidation when a stock has just made a new high for the first time in many months. Often this buy point is indicated by the Relative Strength Index (RSI) increasing over the 50 level for the first time. Visually, the stock will also be in an obvious uptrend, at least in the short term. This also means don’t try to chase a stock; if it just had a huge up move, wait for it to ease back before jumping in.
  • Take profits. It’s not a profit until you sell, so decide in advance when you want to take profits. Once a stock doubles, sell half, or sell 25% if you think it still has room to double again. Keep selling all the way up.
  • Use Mental Stop Losses. Keep a list of the “high” price since you bought the stock. (Each day that a stock increases, increase the high price). Once a stock drops 20% from the high price (or a lesser percentage for less speculative stocks) sell it, because obviously it is no longer going up. Many speculative stocks can move 5% or more in one day, but it is very rare that a stock will fall 20% and then immediately go on a big run. Normally if it has fallen that much, it has farther to go on the downside. The advantage of this rule is that you will never lose much more than 20% on any stock. If a stock increases after you buy it, your loses will always be less than 20%, since the 20% is measured from the high for the stock, not from your purchase price.

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    My biggest mistake in 2007 was not using stop losses. Obviously losing 34% in a year means that many of my stocks fell by more than 34%, which is unacceptable. Here’s what I have done for this year:

    I have created a spreadsheet that lists my portfolio, just like the Excel spreadsheet with the JDH Target Portfolio. I have added a column called “Stock Price High”, which is the highest price the stock has reached since I bought it. (For simplicity’s sake I just use the highest closing price). Whenever there are significant moves, which this week was every day, I download my holdings from my broker as an Excel spreadsheet, and insert the data. If the closing price of any stock is higher than the previous high, I reset the high to today’s price.

    I then have another column called “Stop Loss”, which is equal to 80% of the Stock Price High. If the price of the stock ever hits the Stop Loss price, it means the stock has fallen by 20% from it’s peak. If it does, I sell it.

    By doing this I limit my losses to 20%, but I’m not using a stop loss that’s so tight that I get stopped out of a good stock in a normal volatile consolidation. In practice I expect my losses to be less than 20%. For example, if I buy a stock at $10 and it increases to $11, my stop loss will be set at 80% of $11, or $8.80. If the stock then falls to $8.80, I sell. In this example I lose $1.20, or 12% of my original investment.

    Of course if my $10 stock increased to $15, my stop loss would be set at 80% of $15 or $12, so if it then fell from $15 to $12 I would sell, which gives me a 20% profit.

    I realize that because these are “mental” stop losses I won’t be able to sell at exactly the price I want. If the stock falls to $12 and I put in a sell order, I may get filled at $11.50, or whatever, so my losses could be higher or lower, but they will always be in the range that I consider acceptable.

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    I have also employed another tactic this year to limit my downside risk: Covered Writing. In simple terms, I sell call options on stocks I own. Here’s an example:

    On Wednesday the market was up, and I wanted to protect myself against stocks dropping. But I didn’t want to sell my stocks, because I believe they will continue to increase over the next few months. So I covered.

    On Wednesday I sold 18 contracts of the SLW January 19 call. (In this case a call is the right for the purchaser to buy 1,800 shares from me of SLW.TO – Silver Wheaton Corp. for $19). At the time I sold the calls Silver Wheaton was trading around $18.50, meaning the calls were out of the money by 50 cents. (This means that the price of the stock would need to increase by more than 50 cents before the third Friday in January for the calls to be worth anything, otherwise they expire worthless).

    I sold them for 70 cents, so my gross cash in take was $1,260, less commissions for a net inflow of $1,227.51

    If at the end of the day on January 18, which is the third Friday of the month when options expire, Silver Wheaton closes at less than $19, the options expire worthless, and I get to keep my $1,227.51.

    Because this is a covered write, I have to own the underlying 1,800 shares (that’s the “margin” or security I put up for the investment). If the options expire worthless and I keep my $1,227.51 I have effectively lowered the cost of my shares by 68 cents each.

    As luck would have it, on Thursday morning an analyst downgraded the stock, causing the stock to drop from it’s peak of $19 to close at $17.65 on Friday. At the close on Friday the options were quoted at a bid ask spread of 30 cents to 40 cents.

    I have done the same with some of the other stocks I own that are optionable. On Wednesday, after the big run up in some of my holdings, I sold out of the money January calls on G.TO – Goldcorp Inc., K.TO – Kinross Gold Corp., PAA.TO – Pan American Silver Corp., and SSO.TO – Silver Standard Resources Inc.

    On Friday, I put in buy orders on all of the calls that I had sold. I put the buy orders in at a price that’s 50% less, including commissions, then what I sold the calls for on Wednesday. I put the orders in for one week, expiring January 11. My goal is to make a 50% profit on the option trade.

    For example, I put in a buy order at 30 cents on my Silver Wheaton call options. I sold them for 70 cents, so if I can buy them back for 30 cents I make roughly a 50% profit on the option trade. As I said above, the options were quoted at the end of the day Friday at a bid ask spread of 30 to 40 cents, so my buy order did not get filled. That’s fine, I’ll leave the order open for the week; unless the stock goes on a big run, the time premium will continue to erode, and I will eventually get filled.

    My thought process is this: I plan to hold the stock for the next month or two or three, so I don’t want to sell it. But, I realize that we are in a volatile period, so the price may swing, so this strategy gives me the ability to make a few extra dollars with minimal extra risk.

    What if I’m wrong? What if the price moves against me? I sold the Goldcorp January 38 calls for 50 cents when Goldcorp was trading at around $36.40. On Friday G.TO – Goldcorp Inc. closed at $37.55, and the options are quoted at $1 to $1.10. In other words, instead of selling the calls, I should have bought them. However, I’m not worried, because the calls are still out of the money, so even if Goldcorp rises by another 45 cents in the next two weeks, the options still expire worthless, and I keep the premium. If Goldcorp rises above $38, I can simply buy back the calls I sold, and then sell calls for a similar value with a February expiration date.

    The time premium continues to erode, so as long as I continue to buy back the current options with money raised from selling future options with more time premium, I never lose my original cash received.

    I only employ the covered writing tactic after a stock has had a big move to the upside, and I only if I can get a decent return on the sale. As of Friday my bet so far looks wrong on the two gold stocks I covered ( G.TO – Goldcorp Inc. and K.TO – Kinross Gold Corp.), but my guess looks correct on the three silver stocks I covered, because silver moved down at the end of the week (PAA.TO – Pan American Silver Corp., SLW.TO – Silver Wheaton Corp., and SSO.TO – Silver Standard Resources Inc.).

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    Those are my thoughts to start the year off. I expect some volatility over the next week, and I will be increasing my positions on stocks I want to own if they fall this week. I also expect that after this next down tick, we will seem some impressive gains; I expect February and March to be very good months; after that, who knows.

    Therefore, take your positions now, for what should be a great ride.

    Thanks for reading, and feel free to post your thoughts on the Buy High Sell Higher Forum.

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