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Two Risk-Management Strategies for Choppy Markets

Before we get to this week’s mailbag, I have a confession to make…

I’m Bill Bonner’s biggest fan. And I’m damn proud of it.

That’s why I’m excited to announce that Bill’s latest book – A Modest Theory of Civilization: Win-Win or Lose – has gone to print. The hardcover version will be available for purchase next month.

Bill has been working on this book for nearly three years.

And, after helping him with the initial rounds of research… and sneaking peeks along the way… I can easily say that it’s my favorite of all his works.

It explains not just when but how humanity went off the rails.

If you’re a Legacy Lifetime, Bonner Lifetime, or Bonner-Denning Letter subscriber, you don’t have to wait… You can download a PDF version right here for free.

For anyone else who can’t wait for the hardcopy, the Kindle version is available on Amazon.

But please proceed with caution…

As Bill notes early on:

WARNING: If you want to get off the bus here, there will be no hard feelings. First, because the going might be rough. And second, because you might not like it very much when we get there. And third, because once you get there, you may not be able to ever come back. This is a one-way ride.

So consider yourself warned.

Now, for this week’s mailbag… First up, a question about risk management for Wall Street insider Jason Bodner (Palm Beach Trader)…

Reader question: Hi, Jason. We know you’re bullish now. You tell us not to listen to the bears!

My question is whether there will be a time, if your view of the market turns bearish, whether you will trim the portfolio before the 40% stop losses are breached? Or do you believe in the stocks we’re in so much that you think they will defy a bear market and recommend we stay fully invested no matter what?

Assuming you would trim back the portfolio, what type of market conditions would prompt such action? Thank you.

– Tom Z. (Legacy Research member)

Jason’s answer: Great timing with your question. Right now is a good time to take profits. That’s why we sold four positions yesterday, booking gains of…

  • 40% in 10 months on Ciena

  • 33% in six months on Broadridge

  • 29% in six months on Paychex

  • 7% in nine months on Medpace

As to why and what that has to do with the market conditions and our stops, let me explain…

My short answer is this: A 40% stop loss is wide enough to keep us in trades with higher volatility so we can earn long-run rewards… while still protecting us from huge losses. But that doesn’t mean we only sell when positions hit their stop.

When things get crowded in the portfolio, and markets are frothy, I look at our overbought/oversold ratio to guide me on when to reduce risk and be careful of adding new risk.

My long answer is:

The stocks we pick are the biggest winners in the market, but they also have a higher than usual level of volatility. I have personally been in stocks that have dropped 30% or more, only to rocket higher to 100% gains or better. The bottom line of the 40% stop loss is: you got to be in it to win it.

As for when we would start trimming, the clues lay in my overbought/oversold ratio. When big buying or big selling becomes unsustainable, the market becomes overbought or oversold. There are many overbought/oversold indicators out there. But I trust ours the best.

We even employed a fleet of Ivy League Master’s of Financial Engineering candidates to test the data on this ratio. They proved with statistical significance that it works. That’s just a fancy way of saying the data was reliable and up to the standards of mathy statisticians. And it doesn’t just work during testing, as Chris Lowe covered in the April 25 issue of The Daily Cut.

Think of our ratio as a yardstick that tells us when it’s a good time to cash out of some trades and reduce risk. Now is starting to be that time.

We haven’t hit overbought yet, but I suspect we will soon. And if we do and stay that way, expect me to take more profits… and do fewer trade initiations until that ratio comes down. If the market is overheated, I don’t want to add unnecessary risk…

Sorry for the long answer but your question has many parts and is also philosophical.

Plus, this guy answering it happens to talk a lot! Thanks for writing in!

With the market chopping back and forth lately, Tom Z. isn’t the only reader with questions about stop losses.

Here’s one for master trader Jeff Clark (Delta Direct, Delta Report, Jeff Clark Trader, and Market Minute)…

Reader question: Jeff, I recently joined both your Trader and Delta Report projects. I’m looking forward to seeing what happens and learning from you.

I traded options previously with mixed success, using a simple trend-following strategy. It was an interesting experience that I eventually put aside to focus on value investing in the resource sector. Ouch!

I have a newbie question, if you don’t mind. I know you may not be able to answer it directly, but I wanted to ask anyway – others may be wondering the same.

Why don’t we set a trailing stop on the more speculative options trades that you recommend?

You say that we must be willing to risk 100% of the trade, but I’d like to know why you don’t suggest, for example, a 50% hard stop or a trailing stop to protect capital. Is it because, in your experience, some trades fall more than 50% and end up profitable?

I would have thought a trade that is down 50% is a losing trade and ought to be stopped in its tracks. I’d be interested to hear your opinion on this and stop losses in general.

Finally, thank you for offering your expertise to the retail market.

– Tony B. (Legacy Research member)

Jeff’s answer: Thank you, Tony, for asking such an important question. I have both a short and long answer.

The short answer is… I don’t use stop-losses on option positions because I limit the size of the position to what I’m willing to risk on a 100% loss.

Here’s the longer answer…

If you put up $50,000 to buy 1,000 shares of a $50 stock, then you need to have a stop-loss plan in place to limit your loss if you’re wrong on the trade. Lots of folks use a 20% stop. So, they’ll risk $10,000 on this trade. Personally… I’m cheap, so I’d only risk a 10% move in the wrong direction. That means, I’d stop out at a $5,000 loss.

So, what I’ll do instead is take that $5,000 over to the option market and see what sort of trade I can put together there.

By using options, I can almost always find a way to increase the potential reward on a trade while reducing the potential risk as well. For example, if I’m willing to lose $5,000 on a stock trade, I should be willing to risk a 100% loss on a $5,000 option position. But, instead of buying $5,000 worth of options I’ll often cut that amount in half and risk just $2,500.

So, instead of putting $50,000 into the stock, I’ll put $2,500 into call options on the stock. If I’m right and the trade goes in my direction, I almost always make more on the options than I would have made on the stock. And, if I’m wrong and the trade goes against me, I’ll lose 100% of the $2,500 I put into the option trade.

But, losing 100% of a $2,500 option trade is far, far, far superior to losing 10% or 20% of a $50,000 stock trade.

So… to answer your question as directly as possible… I don’t use stop-loss orders on options because the option trade itself is a stop-loss order. As long as you limit your position to less than what you would otherwise risk on the stock.

If you read Wednesday’s Daily Cut, you know Jeff held a live open-line Q&A yesterday…

Jeff’s been doing these one-hour calls for his Delta Report subscribers for a while.

It’s a chance to get Jeff on the line for his unfiltered thoughts… market outlook… and trading tips.

This time, though, he decided to open it up to anyone looking to learn more about options trading… or just about where the markets could be headed next.

If that’s you – and you missed Jeff’s live call yesterday – don’t worry. He’s keeping the replay up until midnight tonight. So if you want to learn more about options trading from a 30-year veteran, watch it right here.

Moving on… Crypto pioneer Marco Wutzer (Disruptive Profits) eases one reader’s biggest concern about digital currencies like bitcoin…

Reader question: In the July 6 Daily Cut, it said that “… digital currencies that are decentralized, inflation-proof, censorship resistant, and impervious to the whims of central bankers.”

Maybe? How impervious are digital currencies to the whims of those currencies’ creators? Curiously.

– Bob B. (Legacy Research member)

Marco’s answer: Any change to a decentralized cryptocurrency like bitcoin requires a majority of all parties to agree.

The rules about how the currency works – for example, its total supply and yearly inflation – are defined in its code.

Only if a majority of all participants upgrades to a modified software version of the cryptocurrency can a change in the rules take effect.

Recent bitcoin history has shown that even a relatively simple change can require years of discussion until a majority can form and a change can be made. It took more than two years to come to an agreement to increase the block size to accommodate more transactions on the bitcoin network.

Increasing a cryptocurrency’s inflation rate or total supply would have a negative impact on its value, so it’s extremely unlikely such a change would ever be considered.

Next up in the mailbag… an unexpected controversy.

If you read our Independence Day tribute essay last Thursday, you’ll recognize the excerpt below from Legacy cofounder Bill Bonner…

“Americans today,” wrote one of the founders of the libertarian movement, Rose Wilder Lane, in 1936, “are the most reckless and lawless of peoples.” But, she immediately continued, “we are also the most imaginative, the most temperamental, the most infinitely varied.”

This was after the Lincoln administration had annihilated the principle of self-government… but before the Roosevelt team had finished its work.

By the end of the 20th century, Americans were required to wear seatbelts. And they ate low-fat yogurt without a gun to their heads. By the start of the 21st century, they were submitting to strip searches at airports and demanding higher taxes to “protect freedom.”

Well those comments sparked a question about “The Great Emancipator.”

So we turned to Dan Denning – Bill’s coauthor on The Bonner-Denning Letter and a card-carrying Libertarian – for an answer.

Warning: Proceed at your own risk if you think Lincoln is beyond reproach.

Reader question: Question on one of your talking points: What exactly did Lincoln do to dismantle self-government?

– Diana S. (Legacy Research member)

Dan’s answer: Lincoln acted like a tyrant. Most everyone knows he suspended habeas corpus in 1863. Habeas corpus (you have the body, in Latin) was a hard-won right derived from English Law. It prevented ordinary people from being unlawfully detained by the court or the Crown. They couldn’t just throw you in the clink indefinitely without charging you with a crime.

Lincoln’s action was “lawful” inasmuch as it was permitted by a law passed by a Union-dominated Congress during the Civil War. And it was intended to be used against spies, traitors, terrorists, etc. But it was hardly a great moment for respecting an individual’s God-given right to be free (or given by nature’s god).

The real issue many have with Lincoln, though, is that he used the force of the federal government to prevent several of the separate states from leaving the Union. Remember, our country is called the United States of America. Not the United “State” of America. It’s a Union of Separate States who were admitted into the Union on equal terms once they ratified the Constitution.

The Declaration of Independence says that governments derive their “just powers” from the “consent to be governed.” When the southern states withdrew their consent, Lincoln acted with force.

You could argue that from that point on, the federal government no longer governed “justly.” But the heart of the matter is that Lincoln told the South it couldn’t leave a union it had entered into voluntarily.

Americans, through state government, could no longer govern themselves (self-determination). That power moved to the Swamp. Where it rots today.

That’s all for today. Have a nice weekend.

Regards,

James Wells
Director