A successful self trader – Rule # 39
Ironic as it may sound, this is the biggest single challenge that investors will face. When you are wrong, you either average or stop out. But when you are right, you need to decide whether you should book out, hedge or hold on. This becomes critical because you don’t make profits every day. Therefore, when you are right, you should be able to extract the maximum value from the trade. How to do it?
WHEN YOU ARE RIGHT, YOU BETTER TRY TO STAY RIGHT
There are typically 3 phases to making a profit in the market. The first step involves getting your call or view on the market right. The second step is putting your trade in the right direction in the right asset class. The third and most important phase is what you do after that. Having made the right call and right trade, how do you extract the full value of the stock movement?
Even Warren Buffett considers the third phase the most important. His famous statement, “My holding time frame is perpetual”, is by now legendary. But that is off the point. The point is that being patient with a stock when it is going in your favor is very difficult. You need to fight your short term emotions and the economic simplicity of profit booking. Tough one!
As Jesse Livermore himself said, “The market is never rational and fools most of the people, most of the time”. It is impossible to be consistently correct, forget about being substantially correct. The challenge, therefore, is how do you hang on to a trade or an investment that is working in your favor? Also, what are the checks and balances required when you hold on?
3 BASIC CONDITIONS FOR HANGING ON TO A TRADE
THERE IS A BIGGER FUNDAMENTAL STORY TO IT
Certain companies are at times in a sweet spot. Hero Honda in 1990, Infosys in 1997, Bharti in 2004 and Eicher in 2010 are all classic cases. A sector or business is being redefined. This is a fertile long term story. Just hang on!
NO SIGNS OF SYSTEMIC VALUE DESTRUCTION
A good stock in a shaky market is not a good idea. Even if your stock is in a sweet spot and the market is poised like September 2008, forget about hanging on to the stock. It makes sense to exit and re-enter later. Just log out!
APPLY THE 4-FACTOR MODEL FOR HANGING ON
Four key factors need to combine to justify hanging on to a stock. The ROE must be high, the equity base must be low, net profits have grown for at least 3 years and the stock is liquid in the market. Then you can look to hang on! Otherwise, you must tread with caution!
“Losses are never an outcome of bad luck. They are just an outcome of plain bad analysis” – David Einhorn
FIVE WAYS IN WHICH YOU CAN HANG ON TO A STOCK
- The first method is plain vanilla holding on to the stock. Of course, there is a hold versus re-enter decision you need to make when markets get shaky. If you are convinced about a stock but markets are shaky, it is advisable to re-enter later. Keep a hurdle price, above which you will re-enter the stock, but never ever take a big risk when the market overall is shaky.
- Rolling stop-profit is something I always recommend. As the stock moves higher, keep revising the rolling stop profit higher. You at least rest in peace in a volatile market. Also keep a psychological stop loss, below which you are unwilling to risk capital and hang on to the position. More often, the market is trying to give a signal; and we might as well listen to it. Just let go!
- There are times when capital constraints may force you to exit a position you should be hanging on to. You can always convert it temporarily into a futures position. This way you are only liable to pay the margin and save capital. But remember, you always run the risk of mark-to-market losses. Above all, roll costs can pinch hard over a period of time. Be cautious here!
- Call and put options are another way of hanging on to a position. The initial cost can be lower but over a period of time the premium costs add up. Also in times of high volatility option premiums can be ridiculously high. But the biggest problem is liquidity in far-dated options. This means you have the added cost of using only near term options. In my view, it is best avoided!
- Specific risk management is the best way of hanging on to your position. If you are worried about geopolitical risk, add gold ETFs to your portfolio. Macroeconomic concerns can be handled by buying deep out of the money puts on the index. This keeps costs also in check. And if the risk is about rate-sensitive stocks, you can manage with floater funds. That is surely smarter and more effective!
CLASSIC INDIAN EXAMPLES OF NOT HANGING ON TO A STOCK
Two cases of exiting too early stand out in Indian markets. In 2002, Bharti was languishing at Rs.22. By 2003, most had exited profitably at Rs.60. The error was soon obvious as the stock had touched Rs.1000 by year 2006, largely on the back of a frenetic growth in mobile subscriptions. Same is the case with TTK Prestige. It languished around Rs.100, throughout 2007-2008. By 2009 most investors had exited around 200 levels. By 2012, TTK had shot up to Rs.4400, largely on the back of margin expansion. Of course, a lot of investors ended up looking sheepish.
Hanging on to a position is never easy. It calls for rigorous understanding of the investment and oodles of conviction. Remember John Paulson, the hedge fund manager in 2007. Against all odds, he held on to his mortgage shorts for 2 full years before it generated a gold mine for his fund. As they say, money never comes easy; especially big money!
TAKEAWAYS FROM THE “HANGING ON” DEBATE
Let us get back to the basics. It is not enough to get your view right. It is not even enough to trade right. What is more important is that you jump out of losing trades and hang on to winning trades as long as possible. As I said, booking out of a trade can be financially seductive. But since you have to make the best of your opportunity; hang on to the few trades that are bang on target.
Remember the old market wisdom, “It is not about being right, but what you do when you are right that matters”. A 30% return in a year may be great. But, in the process, if you are throwing away a multi-bagger over the next 3 years, it is absolutely criminal. When you think about this, you will trade differently. That is the precise benefit of hanging on to your profitable positions!