This Week’s Commentary – January 12, 2008 – Discipline

Discipline.

Here’s one definition of discipline:

Discipline – behavior in accord with rules of conduct; behavior and order maintained by training and control.

In other words, to be disciplined means to behave in accordance with a set of rules; by following those rules, order is maintained.

Over the last few weeks we have discussed rules, and I now have three of them on our Rules page, the most pertinent of which is:

If a stock has fallen 20% from it’s high, sell it.

(For those accountants in the group, here’s how I do it: I have a spreadsheet containing my portfolio. Every morning I download the portfolio from my broker. The computer than flags every stock that has made a new high. I then adjust the “high” column for that day’s price. This morning I adjusted the following stocks that made a new high on Friday: AEM.TO – Agnico Eagle Mines Ltd., BCM.V – Bear Creek Mining Corp., G.TO – Goldcorp Inc., K.TO – Kinross Gold Corp., and MFL.TO – Minefinders Corp Ltd. Note that these are new highs since I bought the stock, and not necessarily a new 52 week high. Also note that, with the exception of Bear Creek Mining which is a silver play, all of the above stocks are gold stocks).

For example, if I buy a stock for 52 cents on November 13, 2007, and it ultimately goes as high as 94 cents on January 2, 2008, I would set my rolling mental stop loss at 75 cents, so that if the stock ever falls to 75 cents or less, I sell it. By selling at 75 cents I realize a profit of 44%, which isn’t bad.

If a stock has fallen 20 per cent from it’s high, it obviously isn’t going up, and this approach forces me to be disciplined and take profits, and not watch a stock fall all the way back to where we started, or worse.

The stock in question was MM.V – Magnum Uranium Corp., which I sold on January 9, 2008 for 69 cents, for a profit of about 33%. Obviously I wasn’t paying close enough attention to sell at the exact 75 cent level, but I’ll take the profit and run.

Now of course there may be those among you who are saying: “wait a minute; you waited until the stock fell down to about it’s 50 day moving average, which is a often a good support level, and you sold when the RSI was around 50, which is a good buy point. Shouldn’t you be buying, not selling?”

Perhaps. But I have rules. In 2008, I will be exercising discipline. If a stock falls 20% from it’s peak, I will sell it. By doing so, in most cases I can limit my losses to far less than 20%, and hopefully in most cases actually lock in a gain (because it’s not a profit until you sell). Above all, I do not want a repeat of 2007 where I lost 34%. With this rule, barring a massive market collapse, it is impossible to lose much more than 20%. Which brings me to another definition:

Discipline – punishment inflicted by way of correction and training.

I’m pretty sure that our experiences of 2007 would qualify as “punishment” that we inflicted on ourselves by not having discipline. Watching a portfolio drop by 34% tends to focus the mind.

As much as it pained me, I exercised more discipline this week by selling some other losers. Any stock that I own that was down by more than 20% got sold this week, and that included some old favourites (or favorites for you Americans) like JNN.V – JNR Resources Inc., CHX.V – Cash Minerals Ltd., and even MGA.TO – Mega Uranium Ltd.

I like these stocks, and I have owned some of them for a long time. The argument can be made that many of them have fallen to great buy points. (In fact, that’s exactly the question that john77 asked in this post on the Buy High Sell Higher Forum before the markets opened on Thursday: are we now at a buy point for JNN.V – JNR Resources Inc., given the positive divergence on the MFI?). I don’t know whether it’s a buy point or not, but I do now that once I have lost 20%, I am no longer willing to stick around to find out. I’m leaving, because if I don’t, 20% can turn into 30% very quickly.

Some Thoughts On Gold

Of course this strategy of constantly resetting the “high” prices on my computer screen is not just a protection against losses; it also highlights stocks that are making new “highs”, which is also instructive. For example, AEM.TO – Agnico Eagle Mines Ltd., a stock I have not discussed here before, has been making new highs all week:

Which of course raises the question: I am now up over 23% on this stock in a relatively short period of time; is it time to take profits? The stock currently has an RSI of over 80, a MACD of over 3, and a Money Flow Index of over 95. No stock ever stays at those levels forever, so some kind of pullback is inevitable. But when is inevitable? Here’s the same chart over three years:

In the last three years the RSI has been over 70 on four other occasions (see the vertical red lines), and in three of those four occasions it marked a near term top. The only exception was at the end of 2006, which marked the beginning of the year long bull run in many gold stocks.

What does discipline tell me to do? Discipline tells me to take profits. But, my gut tells me this is a great long term stock, for the following reasons:

They have increased, by 50% to 18 cents, their dividend for 2008. They have increased their provable gold reserves by 20%. And, according to the CEO, “our large cash position, expected cash flow and available credit facility will allow us to fund our growth without the need for equity financing.” (You can read the press release here). That all sounds very good, long term.

But, the chart tells me that a pullback into the $55 range would not be that unusual. In fact, it would be healthy. So, what to do?

I don’t want to sell the stock, because I believe that long term it should be a core holding in my portfolio. If I sell it, will I be nimble enough to buy it back at the appropriate time? Probably not. I think a better strategy is to cover it.

Yes, I know, your eyes all glaze over when I talk about Covered Writing, which is where I sell call options on a stock I own. If the stock falls, the options I sold lose value, so I can buy them back at a cheaper price, and pocket the difference.

As of Friday I could sell a February 56 call for $7.75 (you can see all of the options quotes here). The stock closed at $62.67 on Friday, so the options are “in the money” by $6.67, which means I am getting $6.67 for the “true” value of the option, plus I am getting $1.08 for the time premium.

If Agnico Eagle falls to $55.99 by the third Friday in February, the options expire worthless, and I keep my $7.75, which in effect lowers my cost of ownership of the stock by $7.75. If the stock increases in value, some of the time premium will erode as time goes on, I will lose money buy back the options, but I will still own the underlying stock, which will have increased in value.

Here’s what I plan to do: on Monday, I will sell the February 56 calls (or perhaps the February 58 or 60’s; it depends where the stock opens on Monday, and how risk averse I am feeling). On Tuesday I will then put in a buy order for half of the value I received, so my goal is a 50 per cent profit on the options. If I sell them for $8, I’ll put in a buy order around $3.50 (so I can make 50% including commissions).

Covered Writing – How Did I Do?

Of course, I have tried this strategy before.

As I discussed last week, on January 2, 2008 I sold 18 contracts of the SLW January 19 call. (In this case the call was 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

On January 8 the stock had fallen, and I was able to buy the calls back for 30 cents, which after commission cost me $572.49, for a net profit on the transaction of $655.02, or 53%.

I did the same with my other silver stocks, PAA.TO – Pan American Silver Corp., and SSO.TO – Silver Standard Resources Inc. , with similar results (about a 50% profit).

My sharp eyed readers will be saying “wait a minute, Silver Wheaton closed on Friday at $16.85, so this was a stupid strategy. Instead of covering the stock, you should have sold it. You could buy it back today for $16.85, which would have saved you $1.65, as compared to the 36 cents you made on the option transaction.”

Gee, you readers are harsh. But correct. However, I don’t know what the stock will do from day to day. I do believe, however, that over the course of the next few months the stock will increase in value, so I want to own it. To me, the options strategy is simply a way to reduce my cost of ownership by pocketing same cash during the inevitable volatile swings.

Unfortunately this strategy has not worked out with my covered writes on my gold stocks, namely G.TO – Goldcorp Inc., and K.TO – Kinross Gold Corp. The Goldcorp options have increased by 225% since I sold them, and the Kinross options are up by 460%, so obviously instead of selling the options, I should have bought them.

Am I sad? No.

First, I don’t “play” options. They are far too risky to simply buy and sell. I use options to reduce risk by only selling options on stocks I own, not by buying or selling them “naked.”

Second, the reason the options have increased in value, obviously, is because the underlying stocks have increased in value, and since I own the stocks, I’m happy.

So, again, what do I do?

I have two choices.

First, I could let the options expire, which means at the end of the day Friday the holder of the options will exercise them, and I will have to give them my stocks. Since I plan to own the stocks long term, I don’t like that idea.

Second, I could simply buy back the options, take the loss, and move on.

Third, I could buy back the options, and then sell some February options to recoup my original investment, and play the game again.

I will probably go with option #3.

To buy back the Kinross January 20 calls will cost me around $3.55; I can sell the Kinross February 20 calls for $3.80, which leaves me in a cash neutral position. Since Kinross closed Friday at $23.47, the $20 calls are in the money by $3.47, so I am only bringing in a time premium of 33 cents, which isn’t much for a month. A better play may be to sell the February 22 calls for $2.35; I don’t get all of my money back, but I’m then taking in a time premium of 88 cents, which is more likely to erode over the next month.

I’ll decide on Monday what to do. I don’t have to sell on Monday, I could wait until later in the week. Given the volatility in these stocks, a sharp downtick is still possible this week.

Again, it all comes back to discipline. I want to cut my losses, protect my gains, and not risk everything on the “big score” if some simple profits are staring me in the face.

Discipline is not easy, and it’s not fun. I don’t like to sell a stock that’s down, because it means I must admit failure. I don’t like to sell a winner, because it may go up even more. However, I don’t want to lose 34% in a year, so some discipline is in order.

I have been long-winded enough for this week, so thanks for reading, and feel free to post your thoughts on the Buy High Sell Higher Forum.