Before Market Timing or Buying and Selling Any Investment Ask and Answer These Questions

The following is a discussion of questions you should ask prior to investing or market timing that concern your reasons for buying, your selected stop losses or technical analysis parameters, the reward: risk ratio (or risk reward ratio if you prefer), position sizing, scaling in and out of investments and trades, and recording your thoughts.

1. Do you understand WHAT you are buying?

If you don't, don't invest or even trade.  Using market timing to buy something you don't understand is playing with fire.  You must understand how the given ETF works for example.  If you buy a triple inverse financial ETF, are you aware that you could have 20% losses in one day?  That's just one example.

If you are buying a tech company but have no clue as to what their product does or what its competition is that could make it obsolete, why would you buy it?

2. Have you decided WHY you are buying and have you recorded the reasons whether fundamental or based on market timing methods?

It is a good idea to record the reasons whether they are based on technical analysis or fundamental analysis.  If you are using market timing to decide to buy, write that down and indicate why you are buying in terms of specific technical signals.  It may be simply that the market is in an up trend based on market timing parameters or that it has just switched to a stronger buy signal.  Simply record that.  Send your market timing or fundamental reasons for buying in an email to yourself or write it down in a notebook. Either way, record it.   If you cannot go back and examine your thinking, you may fail to learn from your gains and losses.

And if you don't write your reasons for buying down, you will likely never take full responsibility for your results and your progress as a trader and/or investor will be hurt.

3. Where are you selling? A. Have you decided WHY and AT WHAT PRICE you will SELL and have you recorded the reasons? AND B. Have you set up a TRAILING STOP LOSS? (Please do 3 A and 3 B before buying.)

You may sell for technical market timing and/or fundamental reasons. 

Regardless of why you bought the financial instrument (stock,ETF, mutual fund, gold, currency, etc), if you don't have a sell stop in mind AT THE TIME YOU BOUGHT IT, meaning a place where you will absolutely get out of it if it falls a certain amount, you are kidding yourself.  You don't always find out why a stock is trading lower until it does.  Ask those who owned Citigroup from over $50 a share to under $1 per share.  Did Citigroup send out enough flares to warn their investors?  If they did, which investors actually heard that problems were arising?

You will suffer losses that are very difficult to overcome if you let an investment go to a maximum loss of more than 20-25% or so.   The math is simple. If you lose 50% you have to make back 100% which is a big gain just to return to EVEN! Talk about bad market timing! If you lose only 20%, you only have to make 25% back to get back to even.

If you want to use a tighter slop loss percentage than 20%, of course, do so.  We use tighter stops in our newsletter based on our analysis.  If you make them too tight, you will be kicked out simply due to a small amount of "noise" in the price, so look at the price swings in the stock that seem tolerable to you given it's past behavior. If the swoons are too big and you could not stomach the loss, then simply DO NOT INVEST in that stock or ETF.

The most effective sell stops are trailing stops that are based on the highest price reached after your purchase. 

Example: If you buy at $200 and the ETF goes to $400, then you sell on a close below $300 after it drops $100.  This ensures that you do not give up ALL of your profit in any investment or trade.  You keep a 50% gain in that example.  You bought at $200 and sold at $300.

When you do not set a mental SELL STOP up in advance, you set yourself up for falling asleep in unconsciousness on your investments and/or trades.  

I'll help you by making sure you hear this: NEVER EVER BUY anything without deciding WHEN YOU WILL SELL BEFORE YOU BUY.

I recommend you start a trading and/or investing log to record your decisions with the dates you made them.  Put your sell stop thinking down as well as your buying thinking so you can learn from your successes and losses.  If you do not learn from what you have done, you will progress as an investor and/or trader very slowly.   But if you make it CLEAR TO YOURSELF in writing why you DID WHAT YOU DID, you will start to WIN more and more often.

The Risk of Setting a Trailing Stop Loss IN the Market: If you set an actual order to "SELL STOP" at a specific price there are risks.

1. The market maker may be close enough to your price that he/she will take out your order and then move the market right back up. You may be "picked off."

2. In the "Flash Crash" of May 6, 2010, the market went haywire because there were suddenly not enough buyers and too many sellers due to varying practices on the NYSE vs. the NASDAQ. At least it seems that way to some people. The point is that many people lost a HUGE amount of money. As an example, look at the index ETF PIN on that day; just plug PIN into your favorite financial site such as Yahoo or Google Finance. What a swoon! So if you set a sell stop 25% below the current price for that day, you were forced to sell. And what if you did not know why this had happened and did not immediately rebuy it? You lost the difference between your ridiculous discount price and the closing price on May 6th. So placing a SELL STOP ORDER in the market is very dangerous at times. At times, there may be no way around it (if you are away for a bit during the day), but avoid it whenever possible.

Use "mental sell stops" instead and execute them as your schedule allows. Yes, that gives the professional trader an advantage as they are glued to their computer, but such is life. You can still protect your assets using trailing stop losses even if you can't be glued to the computer.

4. Is the Reward: Risk Ratio at least 2:1 (even better 3:1)?

This means that whether you are buying or selling short, you determine that you are likely to make at least TWICE as much money as you will lose if your stop loss is hit should the shares or investment sell off.

A 2:1 reward: risk ratio is the minimum any market timing trader or even value investor will generally accept.  Expressed as a risk reward ratio, you want to risk only half as much as you stand to gain on your investment (not half of what you invest; half of your gain or less). Some traders and investors may demand a 3:1 Reward: Risk ratio or more.

Let's use an exaggerated but simple example to make a point now about the value of trailing stop losses. If you are right only half of the time and you double your money on all winning investments, and you set a stop loss at 25% on the half that are both losers and go to zero, then after 10 trades you move from $1 million in starting capital placed into 10 equally sized investments to $1.375 million dollars ([$100000*5]* 2 + [100000*0.75]* 5 = $1,375,000).  I realize this is an extreme example, but it makes the point about cutting losses. 

If you had let 5 of the 10 investments go to zero as some investors do, instead of getting out after a 25% loss in each losing investment, you would have ended up with only $1 million dollars at the end!  You would have made nothing instead of a 37.5% gain.

Cut your losses and let your winners ride and you will make money provided you invest in up trends technically using market timing or in upward sloping economic trends fundamentally that are accompanied by rising prices in the related investment.  If the economics make sense, but you make no money because you ignore technical analysis, what is the point of investing? 

5. Have you selected a reasonable position size?

A stop loss won't protect your capital if you position size is too big.  This means that you should in general not invest more than 2-4% of your assets in any given investment, other than your house.  A "standard" gold investment is often said to be 5%, and some are advocating a 10% gold position currently. Some say it's fine to invest 10% of your money in one stock, but you had better have done your homework and be on top of the company and be available the entire trading day to react to adverse news if you do!  Sounds exhausting.

Why is this important?  Because your market timing or fundamental analysis may be wrong.  If you have invested 4% of your money in a given ETF, and your stop loss is 25%, you will lose only 25% or just 1% of your money if you are wrong.  This does not mean we use a 25% stop loss routinely.  That's too much in our opinion, but it gives you an example of how position sizing works.

6. Do you have a plan on HOW to buy or sell?  In steps or all at once?

This means that you are often better off scaling into or out of an investment, rather than buying or selling all at once, respectively.  We have a report on this that is available to subscribers of our free trial as a bonus.  Generally when you buy in scale, you buy more at lower levels than you buy at higher levels.  That way if the investment moves down rather than up after your first purchase and your market timing signal tells you to exercise a stop loss, you lose less of your total capital.  

When you scale out, you sell more at higher levels and less at lower levels.  This is in case there is a one day move to the downside that then reverses itself.  If your stop loss signal goes off because you are using market timing, you will be able to rebuy less than your total position if the market immediately reverses and move UP.

The time you may want to move in one step is if there is a clear change in your investment that violates the reasons you bought.  With technical signals, there are times when you want to move faster to react to signals.  More often, you have time to buy and time to sell.

7. Are you willing to follow this investment?

Those who fell asleep on their investments in 2000 and in the 2007-2009 periods did not do well!  If you are not willing to follow what you own, don't invest. Not following your stop losses and adhering to your market timing or fundamental parameters will hurt.

The other point of this newsletter devoted to combining market timing and fundamentals is that we provide a check on your thinking and the thinking of your advisor if you have one.  If they are way off, our newsletter may help to alert you of that.  Often they make less if you move to cash.  That depends on now they are paid of course.  Regardless of that, they may still fall asleep or be stubborn about their ideas.  You need to keep an eye on your investments no matter how many advisors you can afford.

I need to repeat this: Record your plan and stick to it unless you record why you are departing from it.  And you had better have good reasons other than "It will come back" or "I don't want to tell my spouse I messed up" etc.  You have no plan if you override it simply out of fear or greed.  That is a losing investment strategy.

Decide to win.  Write down your investing and trading plans.

Here is the short version of the above checklist:

1. Do you understand WHAT you are buying?

2. Have you decided WHY you are buying and have you recorded the market timing and/or fundamental reasons??

3. A. Have you decided WHY and AT WHAT PRICE you will SELL and have you recorded the reasons? AND B. Have you set up a TRAILING STOP LOSS? (Please do A and B before buying.)

4. Is the Reward: Risk Ratio at least 2:1?

5. Have you selected a reasonable position size?

6. Do you have a plan on HOW to buy or sell?  In steps or all at once?

7.  Are you willing to follow this investment?

You can learn more from Dr. Van Tharp's book, "Trade Your Way to Financial Freedom" where he popularized the idea of position sizing and stops. These concepts are none other than the ancient "don't put all your eggs in one basket" and "cut your losses and let your winners ride," but he demonstrates the grave error you make if you fail to use position sizing and trailing stops to manage your portfolio.

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Finally, if you liked the above list and found it useful, I am certain that you will really enjoy my free newsletter.

NOTE: Sorry, but subscription to the free newsletter is now closed. I may reopen it at a later date, so keep following the weekly "Market Timing Brief" posts on the "Market Timing Blog" for updates (see blue navigation bar to left near top).

Market Timing and Fundamentals: My System


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