This Is The Most Important Decision for Every Investment
Editor's note: There's no such thing as risk-free investing...
Even if you're a skilled trader with decades of experience, you probably don't have a perfect trading record. There's always a chance that an opportunity – no matter how good it seems – can go south.
That's why it's critical for every investor to consider one thing above all else...
We're talking about risk management. If you know how to protect your principal and your gains, you'll be better prepared for a market downturn.
In today's Masters Series, we're featuring an essay from Keith Kaplan, CEO of our corporate affiliate TradeSmith. Keith will explain the most important question you should ask yourself before every trade... reveal why you don't need a professional to manage your portfolio... and detail three strategies to help protect your upside...
This Is The Most Important Decision for Every Investment
Not long ago, I watched a trading and investment video that caught my attention.
One of the world's most renowned options traders started a training course for two novices.
He would teach them how to buy and sell call and put options. He would educate them on the ways to purchase stocks and sell options to boost income (covered calls).
His pupils barely understood the stock market. And they were a bit intimidated by the idea of trading call and put options.
Given his expertise, I expected that he would have them prepared for trading greatness.
After all, everyone wants to learn from people who have traded professionally and successfully for decades.
However, when the three of them gathered for their first lesson, I couldn't believe my ears.
His first question to them was simple...
"What companies are on your list to buy or trade?"
The students eagerly rattled off meme stocks, Apple (AAPL), and even a few retail companies that I thought had gone out of business.
Then he asked the following question... "How do you want to enter your position?"
Despite all of his experience, I think he broke a cardinal rule of trading and investing by asking that question.
The most important question is never how or where you want to buy a stock or option. The most important part of a trade is never the entrance.
It's the exit.
I don't care how long you've been trading or investing... Risk management is always the most critical component of what we do.
We want to make as much money as possible. But we also want to protect our principal and our gains, should our position go sideways.
And it doesn't matter how good you are – a position can always go sideways.
If anyone says that he or she has a perfect trading record, you should ask for proof. If anyone says that trading is the "easiest thing in the world," then you should walk away.
Trading is very hard. Investing is equally tricky. That's why there is a perception that you need a professional to help you.
But you don't. It's a myth that you need someone to help you manage your portfolio or assess your risk.
One of the first things you need to learn when doing both is how and when to exit a position.
The markets are littered with stories of people who didn't take profits off the table and became too psychologically invested in their losses from all-time highs. Instead of taking gains, they found themselves stuck in a situation where a 100% gain retreated to 0%... or even went into negative territory.
Keep in mind that in the stock market, no company remains on top forever. The entire economy is marked by cyclical phases, changes in competition, and innovation.
Back in 2000, investors flocked into General Electric (GE), which ran into the $50s.
Today, GE is around 75% lower. And I know people who are still holding onto this stock, hoping that it just gets back to $20. Talk about an opportunity cost.
Or take a stock like Nokia (NOK)...
There was a time that this company traded just shy of $60. It crashed after the dot-com bubble burst. But it did give investors a nice pop in 2007, pushing back to $40 from the $20 range the year before.
Guess what happened next? Despite being one of the leading mobile companies globally, it suddenly found itself facing new competition from a company called Apple.
Nokia cratered. It hasn't traded above $10 in a decade.
I could tell story after story after story like this. That's why knowing how to exit a position is so important.
There are multiple ways to exit a trade or position to avoid the fate of those who hold on too long...
Option 1: Profit-Booking Exits
The first option is known as a profit-booking exit.
In this situation, a trader or investor sells part of his winning position to reduce risk.
So, let's say that a position increases by 25%. At that point, you might sell 25% of your stake in your position.
Here's an example of how this works...
Let's say that you buy 100 shares of a stock at $100. That's a $10,000 position.
If the stock goes to $125, your position is now worth $12,500. If you sell 25%, or $3,125, you now have 75 shares remaining.
In this situation, your breakeven stock price is no longer $100.
It has been reduced to $91.66 because you've taken some gains off the table. That $8.34 difference is one-third of your $25 gain, because you still have three equal parts of the original position size.
You've protected yourself and lowered the breakeven price if the position does fall.
You can choose your profit exits, but I recommend that if a stock position ever gains 100%, you immediately sell half of your position. The reason is that you have secured your original investment capital. You are then playing with house money.
Option 2: Time Stops
A time stop is not as common for buy-and-hold investors. However, it is important to keep in mind whether big macroeconomic events are on the horizon (and when). Recently, we saw a significant announcement by the Federal Reserve that impacted markets in a big way. If you wanted to reduce your exposure to this event, you might decide to sell a position ahead of a meeting like that one. In this case, you have defined a time period for your trade.
Day traders and swing traders more commonly use time stops. Many day traders I know don't like to hold their positions for more than 30 minutes. If a stock isn't moving, the traders might move on to a different position.
Option 3: Trailing Stops
If you're like me, you don't have a ton of time to stare at your screen all day. I am a long-term, buy-and-hold investor. So I'm not engaging in too many weeklong trades unless it's an exceptional occasion.
I prefer to use trailing stops to ensure that I can protect my principal and my gains. The best part about trailing stops is that they don't require you to manage your positions actively. So, if you have a position in a company that has gained 25%, your trailing stop will rise higher from your entry position as well. This acts as a protection for your existing profits.
For example, let's say you buy 100 shares of a stock at $100. You might set a trailing stop at 10% to protect yourself from a downturn. If the stock hits $90, your trailing stop will automatically exit the position. Yes, you'll have lost 10% on your position, but you'll be protected from any further downturn. If that stock falls to $75... well, you'll be happy that the stop executed at $90.
But let's say that the stock rises to $125. You've now got a position worth $12,500.
With a 10% trailing stop, you now have protected your downside with a trailing stop at $112.50 per share.
This means that you'll have automatically protected your gains if the stock pulls back to that level. You'll exit the position with a 12.5% win. That's why I highly encourage investors to use trailing stops.
I believe that the exit to every position is by far the most important part of a trade. And I encourage you to implement some or all of these strategies in your trades today.
Enjoy your day,
Keith Kaplan
Editor's note: Having a predetermined exit plan can help you protect your gains and minimize your losses... and these strategies are a great place to start. But according to Keith, there's another tool that you should be using to take advantage of a dramatic shift in the markets today...
Put simply, Keith says that a huge change is taking place at a technical level – and those who are paying attention could stand to make extraordinary gains over the next few years. He recently put together a detailed presentation to explain exactly what his system is showing... and how you can prepare. Learn more here.