This week the ZachStocks Newsletter portfolio was stopped out of a position in Zumiez Inc. (ZUMZ).  Although the position initially showed a profit, a monthly sales report followed by a Wall Street downgrade was enough to send the stock below our stop level…  The small loss is something that we as traders have to get used to in order to stick around long enough to capture the big winners.

The transaction prompted a great comment from reader Alex:

Why is there a stop on this company at $19.80 in your “long position” for your service? Interested in your reasoning why, if this is a long position, you would want to sell when the company becomes cheaper. Wouldn’t a lower stock price without a change in the underlying business be a reason to buy more shares, not sell them?

Thanks for the great question Alex…  It gives me a great opportunity to talk about the difference between tactical trading and true value investing.  True value investors analyze stocks based on what they perceive as a fair price to own the company.  Typically these investors hold positions for an extended time – until the price rises to a point where they believe the market is paying too much for  the investment.

True technical traders, on the other hand, usually pay very little attention to the actual fundamental value for the company in question.  Traders are much more concerned with the direction or trend of the price and often hold positions for much shorter timeframes than investors.  Whether using a “reversion to mean” approach (expecting extended stocks to revert to more “normal” patterns) or a “trend following” approach (holding positions that have strong momentum), successful traders almost always have a very disciplined approach to exiting losing trades.

Disciplined Value Investing

It takes a lot of hard work to be a truly successful value investor.  If you are going to consistently generate profits above the benchmark indices, you have to command both nerves of steel as well as developing some base of information which is better than the general knowledge base on the street.  To quote Gordon Gekko from Wall Street, “The most valuable commodity I know of is information.”

Alex’s rationale is perfectly logical if an investor does his homework, is confident in his findings, and the fundamental metrics of the investment do not change.  If I’m buying a stock at $15 based on the fact that I believe the company should be worth $25, then I should be even MORE excited about buying the same stock at $10.

The problem that most amateur value-based investors eventually face is the fact that it’s nearly impossible to know everything about a company.  And sometimes the minor detail missed can become the most important factor for an investment.  There may be an off-balance-sheet liability which eventually generates a significant loss for the company.  Maybe a particular business line is pressured by unexpected competition.  Or the visionary CEO could have a rare illness kept under wraps to all but a few close friends.

For value investors who miss these subtleties or fail to put all of the pieces together, the oversight can be devastating – and result in material losses.  Usually by the time a serious issue becomes apparent, the stock in question has already lost a significant amount of its market value as “in the know” investors have begun liquidating shares before the public realizes the true long-term ramifications.

So the danger to value investors is doubling down on a position without truly understanding why a stock is trading lower.  The question I usually pose to a value-based investor wanting to buy more at a lower price is – What if you’re wrong? – What will you do to protect your capital against an unexpected change in fundamentals?

The Pure Technical Trader

On the opposite end of the value-based investor is the Pure Technical Trader.  This market participant typically shuns any fundamental information and follows a rules-based technical system.  It may be a trend following system which uses indicators to target particular investments which are exhibiting strong momentum, or a mean reverting system which shorts stocks that have run too high too quickly, and buys significantly depressed stocks.

There are many ways to approach technical trading and it is beyond the scope of this article to dive too deeply into different methodologies.  But when studying successful traders, it has become clear that the ones who are able to stick around for years and years – consistently generating profits – are almost always fanatical about managing risk.

Many of these traders are much like baseball players who almost never have a batting average above 500.  This means that if you look at each position a trader takes over the course of a year or three years or a decade, the number of losing trades is often materially higher than the number of winning trades.

But while this may seem counterintuitive, the reason these traders are able to make huge profits is because they cut their losses quickly.  The great Paul Tudor Jones II is well known for taking hundreds of tiny positions and kicking them out for losses until he finds the perfect investment with the right timing.  At this point he is able to increase his commitment (once the position has proven to be profitable) and eventually generate the majority of his annual profits from just a handful of truly successful positions.

When the market moves against a technical trader, it’s a sign that he is either wrong or that his timing is off.  In this case, the best strategy is usually to exit the position (taking your loss out of discipline) and re-evaluate why the market is moving against you, and whether the original rationale still stands.  There should be no shame in re-entering a position 2,3 or even a large number  of times, provided that the losses are kept small and once the trade becomes successful, the trader sticks with the position long enough to generate a good portion of the possible gains.

The Two are Not Mutually Exclusive

As a market participant, you don’t have to choose one or the other.  There are many successful traders who use technical analysis to help fine-tune their timing.  By the same token, quite a few strong traders use fundamental value-based analysis to determine which vehicles or which market direction is likely to produce the strongest opportunities.

The concept has been over-used and trivialized to some extent, but I find it helpful to use fundamental analysis to determine what I want to be long or short, while using technical patterns to develop a sense of when I actually pull the trigger on a trade.  And because I firmly believe that there can always be variables that I was not able to cover in my analysis, I recommend using a stop-loss order to exit a position in the event that it turns against you.

Where to place the stop order is a matter of personal preference and should match each trader’s approach uniquely.  For very active traders, stop loss levels will be very tight, kicking the trader out of many positions with minimal losses and requiring each new position to show profits quickly or else be discarded.  For more fundamental investors, a stop loss may take the form of an alert – “if the market gets to THIS point I will be forced to re-evaluate my position to ensure that my strategy is correct.”

Positioning of stop orders can also depend on the market environment.  In a strongly trending market, traders may choose to keep a wider stop to protect against being taken out of a position pre-maturely.  And during the more choppy times, stops may be tightened and traders may expect to hold positions for much shorter intervals.

The bottom line is that in order to trade successfully for long periods of time, investors and traders alike must understand and manage their risks carefully.  Having a firm grasp on what events would signal that a trade is wrong – and what actions would be taken at that time, should lead to shallow losses and create an environment for much larger gains.  So when managing your investment capital, make sure that you operate with a disciplined plan and always understand what is at risk and how you will manage that risk.

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