Take a Break
What a week.
If you’re anything like me, you were relieved when the closing bell rang on Friday. The combination of Euro zone debt concerns, the BP oil spill, and a market that was due for a pullback anyway had created significant volatility in stocks. Friday’s up session provided a break from the prior four day pattern of lower closes, and was overdue. It gave everyone a chance to take a deep breath and enter the last weekend of spring without visions of plunging stock charts dancing before their eyes.
At least that’s how I felt about it anyway.
As I wrote in Friday’s issue, Run Like Hell, “…large masses of people are infinitely wise, and profoundly stupid.” This often competing dynamic leads to periods of heightened volatility, like the one we’re in right now.
But that doesn’t mean that life outside of the market doesn’t move on. And I suspect this week will be much calmer than the last two, at least in U.S. markets. Next Monday is Memorial Day, and many people have likely taken this week off to take advantage of the extra day. From this past Saturday through next Monday is 10 days, a pretty nice break by most measures.
***Whether you are one of these fortunate people or not, it’s still good to step back from the market and assess the situation from time to time. Now is a good time to do this, and there are a few key facts that we know for sure:
-Stocks had a heck of a run from their March 2009 lows-Investors were bound to take profits at some point, and should have
-There are debt concerns throughout the world
-There are all sorts of other problems – there always are, and always will be
-Many companies have real profits, and are operating very efficiently
-Stocks go up, down, and sideways
This last point is aided by the perspective of a chart, so I’ve included a five year chart of the Russell 2000 small cap index. You can clearly see that last week’s closing price of 650 is at a major support zone.
I’m not the only one aware of this, and stocks will either bounce higher from here, or plunge through to find lower lows. Since we don’t know 100 percent which way things will go, we want to be positioned, and protected for both scenarios.
***If you believe, as I do, that we have a real economic recovery underway, then you should be using this pullback in stock prices for two things: to exit stocks in underperforming companies that you don’t want to hold for the next round of either selling or buying, and to average into the positions that you do want to hold for the next round of either selling or buying.
Buy what you like, and sell what you don’t. It’s pretty much that simple.
***I’ve talked a lot about what I like over the past weeks, and I’ll continue to bring you actionable investment ideas in the coming weeks. But I also want to remind you of the various ways you can buy and sell stocks, so that you can use the best order type to accomplish your goals.
1. Market order. The standard, default order is called a market order, meaning your trade will be executed at the current market price. Market orders are generally executed immediately at the best price available in the market. For small caps with low volatility the market order is an easy one to place. But in most circumstances, using market orders is not advisable since the price of small-cap stocks tend to be more volatile than their large-cap cousins. This is due to lowered liquidity and greater volatility. Instead, I recommend using limit orders at an exact price. While these trades don’t get executed as quickly as a market order, you’ll have the assurance that the trade will be made at your desired price (if it is executed).
2. Limit orders. When you place a limit order, you state the exact price at which you want to make a purchase or sale. The order will only be placed if that price is available. This is a smart way to buy and sell small caps, because you set and control the price; if the market price varies from that level, the buy or sell order will not go through. However, limit orders are not effective if you want to make the trade immediately, since the trade may not be executed.
3. Stop loss. As the name suggests, the stop-loss order is used to limit losses. This order includes a price trigger that generates a sell if the stock falls to a specified price level. When shares fall to the prescribed price, an order to sell the stock is executed. This is a wise form of protection when you are in a highly volatile market, and especially if the market risk and volatility levels for your stock are higher than average. You pick the stop-loss price knowing that the stock is going to be sold when that price is triggered. This order is best used to protect downside exposure by limiting potential losses from your stocks.
However, with small caps you must be careful as the volatility could “stop out” a position based on intra-day volatility. Therefore, use these cautiously, and set them at a price at which you’ll definitely want to sell the stock. For hands-on investors watching the market, stop losses are less useful, since you’re always watching your positions.
In this case, I’ll often use a manual stop loss. This means that I know the price at which I’m ready to sell, but I’ll confirm the downward trend by paying attention to other market factors affecting my stock’s price. This gives me a few percentage points of flexibility rather than simply a hard stop.
4. Trailing stops. A useful variation on the stop-loss order is the trailing stop. In this situation, you are preserving paper profits rather than limiting losses. In cases where your small-cap stock has appreciated, a trailing stop is a smart order to have in place. The order represents a fixed percentage of the current market price. If the price falls by that percentage or more, the trailing stop becomes a market order and a sell is placed. But if the stock’s price continues on its upward rise, the trailing stop continues in force without any action. Like the risks of a stop loss, this can cause problems for small-cap investors. If a stock rises quickly, and then falls back from a high price, the shares would be sold using a trailing stop.
*** The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks, is filled with every tip and trick I know about investing in small-caps, and I think it’s absolutely vital to anyone interested in the topic. There is a ton of great information in the book, and it is a great compliment to Small Cap Investor PRO.
