Readings: Week 14 - 20 Aug 2017

To Sell or Not to Sell Prior to Earnings

There are basically 2 schools of thought when it comes to this issue:

Option No. 1: It’s just too risky to hold a position into an earnings call. This is one news event that we DO see coming and therefore, we should sell our position prior to the news and evaluate the stock afterwards.

Option No. 2: The technical action leading up to the earnings announcement tells us all we need to know. If the trend is still valid, there’s no reason to sell before the announcement. Selling will only cause us to miss out on a potentially huge post-earnings profit. We therefore need to trust the technicals and ignore the news and rumors.

Option No. 2 was Nicolas Darvas’ approach. He found that his biggest gains came when he “walked away” from his positions and only evaluated them from afar, regardless of the news and events that were directly impacting those positions.

I’ve noticed that when a stock gets hammered by an earnings announcement, it USUALLY flashes technical sell signals PRIOR to the announcement. For instance, the stock will undergo heavy-volume selling and/or break below a key support level without bounce-back action. Along those same lines, a stock that surges higher after an earnings announcement USUALLY shows signs of Accumulation Prior to the announcement. For instance, we’ll see the stock move higher on increased volume or bounce off a key support level right before the announcement.

Buying correctly out of sound bases and learning to identify and trust proper support levels during a stock’s rise will USUALLY keep you out of trouble when it comes to earnings announcements. I take a middle position between the two approaches mentioned above.

Signs of distribution will tell you the earnings news is likely to disappoint and signs of accumulation will tell you that even if the news IS disappointing, institutional buyers will likely be there to hold the stock up. But yet, I recommend selling half of a position prior to an earnings announcement.

By selling half, I can still benefit from good news and a gap higher, but I also won’t get hurt too bad by disappointing news and a gap down. I remind myself and others that you can always buy back the other half if the news is good.

Selling half of a position prior to an earnings announcement makes me FEEL (and sleep) better. If I’m completely honest with myself, my “sell half rule” is executed for EMOTIONALmanagement more so than for MONEY management.

A trader MUST learn to control his emotions just like he must learn to control his money. He needs to implement specific techniques to enhance his control over both.

Charles Kirkpatrick’s approach to value and momentum investing

Kirkpatrick’s approach is mechanical – he relies less on what the company actually does and more on ‘relative’ indicators connected to the stock price and fundamental data. He is a strong believer in behavioural biases, so his strategy seeks to strip out potential frailties like investor impatience, lack of discipline and fear of being wrong.

He developed 3 investment models – Growth, Value and Bargain.

  • With Growth, he looks for stocks in the top 10% of the market for relative price strength over the previous 130 days (on page 119, he suggests increasing that to 20% if overly restrictive). In addition, he screens for stocks in the top 10% of the market for relative reported earnings growth over the previous four quarters.

  • With Value, the relative price and reported earnings growth once again apply. This time, he also wants to see a relative price-to-sales ratio that ranks among the lowest 30% of the market.

  • In the Bargain model, the demands are even more precise. Stocks ideally need to be displaying relative strength in the top 3% of the market, while the relative price-to-sales ratio has to rank in the 17th to 42nd percentiles.

When to sell

As a technician, Kirkpatrick had very fixed views on when to sell stocks in each of his three models. In varying degrees, all sale triggers involved a substantial negative change in the relative strength of the price, the reported earnings growth rank and the price-to-sales ratio rank.

  • With Growth, stock are sold when the relative price strength rank falls to below 30% in the market; relative reported earnings growth rank falls below 70% and the stock price falls below two previous notable lows.

  • In Value, the sell drivers are when the relative price strength rank falls to below 30% in the market are when the relative reported earnings growth rank drops below 50% against the market. Kirkpatrick didn’t use the price-to-sales ratio as a sell indicator in this model.

  • In the Bargain model, Kirkpatrick’s precision screening involved selling stocks when the relative price strength ranked below 52% in the market and when the relative price-to-sales ratio ranked below 7% or above 67%.

Being Comfortable with Risk

The best strategy for you, is not only one that makes sense, but one you can stick with. – Joel Greenblatt

Risk is really simple. Risk is the way you think about it in your personal life. Risk is how much can you lose and what are the chances of losing it? That’s risk

That the way we think about what a security is worth, if we think a stock is trading at $10 and it’s worth $20 and it falls, it’s gotten safer, not riskier because the amount you can lose is less. It’s very simple math. It’s closer to zero. And the upside is bigger. Instead of going from $10 to $20, you can go from $8 to $20 or from $6 to $20.

If Your Investment Thesis Requires You To Fire Up Excel, It Should Be A Big Red Flag

The psychological warfare with our brains really gets heated after we buy a stock.

The most potent weapon in your arsenal to fight these powerful forces is to buy painfully simple businesses with painfully simple theses for why you’re likely to make a great deal of money and unlikely to lose much.If it takes more than a short paragraph, there is a fundamental problem.

If it requires me to fire up Excel, it is a big red flag that strongly suggests that I ought to take a pass.

Pyramiding, Locking in Profits, or Enjoying the Ride

Let’s say you’ve bought shares in Livermore Financial Services Inc. and the price has been rising in a satisfactory way – there’s a solid uptrend and it’s showing no signs of weakening. There are three ways of managing your trade:

  • Lock in Profits – sell some shares now so if the price falls suddenly, you’ll have locked in a good profit on the ones you’ve sold.

  • Pyramid – buy more shares hoping to further increase your profit.

  • Enjoy the Ride – neither increase nor decrease your position.

Which is best?

If we assume that trending is real, then it would be illogical to sell during an uptrend. You would be selling at a time when prices are likely to continue rising. The correct time to sell is after the uptrend has broken.

Provided the trade continues to move in your desired direction, you will certainly increase your profits by pyramiding.

Jesse Livermore’s Pivotal Point: Ugly Duckling Buy Set-up

“The final time a trader can pyramid is when a stock breaks out to a clear new high on HEAVY VOLUME; this is a very good sign because it most likely means that there is no more overhanging stock to stop the progress of the stock for a while.”

The Ugly Duckling buy set-up is based on a similar idea. When looking for these types of set-ups I look for stocks that were prior market leaders but which have since gone into corrections and possible base-building processes

Record highs! Time to sell?

This accords well with attempting to “sell high”, and we can see that some of our clients are clearly “banking gains”, “selling at the top”, and “reducing risk”. The problem is that all of these phrases are backwards-looking, and investment decisions should be made on a forward-looking basis.

The Remarkable Truth about 52-Week High Stocks

So how do people perceive stocks that are at a 52-week high, and might this metric cause us to do something inappropriate?

The anchoring effect describes how we can be influenced, or “anchored,” on specific information. In “Psychological Barriers, Expectational Errors, and Underreaction to News,” (a copy is here) Justin Birru argues that when stocks are at a 52-week high, this creates a psychological barrier of sorts, beyond which investors think the stock is unlikely to go. Investors discount the possibility that the stock will continue higher, which induces them to sell.

Our associative machinery, with its tendency to create narratives to accompany our observations, might say something like,“This stock has run up a lot and so it is expensive relative to where it’s traded in the past year. I better sell now, since the price is undoubtedly good, at least relative to where it has been.”

Birru found strong evidence that investors became overly pessimistic about earnings for stocks near a 52-week high, since they were systematically surprised by subsequent strong earnings. Clearly, these strong earnings results were not anticipated by the market, and Birru hypothesizes that this occurs because investors improperly anchor on the 52-week high.

So if one of your stocks hits a new 52-week high, you probably shouldn’t be nervous. In fact, perhaps you should be excited.

The Easy Way to Minimize Drawdowns

Drawdowns are caused by two factors.

  • The first factor is a streak of losing trades

  • The second major cause of drawdowns is when a large winning position reverses and breaks its trend. This factor is much more significant for trend traders.

The key to successful trend trading is riding a trend until it breaks. Usually, once a stock has broken out, a trend trader will add to his position as the stock climbs. By the time the stock is up, say, 50% or more, a trend trader who got in at the initial breakout is HEAVILY invested in the stock.

Of course, all great trends eventually come to an end, and this is where a trend trader experiences significant drawdowns.

How can a trader minimize the pain of these types of drawdowns? The simplest way I know is something called “reverse pyramiding".

”Standard “pyramiding” means adding to a position as it shows strength.

“Reverse pyramiding” means unwinding a position as it pulls back after a massive run. For example, if a trader catches a trend and becomes fully-invested in that trend, he should start easing out of the position when the stock starts pulling back. You can eliminate these holdings by cutting each of your positions down by 25% or you can cut back larger amounts from the stocks that are struggling the most.

The nice thing about this method is that with each quarter of your holdings you cut, it gets harder for your portfolio to drop significantly (because you now have smaller positions). In other words, this strategy makes it very difficult to actually hit a 20% drawdown because most of your positions would have already been exited.

Pyramiding, in either direction, is a powerful trading tool. Learn to use it effectively. It’s a simple way to maximize your profit potential and minimize your drawdowns.

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