I want to emphasize that perhaps the best strategy of all, for most people, is to simply apply the stock picking criteria in the past chapters, then buy and hold their selected stocks without ever selling them. Of course, you will need to select a substantial number of stocks to achieve an adequate level of diversification, but for results versus risk and time expended, it is hard to beat a buy-and-hold strategy. I recommend the simple buy-and-hold approach for the vast majority of people.
This chapter, and following chapters, are written only for those who are willing to take more risk of loss and expend more time in order to have a chance at winning big. However, keep in mind that you can always lose big whenever you employ any type of trading strategy!
In the previous chapter, we studied the worst of all trading strategies. It systematically snowballs your losses and jettisons your best stocks just as they start to become winners. Practiced consistently, the scale-trading approach is a surefire ticket to the soup line. The Reverse Scale Strategy, on the other hand, is developed by inverting the Scale Trading approach, and in the right market conditions may deliver large profits over time. Before we get into the details of the Reverse Scale Strategy, though, let's take a side trip to examine how all portfolios inevitably act over time.
The one inevitable characteristic of all stock portfolios.
To begin with, let's think about a portfolio of ten stocks held over a period of time, say, five years. For now, let's not worry about which stocks are in the portfolio. The only thing we know about the portfolio is that it is composed of ten stocks. Now let me ask the question, "what can we predict about the portfolio five years from now?" In other words, what is certain to happen over the next five years?
First of all we can't predict what the total return on the portfolio will be, because that will depend on market conditions over the next five years, and also will depend on how well our ten companies individually perform over that period of time. Stocks have historically returned on average about 9% per year, but over any five year period this can range from a negative number to a very positive number of 20% per year or more. It also varies considerably from company to company. So obviously we can't accurately predict what each individual stock in the portfolio will return, either.
It may be disheartening to you to realize how little we actually can foretell about the future performance of our portfolio. However there is only one thing that we can fairly confidently predict about any basket of stocks, and it is this:
At the end of the five year holding period, some stocks in the portfolio will have performed vastly better than others.
For the sake of reference, I will call this the Variability Concept.
This is not exactly a revelation. We could expect that one or two of the stocks will have tremendously outperformed the market averages, which might mean a move of two, four, or maybe even ten or more times our entry price, depending on market conditions. Some will have proven to be dogs, perhaps declining marginally, or in the extreme case, gone out of business in the meantime. A large portion of the stocks will have performed pretty much in line with the market. If you've chosen your stocks randomly, there's also a very good chance that your ten-stock portfolio will have returned something close to what the market averages returned over the five years. Since every portfolio of stocks contains future winners and future losers, we are left with this: The challenge of investing is to make sure that when you get to the end of your holding period, you find that most of your money was invested in the stocks which performed the best, and relatively little was invested in the stocks which did the worst.
To realize how this concept can be useful to us, we also have to add to it another fact we've already discussed in great length about the stock market:
Stocks make large moves in continuous trends which almost always take months or years to develop.
Let's call this the Trend Concept.
Large price movements are gradual incremental events, not all-at-once step functions. They are evolutionary, not revolutionary. Whether the move is up or down, a really big move does not normally happen overnight unless there is a merger announcement, bankruptcy filing, or something of that sort. Even then, the actual announcement has often been preceded by an uptrend (in the case of a pending buyout) or a downtrend (in the case of a pending bankruptcy filing). The reason for this is that there are always some folks who know about these pending announcements before they happen, even if they are not supposed to know. Their buying or selling leading up to the announcement moves the stock while the public is still clueless as to why it is moving.
Putting the Trend and Variability concepts together, it becomes apparent that there will most likely be a wide gap in the returns between the best-performing and worst-performing stock in your ten-stock portfolio. It is equally apparent that this condition will develop slowly, with the gap in total returns between the best and worst stock growing steadily as the holding period lengthens. The union of these two inevitable events should lead logically to this conclusion:
If only we could find a way to gradually allocate our investment dollars to the best-performing stocks in our portfolio as they are becoming the best-performing stocks, then we'd have a tremendous chance of greatly increasing our investment returns above and beyond what would be achieved by simply choosing those same ten stocks and holding them in equal dollar amounts.
Reversing the Scale Trading example
What we need, then, is to develop a system that will accomplish this allocation of capital to our strongest and best-performing stocks. As it turns out, we can do this by simply reversing the scale trading approach learned about in the last chapter. So in other words, we add equal dollar amounts to our stock positions as they move up in price, instead of when they move down in price. This is what I call the Reverse Scale Strategy. In the rest of this chapter, you will see how the mathematics of this approach work greatly in our favor.
Since one picture is worth a thousand words, take a look at the following chart. It is a price chart of Wireless Telecom, a stock which I began buying in early 1994, and still own as of this writing. I purchased the stock after it had already more than doubled in value, at slightly above $2/share (marked by the arrow). I added an equal dollar position (not an equal number of shares) with every 50% increase in price from the previous purchase level, represented by the horizontal lines in the chart below. That is, each successive purchase was for less shares than the previous purchase.
Pursuing the Reverse Scale Strategy I purchased positions at approximately $2.07 (all prices are adjusted for stock splits which occurred during the stock's rise), $3.10, $4.65, $6.97, $10.44, and $15.64. The price has not yet reached $23.44 or I would have purchased an equal dollar amount there, too. For the sake of an example, let's say I put $2,000 into the stock at each of those price levels, and every time I did make a new purchase, I moved my stop-loss order (if you are not familiar with stop-loss orders, they are explained in Chapter 8) up to the price of the previous purchase. Hence, my sell point was constantly rising during this time, most recently at a price of $10.44. Obviously, I owned other stocks in mid-1994 when I first bought a position in Wireless Telecom, but at that time I had no idea this particular stock would increase as much as it did in value versus the other stocks. I didn't need to know, because my strategy guaranteed that if it made an exceptional move, I would have a disproportionate amount of money invested in it. As I said earlier in the book, it is best to avoid prediction altogether, and rather rely on a strategy which can guarantee a good allocation of your dollars.
If you followed the Scale Trading example as presented in the last chapter, you saw how no matter what happened, the scale-trader's poor strategy allocated most of his capital to the worst-performing stocks gradually, with a large loss being the inevitable result. Like a snowball rolling downhill, the tendency for a declining stock to keep on declining, in combination with the scale trader's foolish trading rules required the poor trader to buy more and more while his position became worth less and less. Once you have really grasped how foolish the scale trading strategy is, it becomes much easier to see how wise it is to follow the Reverse Scale Strategy. To give you a flavor for the advantages of adding to a position as it moves up in price, following is a brief contrast of Scale Trading versus the Reverse Scale Strategy:
Scale Trading Reverse Scale Strategy
Positions added only if stock declines. Positions added only if stock increases.
Your average cost per share is always above the current market price after second purchase. Your average cost per share is always below the current market price after second purchase.
Sacrifices large long-term gains for small short-term gains. Sacrifices small short-term gains in order to realize large long-term gains.
Unlimited potential for loss. Unlimited potential for gain.
Makes no attempt to cut losses. Adds to losing positions. Cuts losses. Does not add to losing positions.
In a portfolio, automatically allocates majority of capital to worst-performing issues. In a portfolio, automatically allocates majority of capital to best-performing issues.
The Snowball Effect
To help you envision the principle of the Reverse Scale Strategy, I'd like to offer the following illustration. Imagine you are standing at the top of a large hill. You have made five snowballs, all equal in size, and you give each of them a equal push to start them rolling downhill. One of the snowballs starts out okay but doesn't get very far, as it hits a rock that was hiding below the surface of the snow, exploding the snowball into smithereens. Two others make it about halfway down the hill, but then stall out because they became large and happened to be on a part of the hill that was not as steep as some other areas. Still another makes it a bit further than those two, but then hits a wet area and gets bogged down. One of the snowballs, however, happens to have just the right type of snow and a nice steep incline, and its quick start, momentum, and after a while, sheer size make it unstoppable. It goes several times the distance of any of the other snowballs.
The analogy between snowball-rolling and a portfolio of stocks is a good one. Obviously, the snowball that rolls the farthest gets the biggest and picks up more snow gradually as it goes. The size of the snowball can represent either losses or gains, depending on whether you are using the Scale Trading approach (snowballing losses) or the Reverse Scale Strategy (snowballing gains). Really, both the Scale Trading approach and the Reverse Scale Strategy cause a snowballing effect. You have to choose which strategy you would prefer: One which snowballs losses or profits. Tough choice, huh?
With snowballs, as in the stock market, there are things you can control and things you cannot control about the stocks you are investing in. You can control how big you make each snowball initially, and you can control how much of a shove you give each. From then on, many of the factors are out of your control or unpredictable. Even though we can't predict which snowball will roll the farthest, the hill still gives more snow to the one that eventually does go the furthest, because it adds snow to it gradually as it progresses. Hence, the beauty of the Reverse Scale Strategy is that just as the hill and gravity make sure the snowball that goes the furthest gets the most snow, our strategy will make sure that the stock which advances the furthest gets most of our capital.
Trading rules for the Reverse Scale Strategy: an example.
To learn how to implement the Reverse Scale Strategy, let's run through an example for one single stock. Although we will be using the Reverse Scale Strategy in a portfolio of several or more stocks, it is much easier to illustrate the concept using just one stock.
First, we construct a chart similar to what the scale trader in the last chapter constructed, only our chart begins at the initial purchase price and goes up, each succeeding decision point being 50% higher than the previous one, (instead of 50% lower, as with scale trading). The trading rule is:
We will invest an additional designated number of dollars at each price level as that level is reached - and only if it is reached.
As you can see, we will be adding an equal dollar amount at each price level. This dollar amount is the same as our initial position in dollars, but a reduced number of shares due to the higher price paid for each successive purchase. For a stock where our initial purchase was at $20 per share, our decision chart would look as follows (the initial entry position is highlighted):
Reverse Scale Strategy, 50% purchase increments (Chart #1)
Decision Point
Price Level Amount Invested
this Purchase * Shares bought Cumulative $ Invested Cumulative Shares Owned Current Value of Shares Cumulative Cost per Share Total $ Profit/(Loss)
Loss-cutting point 13 1/4 N/A N/A N/A N/A N/A N/A N/A
Initial entry point 20 $1,000 50 $1,000 50 $1,000 $20.00 $0
Decision point 1 30 $990 33 $1,990 83 $2,490 $23.98 $500
Decision point 2 45 $990 22 $2,980 105 $4,725 $28.38 $1,745
Decision point 3 67 1/2 $1,013 15 $3,993 120 $8,100 $33.27 $4,108
Decision point 4 101 1/4 $1,013 10 $5,005 130 $13,163 $38.50 $8,158
* Since shares can only be bought in increments of one, this number does not always equal $1,000 for each purchase, but the cost of the closest increment of one share that can be purchased with $1,000.
Again, each successive Decision Point is arrived at by multiplying the previous one by 1.5. So the first decision point is calculated by multiplying the $20 initial entry price by 1.5, which yields $30; $30 times 1.5 results in $45, and so on for as far as you need to go.
Our other trading rule is:
Whenever our stock increases to reach a decision point and then retreats all the way back to a previous decision point, we will sell out our entire position in the stock.
Why do we have this trading rule? Simply because if a stock retreats enough to make it all the way back to a previous decision point, then it's a good bet it's lost enough momentum that it will have a hard time becoming a market leader once again. In other words, its uptrend may be ending or about to go dormant for a long, long time. So, it's best to trade it in and start over with another more promising issue. As we have discussed in earlier chapters, we need to give a market-leading stock plenty of room for normal retreats off its highs in order to be able to ride the long trends when they develop. However, we have to draw the line at some point. Given that our decision points are 50% apart, the prospect of "whipsaw" losses or prematurely bailing out of a stock are limited with this approach.
To illustrate, let's assume we took our initial position at $20/share as indicated in Chart #1. Over the next year, the stock increases in value gradually to $105/share, as graphically illustrated in Chart #2. We would have picked up shares at $30, $45, $67 1/2, and $101 1/4, for a total of 130 shares owned, referring once again to Chart #1. Because the stock reached the Decision Point #4 at 101 1/4, our sell point would have ratcheted up to 67 1/2.
Chart #2:
Let's say then that the stock retreats back to the $67 range. Since the stock has at that point violated our sell Decision Point #3 by falling below $67 1/2, we unhesitatingly enter a market order to sell the entire 130 shares. For the sake of simplicity, let's assume we were able to sell our shares at exactly $67 1/2. We could then compute our profit from the trade as follows:
Summary of Purchases and Sale (Chart #3):
Shares Purchased Price per Share Total Cost Commission Net Cost
Purchase #1 50 $20 $1000 $25 $1025
Purchase #2 33 $30 $990 $25 $1015
Purchase #3 22 $45 $990 $25 $1015
Purchase #4 15 $67 1/2 $1013 $25 $1038
Purchase #5 10 $101 1/4 $1013 $25 $1038
Total cost of all the purchases: $5,131.
Total shares purchased: 130
Proceeds from 130 shares sold at $67 1/2 = $8,775. Minus $ 25 commission = $8,750.
Net Profit = $8,750 minus $5,131 or $3,619.
Just to illustrate the previously made point about the Reverse Scale Strategy making it hard to get shaken out of a stock prematurely, please note what our sell decision point would have been had the price topped out at only $100 instead of at 101 1/4 or higher. In that case, the price would have had to retreat from $100 all the way down to $45/share in order to trigger a sellout of the position, since it never reached the $101 1/4 level and therefore $67 1/2 never became our sellout point. Now, I know emotionally it might seem disheartening to you to have to sit idly by while a stock sinks from a peak of $100 down to $45. But believe me, there are plenty of times where this discipline of being able to ride out the occasional temporary steep correction will be the very thing that allows you to sometimes go on to make a huge gain of 1,000% or more. Keep in mind that gains of 1,000% happen much more often than you'd think if you are using the stock-picking criteria presented in Chapter 4. It is also much easier to ride a stock down temporarily if it is only one of many stocks you own, so make sure you diversify!
For the sake of covering all the bases in the last example, what would have happened if our stock had turned out to be a loser instead of a winner? If after we took our initial position at $20 per share, the stock declined to 13 1/4 or lower ($20 divided by 1.5), we would have sold the initial position and started looking for a new stock to start over with. We would have incurred a loss of $337.50 plus two $25.00 commissions, for a total loss of $387.50. We then would go prospecting for a new stock to trade. Remember, we do not want to keep gunning for the same stock once we've been bumped out of it by our system.
Risk and Reward
While you might or might not be impressed with a profit of $3,619, keep in mind that we never exposed ourselves to a loss of more than $400 or so in this trade. So, the potential for profit here is unlimited (limited only by the performance of the stock being traded), while the potential for loss is quite limited.
The real power of the Reverse Scale Strategy lies in using it to harness the power of margin borrowing. So in the Chapter 8 we will explore how the Reverse Scale Strategy can go hand in glove with the controlled use of borrowing to enhance the return on your portfolio. Chapters 9 and 10 will cover implementation details and trading rules. When we are done we will have the perfect blend of limited loss, limited personal cash investment, and unlimited profit potential. However, keep in mind that anytime you use margin borrowing to buy stocks, you are taking a larger risk of loss than if you didn't. There is still no free lunch.
Chapter 8: Margin Power
As long as money has existed, risk-takers have multiplied their efforts through the use of other people's money. There is probably no place where the use of other people's money can be used to such advantage (if you have a well-thought out plan) or to court disaster (if you don't have a plan) than the stock market. In real estate, for instance, you can borrow money, but there will be a banker there to make sure you don't make too bad a deal and thus put the bank's loan in jeopardy. In the stock market there are few such safeguards. You are free to lose all of your money (and more) if you are not judicious in the use of debt leverage.
In the stock market, it is possible to easily borrow money, using the value of the stocks you own as collateral. As of this writing, current margin rules allow a person to borrow in order to buy up to twice as much stock as you have cash in your account. By using margin, you now magically have the same number of dollars in your account, but more stock than you had before. This practice is called trading on margin. Does it sound risky? You had better believe that it is, if it's done in an uncontrolled fashion. When using margin, the need to have an airtight plan and the discipline to follow that plan is doubly important. Even then, people can and do lose money trading on margin, because you can never tell what will happen in the stock market. However, if you do have a reasonable plan and discipline, you can obviously make a lot more money in stocks than you can by trading from a 100% cash position. If you try trading on margin, you can lose a lot more money than you could on a cash-only basis. So, be aware of the risks of margin as well as the potential.
The Reverse Scale Strategy that we just introduced can be used with margin leverage while keeping the risk to a manageable level. To effectively use margin, the first, most important rule is that you never borrow money in order to add more shares to a losing position. If you are carrying a losing position on anything, it is by definition trending downward at least from your entry point. As you have seen, in the Reverse Scale Strategy we only add to positions as they are trending in our favor, upward. We already concluded that we didn't want to buy into downtrending stocks even when trading from a cash position. We certainly don't want to add to any losing position, and with the ability of margin to magnify gains and losses we must be especially careful not to add to a losing position when we are borrowing to do it.
The other thing to keep in mind with the use of margin is that while current regulations allow us to finance up to 50% of the value of the stocks we own, such a level of leverage is almost never a wise move. For instance, if you have a $20,000 account you can borrow from your broker to purchase up to $40,000 worth of stock. The use of that much leverage means you are paying a huge amount of interest relative to the cash in your account, which will deplete your capital rapidly with each passing day if your stocks happen to sit idle and mark time. This use of the maximum allowable amount of margin leverage also means that if the position moves against you, you are likely to lose a huge amount of your account equity, in other words the part of the account you actually own. In fact, with margin you can actually end up losing more than all of your money, under the most extreme conditions.
As we said before, current regulations allow us to buy twice as much stock as we have cash. That is the most risk we are allowed to take, but we are not going to take anywhere near that level of risk with our hard-earned money. So, our rule for use of margin will be:
To control our use of leverage, We will choose our initial position size in a stock so that we will always have enough cash on hand to make our initial purchase and half of our second purchase, without borrowing anything.
In the chart below, I've taken our previous chart for illustrating the Reverse Scale Strategy and added two columns, "Percent financed," and "Cumulative Cash Deposited." Since each successive purchase is always $1,000 in value in this example, we deposit $1,000 to make the first purchase and $500 to make the second purchase in accordance with our rule for margin trading. Our total cash deposited for this trade is therefore $1,500.
Reverse Scale Strategy, 50% Price Increments (Chart #1).
Decision Point
Price Level Amount Invested
this Purchase * Shares Bought this Purchase Cumulative $ Invested Cumulative Shares Owned Current Value of Shares Total $ Profit/(Loss) Total $ Borrowed Percent of Position Financed Cumulative Cash Deposited
20 $1,000 50 $1,000 50 $1,000 $0 $0 0.0% $1,000
30 $990 33 $1,990 83 $2,490 $500 $490 19.7% $1,500
45 $990 22 $2,980 105 $4,725 $1,745 $1,480 31.3% $1,500
67 4/8 $1,013 15 $3,993 120 $8,100 $4,108 $2,493 30.8% $1,500
101 2/8 $1,013 10 $5,005 130 $13,163 $8,158 $3,505 26.6% $1,500
151 7/8 $1,063 7 $6,068 137 $20,807 $14,739 $4,568 22.0% $1,500
227 7/8 $911 4 $6,979 141 $32,122 $25,142 $5,479 17.1% $1,500
* Since shares can only be bought in increments of one, this number does not always equal $1,000 for each purchase, but the cost of the closest increment of one share that can be purchased with $1,000.
The Cumulative Cash Deposited column shows the total amount of our own dollars we would have deposited, which in this example is never more than $1,500. This column added to the Cumulative Dollars Invested column and the Total Profit/(loss) column equals the Current Value of Shares column, because the current value of the stock we've invested in is composed of three elements: 1)The cash we've deposited (think of it as our down payment, 2) The amount we've borrowed from the broker (think of this as our mortgage on the stock), and 3) The accumulated profit we carry in the position. You see, the broker's regulation requires us to only put up 50% of the value of the stock, and we can use any unrealized gain as part of the 50% downpayment we are required to make. This means that once we get to the third purchase and beyond, neither the broker's regulations nor our trading rule requires us to add any more of our own money to the trade, no matter how many more purchases our strategy requires us to make.
The Percent Financed column shows how much of the current value of stock we own is financed with borrowings from our broker. As you can see, at no time do we even get close to the 50% threshold, since the maximum borrowing we do tops out at 31.3% of security value as we add our third position. From then on, our profits snowball to such an extent that we are not required to add another dime of our own money to the trade for each purchase after the second one, no matter how many purchases we eventually end up making. Yet, our percent financed declines for each position added after the third one. The beauty of this approach is that when we lock onto a real winner, can really pile onto the position without putting up much of our own money. From the chart, you can see that should we execute our strategy on a stock which runs from $20/share to $227 7/8, we will have an open profit of $25,142, less the minimal amount of interest paid on the borrowed portion and commissions. Our total investment of our own cash was only $1,500 on the trade. You may not find a stock like this every year, but they are inevitable if you stick with the Reverse Scale Strategy and the stock picking criteria from Chapter 4. If you look at the Total Profit column, you will see that you do not need anything even close to a tenfold move to make a large profit relative to the $1,500 of your own money invested.
The decision to use margin or not is yours alone. You can still use the Reverse Scale Strategy without borrowing, by simply ceasing to buy additional positions when you run out of cash. The decision points in the chart are still useful in such a case for deciding when to sell out your position. Obviously, the use of margin makes a big difference in your return only when the stock makes a big move. Here is how the profit picture would look if you simply took a $1,000 position and didn't add to it at all:
Reverse Scale Strategy, no margin leverage (Chart #2):
Decision Point
Price Level Amount Invested
this Purchase * Shares Bought this Purchase Cumulative $ Invested Cumulative Shares Owned Current Value of Shares Total $ Profit/(Loss) Total $ Borrowed Percent of Position Financed Cumulative Cash Deposited
20 $1,000 50 $1,000 50 $1,000 $0 $0 0.0% $1,000
30 $0 0 $1,000 50 $1,500 $500 $0 0.0% $1,000
45 $0 0 $1,000 50 $2,250 $1,250 $0 0.0% $1,000
67 4/8 $0 0 $1,000 50 $3,375 $2,375 $0 0.0% $1,000
101 2/8 $0 0 $1,000 50 $5,063 $4,063 $0 0.0% $1,000
151 7/8 $0 0 $1,000 50 $7,594 $6,594 $0 0.0% $1,000
227 7/8 $0 0 $1,000 50 $11,391 $10,391 $0 0.0% $1,000
Using both Chart #1 and Chart #2, we can construct the following comparison of the profit results of the same trade both with and without using margin leverage:
Profit Comparison of Margin versus Cash-only Basis (Chart #3):
Price Level Profit
Using Margin Profit
Without Margin Additional Profit
from Margin
20 $0 $0 $0
30 $500 $500 $0
45 $1,745 $1,250 $495
67 4/8 $4,108 $2,375 $1,733
101 2/8 $8,158 $4,063 $4,095
151 7/8 $14,739 $6,594 $8,145
227 7/8 $25,142 $10,391 $14,751
So, if the stock moves from $20 to $227 7/8, the difference in profit is nearly $15,000, whereas the difference in our own dollars invested is only $500 (the $1,500 deposit in the margin example versus the $1,000 cash deposit in the non-margined example). For stock trends of smaller proportions, the differences are less huge, but still substantial.
The use of margin is always more risky than not using it. This is simply because whatever you do to try to control the risk, you still own more shares than you would if you were trading without the use of borrowed money. However, I feel anyone who is comfortable taking a little more risk for a lot more potential reward should use margin, and I will assume throughout this book that the reader intends to use margin in building stock positions using the Reverse Scale Strategy.
Precautionary Guidelines
Some important principles to remember when using the Reverse Scale Strategy:
1. Never buy a larger dollar position in your subsequent positions than you took in the initial entry into the trade. In our example where we bought $1,000 of stock at 20, for instance, never buy more than $1,000 of that stock in any single subsequent purchase. If you break this rule you will increase your average cost per share significantly enough that you will practically guarantee yourself a loss at some point.
2. Only buy at the decision points. Don't try to make "extra" buys between decision points. This is just another way of breaking the first rule and leaves you exposed.
3. Never set your decision points closer than 50% in price above the previous one. If you do, you can get whipsawed by normal market fluctuations, resulting in less profit and exiting trends prematurely. You will kick yourself as you watch your stock recover and start making new highs once again - without you.
4. Do not depart from these guidelines!
Applying the Reverse Scale Strategy to Portfolios of Stocks
Up until now we have concentrated on how you would go about making buy and sell decisions for just one stock at a time, because it's much easier to explain the concepts this way. It's easy to adapt the Reverse Scale Strategy to a portfolio environment because all we have to do is construct a separate decision chart for each of the five, ten, or however many stocks are in our portfolio, and begin with an equal dollar amount in each stock. In the next chapter we will review in a step-by-step manner how to use our strategy to accumulate and manage a portfolio of stocks.
When using the Reverse Scale Strategy to manage a portfolio of stocks, always begin with an equal dollar amount invested in each stock. Do not try to guess which stocks will perform best.
Diversification
For the sake of being clearly understood, let me state this in no uncertain terms: You should never invest a major amount of money in just one stock. For one thing, it is risky because all of your eggs are in one basket. Furthermore, it is unnecessarily risky. If you have a number of stocks in your portfolio and use the Reverse Scale Strategy, those few that perform exceptionally well will be added to as they progress upward in price. This will guarantee that in the final analysis your best-performing stocks will make up a larger percentage of your portfolio than your poorer-performing ones. So you don't need to try to second-guess which stock will perform best beforehand.
If you are disciplined and follow the strategy, you will have the benefit of starting with a shotgun approach at the outset and progressing to more of a rifle-shot as the winners begin to emerge. So don't try to hit a home run by investing all your money in one stock. Chances are, you'll simply strike out. Ignoring principles of diversification and investing your money in only one stock is a risky and foolhardy thing to do - don't do it.
In my opinion, you should never invest in less than five stocks to begin with, and that's the bare minimum number assuming you just don't have enough money to invest in more. As a rule of thumb, aim to have about ten stocks in a Reverse Scale Strategy portfolio. There is nothing magical about the number ten, but I feel this number represents a good balance between diversification and the time required for tracking the stocks.
Do not churn your account!
Once you have chosen the stocks you will trade, do not change stocks (selling one, buying another) unless it meets the predetermined exit plan. That is, do not sell a stock unless it hits one decision point below the previously achieved decision point. Ever. If you do depart from this system you will no doubt end up making emotional decisions, and they will most likely be poor ones. Plus, you will lose peace of mind because you will no longer have a plan that you are resolved to stick with no matter what. In short, you'll be right back where you were before you read this book.
There have been a number of studies over the years showing that excessive trading tends to reduce investment results. The other name for excessive trading is churning. Whatever you call it, it is a waste of time and generally is a tip-off that the investor doing this is confused about their strategy or is investing for excitement rather than profits.
If you resolve to use the Reverse Scale Strategy, stick with it consistently. In the long run it will be the best policy.
Guidelines for placing orders
Market orders versus Limit Orders
When you place an order with your broker, they will ask you if you want to execute your trade as a market order or as a limit order. You should always use market orders when buying or selling stocks. A market order specifies a willingness to buy at the current market price, whatever it may be. A limit order instructs the broker to buy at a specified price. A market order ensures that you will have your order filled, but the exact price is not guaranteed. A limit order guarantees that you will not pay a higher price than you specified, but does not guarantee that your order will be filled.
So why not use limit orders? Because if you do, you will find that what would have been your most profitable orders are seldom filled, as the market moves away from your specified price. On the other hand, the orders that are filled on a limit order will most likely turn out to not be your best potential trades. The reason for this is that stocks of companies where something really good is happening will move steadily upward at times, without pausing to backtrack and fill the orders of those who have decided to use limit orders. The use of limit orders generally means that a person is being greedy, hoping to cut his purchase price by a small amount. But, instead, the hapless limit order is constantly left behind by the really good stocks, and wonders why his biggest fish got away.
Bottom line, in real life with the Reverse Scale Strategy it is not critical that you get filled at exactly the prices listed in the decision chart. We are going after the big gains and a quarter or half-point variation won't matter much in the long run. It is important to always use market orders as opposed to limit orders. It is much more important to get your order executed than it is to get a specific price.
Stop-loss orders
There is another type of order you should know about, called a stop-loss order. They are commonly referred to as simply top orders.' This order is placed below the market price if it is a sell stop order, or above the market if it is a buy stop. If the stock's market price reaches the price specified in the stop order, then the stop order becomes a market order to buy or sell. As an example, let's say we bought shares of ABC Co. at $20. They then rise to reach the first decision point price of $30/share, signaling that our sell signal will be reached if and when the price of the stock goes to $20. We could place a sell stop order for our shares at $20, which would instruct the broker to enter a market order to sell our shares if and only if the market price of ABC Co. again returns to $20 or below. If we enter it on a good till canceled basis, (GTC), the order will stand until it is either triggered by the stock's price reaching $20, or until we cancel the order. If you do not specify GTC status for this or any other type of order, your order will be classified as a day order, meaning it will expire at the end of the day it is entered. So be careful to specify GTC on stop orders if you want them to last more than a day. Otherwise you may have a false sense of security that your order is still entered when it really is not.
Currently, stop orders are only available on listed (New York Stock Exchange and American Stock Exchange) stocks, and not on Nasdaq (Over-the Counter) stocks. However, some brokers are starting to offer stop orders on Nasdaq stocks. So, perhaps soon these orders may be available for all stocks in your portfolio. I certainly hope so, because stop orders are a very useful thing for the average investor who cannot be watching the market constantly. They in essence watch it for you.
If you cannot watch the market during the day (and who can?), I encourage the use of stop orders once you have accumulated a large position in a company's stock. The decision point parameters are set far enough apart with the Reverse Scale Strategy that using intraday prices (which is what stop orders are triggered by) or closing prices will not likely change your performance very much and may give you greater peace of mind.
As long as money has existed, risk-takers have multiplied their efforts through the use of other people's money. There is probably no place where the use of other people's money can be used to such advantage (if you have a well-thought out plan) or to court disaster (if you don't have a plan) than the stock market. In real estate, for instance, you can borrow money, but there will be a banker there to make sure you don't make too bad a deal and thus put the bank's loan in jeopardy. In the stock market there are few such safeguards. You are free to lose all of your money (and more) if you are not judicious in the use of debt leverage.
In the stock market, it is possible to easily borrow money, using the value of the stocks you own as collateral. As of this writing, current margin rules allow a person to borrow in order to buy up to twice as much stock as you have cash in your account. By using margin, you now magically have the same number of dollars in your account, but more stock than you had before. This practice is called trading on margin. Does it sound risky? You had better believe that it is, if it's done in an uncontrolled fashion. When using margin, the need to have an airtight plan and the discipline to follow that plan is doubly important. Even then, people can and do lose money trading on margin, because you can never tell what will happen in the stock market. However, if you do have a reasonable plan and discipline, you can obviously make a lot more money in stocks than you can by trading from a 100% cash position. If you try trading on margin, you can lose a lot more money than you could on a cash-only basis. So, be aware of the risks of margin as well as the potential.
The Reverse Scale Strategy that we just introduced can be used with margin leverage while keeping the risk to a manageable level. To effectively use margin, the first, most important rule is that you never borrow money in order to add more shares to a losing position. If you are carrying a losing position on anything, it is by definition trending downward at least from your entry point. As you have seen, in the Reverse Scale Strategy we only add to positions as they are trending in our favor, upward. We already concluded that we didn't want to buy into downtrending stocks even when trading from a cash position. We certainly don't want to add to any losing position, and with the ability of margin to magnify gains and losses we must be especially careful not to add to a losing position when we are borrowing to do it.
The other thing to keep in mind with the use of margin is that while current regulations allow us to finance up to 50% of the value of the stocks we own, such a level of leverage is almost never a wise move. For instance, if you have a $20,000 account you can borrow from your broker to purchase up to $40,000 worth of stock. The use of that much leverage means you are paying a huge amount of interest relative to the cash in your account, which will deplete your capital rapidly with each passing day if your stocks happen to sit idle and mark time. This use of the maximum allowable amount of margin leverage also means that if the position moves against you, you are likely to lose a huge amount of your account equity, in other words the part of the account you actually own. In fact, with margin you can actually end up losing more than all of your money, under the most extreme conditions.
As we said before, current regulations allow us to buy twice as much stock as we have cash. That is the most risk we are allowed to take, but we are not going to take anywhere near that level of risk with our hard-earned money. So, our rule for use of margin will be:
To control our use of leverage, We will choose our initial position size in a stock so that we will always have enough cash on hand to make our initial purchase and half of our second purchase, without borrowing anything.
In the chart below, I've taken our previous chart for illustrating the Reverse Scale Strategy and added two columns, "Percent financed," and "Cumulative Cash Deposited." Since each successive purchase is always $1,000 in value in this example, we deposit $1,000 to make the first purchase and $500 to make the second purchase in accordance with our rule for margin trading. Our total cash deposited for this trade is therefore $1,500.
Reverse Scale Strategy, 50% Price Increments (Chart #1).
Decision Point
Price Level Amount Invested
this Purchase * Shares Bought this Purchase Cumulative $ Invested Cumulative Shares Owned Current Value of Shares Total $ Profit/(Loss) Total $ Borrowed Percent of Position Financed Cumulative Cash Deposited
20 $1,000 50 $1,000 50 $1,000 $0 $0 0.0% $1,000
30 $990 33 $1,990 83 $2,490 $500 $490 19.7% $1,500
45 $990 22 $2,980 105 $4,725 $1,745 $1,480 31.3% $1,500
67 4/8 $1,013 15 $3,993 120 $8,100 $4,108 $2,493 30.8% $1,500
101 2/8 $1,013 10 $5,005 130 $13,163 $8,158 $3,505 26.6% $1,500
151 7/8 $1,063 7 $6,068 137 $20,807 $14,739 $4,568 22.0% $1,500
227 7/8 $911 4 $6,979 141 $32,122 $25,142 $5,479 17.1% $1,500
* Since shares can only be bought in increments of one, this number does not always equal $1,000 for each purchase, but the cost of the closest increment of one share that can be purchased with $1,000.
The Cumulative Cash Deposited column shows the total amount of our own dollars we would have deposited, which in this example is never more than $1,500. This column added to the Cumulative Dollars Invested column and the Total Profit/(loss) column equals the Current Value of Shares column, because the current value of the stock we've invested in is composed of three elements: 1)The cash we've deposited (think of it as our down payment, 2) The amount we've borrowed from the broker (think of this as our mortgage on the stock), and 3) The accumulated profit we carry in the position. You see, the broker's regulation requires us to only put up 50% of the value of the stock, and we can use any unrealized gain as part of the 50% downpayment we are required to make. This means that once we get to the third purchase and beyond, neither the broker's regulations nor our trading rule requires us to add any more of our own money to the trade, no matter how many more purchases our strategy requires us to make.
The Percent Financed column shows how much of the current value of stock we own is financed with borrowings from our broker. As you can see, at no time do we even get close to the 50% threshold, since the maximum borrowing we do tops out at 31.3% of security value as we add our third position. From then on, our profits snowball to such an extent that we are not required to add another dime of our own money to the trade for each purchase after the second one, no matter how many purchases we eventually end up making. Yet, our percent financed declines for each position added after the third one. The beauty of this approach is that when we lock onto a real winner, can really pile onto the position without putting up much of our own money. From the chart, you can see that should we execute our strategy on a stock which runs from $20/share to $227 7/8, we will have an open profit of $25,142, less the minimal amount of interest paid on the borrowed portion and commissions. Our total investment of our own cash was only $1,500 on the trade. You may not find a stock like this every year, but they are inevitable if you stick with the Reverse Scale Strategy and the stock picking criteria from Chapter 4. If you look at the Total Profit column, you will see that you do not need anything even close to a tenfold move to make a large profit relative to the $1,500 of your own money invested.
The decision to use margin or not is yours alone. You can still use the Reverse Scale Strategy without borrowing, by simply ceasing to buy additional positions when you run out of cash. The decision points in the chart are still useful in such a case for deciding when to sell out your position. Obviously, the use of margin makes a big difference in your return only when the stock makes a big move. Here is how the profit picture would look if you simply took a $1,000 position and didn't add to it at all:
Reverse Scale Strategy, no margin leverage (Chart #2):
Decision Point
Price Level Amount Invested
this Purchase * Shares Bought this Purchase Cumulative $ Invested Cumulative Shares Owned Current Value of Shares Total $ Profit/(Loss) Total $ Borrowed Percent of Position Financed Cumulative Cash Deposited
20 $1,000 50 $1,000 50 $1,000 $0 $0 0.0% $1,000
30 $0 0 $1,000 50 $1,500 $500 $0 0.0% $1,000
45 $0 0 $1,000 50 $2,250 $1,250 $0 0.0% $1,000
67 4/8 $0 0 $1,000 50 $3,375 $2,375 $0 0.0% $1,000
101 2/8 $0 0 $1,000 50 $5,063 $4,063 $0 0.0% $1,000
151 7/8 $0 0 $1,000 50 $7,594 $6,594 $0 0.0% $1,000
227 7/8 $0 0 $1,000 50 $11,391 $10,391 $0 0.0% $1,000
Using both Chart #1 and Chart #2, we can construct the following comparison of the profit results of the same trade both with and without using margin leverage:
Profit Comparison of Margin versus Cash-only Basis (Chart #3):
Price Level Profit
Using Margin Profit
Without Margin Additional Profit
from Margin
20 $0 $0 $0
30 $500 $500 $0
45 $1,745 $1,250 $495
67 4/8 $4,108 $2,375 $1,733
101 2/8 $8,158 $4,063 $4,095
151 7/8 $14,739 $6,594 $8,145
227 7/8 $25,142 $10,391 $14,751
So, if the stock moves from $20 to $227 7/8, the difference in profit is nearly $15,000, whereas the difference in our own dollars invested is only $500 (the $1,500 deposit in the margin example versus the $1,000 cash deposit in the non-margined example). For stock trends of smaller proportions, the differences are less huge, but still substantial.
The use of margin is always more risky than not using it. This is simply because whatever you do to try to control the risk, you still own more shares than you would if you were trading without the use of borrowed money. However, I feel anyone who is comfortable taking a little more risk for a lot more potential reward should use margin, and I will assume throughout this book that the reader intends to use margin in building stock positions using the Reverse Scale Strategy.
Precautionary Guidelines
Some important principles to remember when using the Reverse Scale Strategy:
1. Never buy a larger dollar position in your subsequent positions than you took in the initial entry into the trade. In our example where we bought $1,000 of stock at 20, for instance, never buy more than $1,000 of that stock in any single subsequent purchase. If you break this rule you will increase your average cost per share significantly enough that you will practically guarantee yourself a loss at some point.
2. Only buy at the decision points. Don't try to make "extra" buys between decision points. This is just another way of breaking the first rule and leaves you exposed.
3. Never set your decision points closer than 50% in price above the previous one. If you do, you can get whipsawed by normal market fluctuations, resulting in less profit and exiting trends prematurely. You will kick yourself as you watch your stock recover and start making new highs once again - without you.
4. Do not depart from these guidelines!
Applying the Reverse Scale Strategy to Portfolios of Stocks
Up until now we have concentrated on how you would go about making buy and sell decisions for just one stock at a time, because it's much easier to explain the concepts this way. It's easy to adapt the Reverse Scale Strategy to a portfolio environment because all we have to do is construct a separate decision chart for each of the five, ten, or however many stocks are in our portfolio, and begin with an equal dollar amount in each stock. In the next chapter we will review in a step-by-step manner how to use our strategy to accumulate and manage a portfolio of stocks.
When using the Reverse Scale Strategy to manage a portfolio of stocks, always begin with an equal dollar amount invested in each stock. Do not try to guess which stocks will perform best.
Diversification
For the sake of being clearly understood, let me state this in no uncertain terms: You should never invest a major amount of money in just one stock. For one thing, it is risky because all of your eggs are in one basket. Furthermore, it is unnecessarily risky. If you have a number of stocks in your portfolio and use the Reverse Scale Strategy, those few that perform exceptionally well will be added to as they progress upward in price. This will guarantee that in the final analysis your best-performing stocks will make up a larger percentage of your portfolio than your poorer-performing ones. So you don't need to try to second-guess which stock will perform best beforehand.
If you are disciplined and follow the strategy, you will have the benefit of starting with a shotgun approach at the outset and progressing to more of a rifle-shot as the winners begin to emerge. So don't try to hit a home run by investing all your money in one stock. Chances are, you'll simply strike out. Ignoring principles of diversification and investing your money in only one stock is a risky and foolhardy thing to do - don't do it.
In my opinion, you should never invest in less than five stocks to begin with, and that's the bare minimum number assuming you just don't have enough money to invest in more. As a rule of thumb, aim to have about ten stocks in a Reverse Scale Strategy portfolio. There is nothing magical about the number ten, but I feel this number represents a good balance between diversification and the time required for tracking the stocks.
Do not churn your account!
Once you have chosen the stocks you will trade, do not change stocks (selling one, buying another) unless it meets the predetermined exit plan. That is, do not sell a stock unless it hits one decision point below the previously achieved decision point. Ever. If you do depart from this system you will no doubt end up making emotional decisions, and they will most likely be poor ones. Plus, you will lose peace of mind because you will no longer have a plan that you are resolved to stick with no matter what. In short, you'll be right back where you were before you read this book.
There have been a number of studies over the years showing that excessive trading tends to reduce investment results. The other name for excessive trading is churning. Whatever you call it, it is a waste of time and generally is a tip-off that the investor doing this is confused about their strategy or is investing for excitement rather than profits.
If you resolve to use the Reverse Scale Strategy, stick with it consistently. In the long run it will be the best policy.
Guidelines for placing orders
Market orders versus Limit Orders
When you place an order with your broker, they will ask you if you want to execute your trade as a market order or as a limit order. You should always use market orders when buying or selling stocks. A market order specifies a willingness to buy at the current market price, whatever it may be. A limit order instructs the broker to buy at a specified price. A market order ensures that you will have your order filled, but the exact price is not guaranteed. A limit order guarantees that you will not pay a higher price than you specified, but does not guarantee that your order will be filled.
So why not use limit orders? Because if you do, you will find that what would have been your most profitable orders are seldom filled, as the market moves away from your specified price. On the other hand, the orders that are filled on a limit order will most likely turn out to not be your best potential trades. The reason for this is that stocks of companies where something really good is happening will move steadily upward at times, without pausing to backtrack and fill the orders of those who have decided to use limit orders. The use of limit orders generally means that a person is being greedy, hoping to cut his purchase price by a small amount. But, instead, the hapless limit order is constantly left behind by the really good stocks, and wonders why his biggest fish got away.
Bottom line, in real life with the Reverse Scale Strategy it is not critical that you get filled at exactly the prices listed in the decision chart. We are going after the big gains and a quarter or half-point variation won't matter much in the long run. It is important to always use market orders as opposed to limit orders. It is much more important to get your order executed than it is to get a specific price.
Stop-loss orders
There is another type of order you should know about, called a stop-loss order. They are commonly referred to as simply top orders.' This order is placed below the market price if it is a sell stop order, or above the market if it is a buy stop. If the stock's market price reaches the price specified in the stop order, then the stop order becomes a market order to buy or sell. As an example, let's say we bought shares of ABC Co. at $20. They then rise to reach the first decision point price of $30/share, signaling that our sell signal will be reached if and when the price of the stock goes to $20. We could place a sell stop order for our shares at $20, which would instruct the broker to enter a market order to sell our shares if and only if the market price of ABC Co. again returns to $20 or below. If we enter it on a good till canceled basis, (GTC), the order will stand until it is either triggered by the stock's price reaching $20, or until we cancel the order. If you do not specify GTC status for this or any other type of order, your order will be classified as a day order, meaning it will expire at the end of the day it is entered. So be careful to specify GTC on stop orders if you want them to last more than a day. Otherwise you may have a false sense of security that your order is still entered when it really is not.
Currently, stop orders are only available on listed (New York Stock Exchange and American Stock Exchange) stocks, and not on Nasdaq (Over-the Counter) stocks. However, some brokers are starting to offer stop orders on Nasdaq stocks. So, perhaps soon these orders may be available for all stocks in your portfolio. I certainly hope so, because stop orders are a very useful thing for the average investor who cannot be watching the market constantly. They in essence watch it for you.
If you cannot watch the market during the day (and who can?), I encourage the use of stop orders once you have accumulated a large position in a company's stock. The decision point parameters are set far enough apart with the Reverse Scale Strategy that using intraday prices (which is what stop orders are triggered by) or closing prices will not likely change your performance very much and may give you greater peace of mind.
Chapter 9: Implementing the Reverse Scale Strategy: A Step-by-step Approach
Now that you have a good grounding in the Reverse Scale Strategy, we are ready to review the steps needed for you to implement it. Obviously, going through these steps the first time will take more than five minutes, but after you are set up it should only take five minutes a day to maintain and execute the strategy.
Step 1: Determine how much you can afford to commit to this strategy.
All stock market investments involve some degree of risk, no matter what your approach to the market. Bear markets, national emergencies, and other factors are unpredictable and cause most stocks to decline temporarily when they do occur. Because of this unpredictability of short-term stock market performance, you should only invest capital which you will not need for at least five years. Therefore, it's necessary to establish exactly how much you can afford to commit to a longer term strategy such as the one we've just developed - your pool of "risk capital." The term "risk capital" means different things depending on the psyche and risk tolerance of the individual involved, and determining that number for you personally is outside the scope of this book. You alone must determine how much you can commit, but the following are some things to consider when making that decision:
1) Investment experience.
If you have never before traded stocks, start small in using the Reverse Scale Strategy until you are very comfortable with the Strategy and with your understanding of the mechanics and practices of stock trading. If you lack confidence, there is no use compounding your discomfort by adding the stress of trading with the lion's share of your money. You will learn things as you trade that will give you confidence in handling larger amounts. Be patient and give yourself time to learn before committing big money.
2) Establish an emergency fund.
By definition, if you are not going to commit funds which you will need in the next five years, then you must establish an emergency fund. No one, no matter what position they are in, can rule out the possibility of a personal emergency over the next five years. Most financial experts recommend six months' living expenses, and I would consider that the minimum amount necessary.
3) Age.
The older you are, the less years you have to recover from reverses in the stock market. If you are only five or ten years away from retirement, it goes without saying that you may want to be a little more conservative in the amount of capital you devote to an actively managed stock portfolio. More predictable investments such as bonds, CD's, convertible securities and such may need to compose the majority of your holdings.
Using these factors, you need to take an honest look at your situation and assess just how much you want to commit to a relatively risky, longer-term investment program. I do not recommend that you trade on margin with the majority of your money!
Do not speculate in stocks with money that you will need to consume within the next five years.
Step 2: Choose an Appropriate Brokerage Firm
As I see it, there are several criteria to use in choosing a brokerage firm to handle your account: 1) Commission structure, 2) Insurance, and 3) Attitude.
1) Commissions.
With this method (or any other, for that matter), it is vital that you cut your commissions to the bone in order to maximize net returns. In most instances, this will mean using a discount broker instead of a full-service broker. To enhance net returns, commissions should total no more than 1% to 2% per trade, or else you are paying too much. The techniques in this book work with accounts of any size above $5,000. But the smaller your account size, the harder it becomes to maintain reasonable diversification without incurring large commissions as a percentage of your account value. So if you have a relatively small account and are buying stocks in $2,000 increments, choose a broker which will handle your trades for less than $40. You should have no trouble finding a discount broker that will handle your trades for less than that amount actually, and I recommend you do so. My broker charges $25/trade and I get a level of service that has always been more than adequate. The smaller your account size, the more closely you'll have to pay attention to finding a broker who can keep your commissions down to 1% to 2% of the principal amount per trade.
2) Insurance.
Make sure your brokerage account is insured in case they should go bankrupt. Before you open an account, ask to see (in writing) what would happen in the case of the brokerage firm's bankruptcy. The vast, vast majority of firms these days have adequate insurance in case of failure through the Securities Investors Protection Corporation (SIPC), but the possibility that a firm wouldn't have insurance exists and it's good to inquire about such things before committing your funds.
3) Attitude.
Discount brokers are essentially order-takers who offer no advice, which is precisely what we want and need. Even so, before you open an account it is good to call the firm's customer service department and ask a few questions, even if you have to make some up. I believe that you can learn a lot about the attitude of the brokerage firm and its employees by speaking with them personally. This provides a good reality check on whether you will be able to do business with them or if there will be a clash between their culture and your personality.
Step 3: Determine how many stocks you will invest in.
It's best to pursue the Reverse Scale Strategy with ten stocks or more if you can, with five stocks being the absolute minimum number to achieve adequate diversification. Because of the practical constraint of trying to minimize commissions as a percent of the value of your portfolio, the goal of owning ten or more stocks is probably only realistic with accounts of $20,000 or more. If your account is small (between $5,000 and $20,000) you may have to settle for five to nine issues and get a very inexpensive discount broker in order to keep commission expenses manageable.
Amount of Capital Available Recommended Number of Stocks
$5,000-$10,000 Five
$10,000-$15,000 Six or Seven
$15,000-$20,000 Seven to Nine
$20,000 & Up. Ten or More
If you are adequately capitalized, though, ten issues represents an acceptable level of diversification and is a manageable number of issues to track daily. This number is not critical, though. If you feel you have time, and a fairly large amount of risk capital (say, more than $100,000) you can have fifteen or twenty stocks in your portfolio. I would not try this method with less than five issues, because the volatility in your account will likely be emotionally taxing. One thing to keep in mind is that the more stocks you have, the better your chances of finding an exceptionally good-performing stock.
To determine the dollar amount you will invest in each position, take the number of dollars in your trading account and multiply by 65%. Then, take this results and divide by the number of issues you will be trading in your account. This will yield the dollar amount you will initially invest in each issue.
As an example, let's say you have $15,000 in your trading account. Multiplying $15,000 by 65% yields $9,750. $9,750 represents the total amount that you will invest to begin with. Now, if we tried to split $9,750 up into ten stocks, we would only be investing $975 per stock. Since we would have a hard time keeping our commissions down to the 1% to 2% of principal level on a $975 trade (for instance, if our commission was $25 per trade we'd be spending $25/$975 or nearly 2 1/2%), we opt to trade six issues instead of ten, after referring to the chart above. $9,750 divided by 6 yields about $1,625 per stock. This amount, $1,625, is the amount we will invest in each of our six issues.
The reason we are using only 65% of our capital at first is that we want to abide by the margin trading rule we developed in Chapter 8:
To control our use of leverage, We will choose our initial position size in a stock so that we will always have enough cash on hand to make our initial purchase and half of our second purchase without borrowing anything.
Using no more than 65% of our capital for our initial positions in our six stocks ensures that we are in compliance with this part of our trading strategy.
Step 4: Determine which issues you will invest in
Keep it simple. Use the criteria for stock-picking presented in Chapter 4, which is essentially:
1. Restrict your stock picking to the 52-week highs list (better yet, use stocks making new all-time highs in price).
2. Weed out defensive issues such as precious metals, oils, utility companies, closed-end mutual funds and food/grocery issues.
3. Weed out stocks selling for less than $15/share.
4. Lean toward the smaller-capitalization stocks remaining on your list that meet criteria 1 through 3 above.
5. To maintain adequate diversification, select stocks from several different industries.
6. Check out the chart of the stock for clues on goodness of trend, volatility, and whether or not a buyout situation is responsible for its being on the 52-week highs list.
You can be assured that these stocks are high-potential and they will have a excellent chance of leading the market in a bullish environment. If we use this criteria to choose the six stocks we will buy and follow in our example, our chances of having some really big winners will be increased dramatically over just about any other method. Why? Because we are getting our recommendations directly from the market, where investors are voting with their dollars. Not from a broker who may not even have his own money invested in the stock he's selling to you. Remember, stock brokers are successful because they know how to get people to buy stocks, not necessarily because they know how to make money.
To continue our example, after applying the criteria above, let's say we end up choosing the following six stocks (these are hypothetical examples only):
Stock Purchase Price
Zeneca $56 3/4
Hummingbird $50 3/4
CUC International $31 1/8
Tiffany $46 3/4
First Data $69 1/2
Imperial Bcp $24
As we determined earlier, we will purchase $1,625 worth of each stock.
Step 5: Buy your initial positions in each stock
Now that you have chosen which stocks to build positions in, calculate based on the most recent closing price of each stock how many shares you will initially buy in each issue. Don't worry that they are not in even 100-lot quantities, which they almost certainly will not be. Instead concentrate on buying an equal dollar amount in each issue purchased. For example, we previously calculated an initial position of $1,625 for each of our six issues. Therefore, if one of the stocks on our buy list is Zeneca and it is selling for $56 3/4, we would place an order to buy 29 shares ($1,625 divided by 56 3/4, rounded up to the next even-number share quantity) at the market price. This calculation would be repeated for each of the other five stocks you are buying using their specific closing prices from the previous day.
Here's a helpful hint: Try to place the orders well before the 9:30 AM market opening so that you will receive the day's opening price. Odd lot trades (less than 100 shares) are usually upcharged some amount for a handling charge, but this is often waived if the order is entered before the market opens. Also, you'll be more likely to get a price closer to the previous day's close by getting in when the market first opens. As always, use market orders and not limit orders.
Once your orders are filled, be sure to make a note of the price per share you actually paid for each position.
Step 6: Construct your predetermined entry and exit plan matrix.
Now that we have taken our initial positions, all that is necessary is to finish filling out the Reverse Scale Strategy Decision Chart, as shown in the example below. In this chart, we define the first few Decision Points (more can be added later, for those stocks which make hefty advances) for each stock based on your initial entry point into that stock. The number of shares we acquire at each decision point can be penciled in as these acquisitions occur, as well as the total number of shares owned. For each stock individually, the sell point is always one level (33%) below its highest Decision Point reached, as covered in Chapter 7. Once we have constructed this worksheet we can carry it with us and pencil in acquisitions as our decision points are reached. Then we will know which Decision Points have been reached, and hence we will also know just by looking at the chart what our current sell point is for each stock, as well as the next buy point. In keeping with our example, here is how the chart would be filled out for the six stocks we picked out for our example portfolio, once we've taken our initial positions:
Reverse Scale Strategy Decision Chart
Company Zeneca Company Hummingbird
Symbol ZEN Symbol HUMCF
Target
Price/share Shares
Purchased Total Shares
Owned Target
Price/share Shares
Purchased Total Shares
Owned
Initial sell point 37 7/8 (n/a) (n/a) Initial sell point 33 7/8 (n/a) (n/a)
Inital entry point 56 3/4 29 29 Inital entry point 50 3/4 32 32
Decision point 1 85 1/8 Decision point 1 76 1/8
Decision point 2 127 3/4 Decision point 2 114 1/4
Decision point 3 191 1/2 Decision point 3 171 1/4
Company CUC Int'l Company Tiffany
Symbol CU Symbol TIF
Target
Price/share Shares
Purchased Total Shares
Owned Target
Price/share Shares
Purchased Total Shares
Owned
Initial sell point 24 3/4 (n/a) (n/a) Initial sell point 31 1/8 (n/a) (n/a)
Inital entry point 37 1/8 44 44 Inital entry point 46 3/4 35 35
Decision point 1 55 3/4 Decision point 1 70 1/8
Decision point 2 83 1/2 Decision point 2 105 1/4
Decision point 3 125 1/4 Decision point 3 157 3/4
Company First Data Company Imperial Bankcorp
Symbol FDC Symbol IBAN
Target
Price/share Shares
Purchased Total Shares
Owned Target
Price/share Shares
Purchased Total Shares
Owned
Initial sell point 46 3/8 (n/a) (n/a) Initial sell point 16 (n/a) (n/a)
Initial entry point 69 1/2 23 23 Initial entry point 24 68 68
Decision point 1 104 1/4 Decision point 1 36
Decision point 2 156 3/8 Decision point 2 54
Decision point 3 234 5/8 Decision point 3 81
Step 7: Monitor your positions
After we have taken our positions, it's pretty much a game of waiting to see what happens next. We must check performance of all the issues in our portfolio after the close of every trading day in order to see if you need to add to any of your positions or sell any of them. If you can, check twice a day, but this is not a requirement for success. Even though our decision points are placed far apart, under certain market conditions large moves can happen in a single day, so it's critical to keep on top of developments - and so the necessity of checking in every day. The way to accomplish this is by using a discount broker that offers a touch-tone quoting and order entry service, which should bring the time necessary to check up on things down to about about two or three minutes a day. Who knows, we may become a "Less Than Five Minute" Investor! If your discount broker does not offer this service, find one who does and save yourself a lot of time. These services allow you to set up a list of stocks whose closing prices will be automatically reported to you at the end of the day when you call. With this type of service, monitoring your stocks can easily be accomplished by even the busiest persons. I like the touch-tone quote retrieval services because even if I am on a business trip, I can check my investments at 10PM in my hotel room, and I don't need a computer to do it. If a buy or sell point has been reached, I can enter the necessary orders right there on the telephone, without talking to anyone or having to wait until the broker gets in in the morning.
I strongly recommend that when you have built a fairly large size position in a successful stock, use good-til-cancelled stop-loss orders, which were described in Chapter 8. I use these whenever I have made two or more purchases in a stock, because at that point I have enough invested in the stock to warrant protecting myself with such a mechanism. However, there is no reason you can't choose to use a stop-loss order on every position in your account. This helps to avoid the situation where you call in at the end of the day only to find that your stock has fallen to substantially below your Decision Point for selling. Stop orders give you peace of mind for keeping your mind on your job during the work day, without the distraction of needing to watch your investments. One necessary discipline for the use of good-till-cancelled orders of any kind is that you must keep meticulous records of your orders, so that you know exactly which orders you have entered and which ones you have canceled. Otherwise, you may end up executing orders which you did not intend to execute.
Step 8: Know and Apply the Trading Rules
As you monitor the stocks in your portfolio, eventually one or more of the stocks will reach the next decision point above where you got in, or will decline below the decision point previously reached. In either case, action on your part is required. Thus it is good to review and know the trading rules well so that you can apply them decisively.
Trading rule #1: Whenever a stock advances so that it touches a Decision Point not previously achieved, add a dollar amount to your position in that stock approximately equal to the dollar amount originally bought.
In our example, we bought $1,625 worth of Zeneca at $56 3/4, so if Zeneca rises to touch $85 1/8, we will call the broker and add 19 shares ($1,625 divided by $85 1/8) to our position. We would update the Zeneca portion of our decision chart as follows in the highlighted area:
Company Zeneca
Symbol ZEN
Target
Price/share Shares
Purchased Total Shares
Owned
Initial sell point 37 7/8 (n/a) (n/a)
Initial entry point 56 3/4 29 29
Decision point 1 85 1/8 19 48
Decision point 2 127 3/4
Decision point 3 191 1/2
No other stocks' decision charts are affected by this change. We are making decisions for each stock separately, based on the performance of that stock alone. Now that the chart has been updated, we can see all the information we need to know: We can see that the Decision Point of $85 1/8 has been reached, that we now own 48 shares, and that in order for us to sell our entire position Zeneca would have to decline to $56 3/4 or lower. This scenario is covered in the next trading rule.
Had Zeneca risen to $191 1/2 or higher over the next several months or years, we would have added positions at $127 3/4 and at $191 1/2, for a total position of about 68 shares. At that point, the new sell stop for all 68 shares would be at $127 3/4.
Trading rule #2: Whenever a stock declines to touch the previous Decision Point, sell the entire position.
If, instead of advancing, Zeneca had declined instead of advancing and had dropped as low as $37 7/8 after we took our initial position, we would have to sell out the initial position (29 shares) for a loss. Obviously, we never got the signal to add to the position because we are assuming here that it reached $37 7/8 before it got the opportunity to hit $85 1/8.
Once one of the sell points is reached, do not hesitate. Sell. Likewise, do not hesitate to buy whenever a new decision point is reached during an uptrend. Sometimes the best stocks rise very quickly, so to act decisively is all-important whether buying or selling. He who hesitates is lost. If you believe in your plan, there is no reason to be hesitant.
Trading Rule #3: Once you have sold a stock, recommit the proceeds of that sale to a different stock (or stocks) than the one you've just sold. To pick this new issue, use the same criteria used in choosing your original list of stocks.
As we've reviewed, some people, once they've taken a loss on a stock, take it personally and they keep trying to "get even" with the stock by looking for an opportunity to buy it again. Don't fall into this trap, because if you do you are acting like the Ego-Driven Investor described earlier in the book. Forget the loss and the stock. If a stock has fallen far enough from its highs that it's now down at least 33% from the peak (the percentage difference between every Decision Point and its next lower Decision Point), then it may be entering a downtrend, and you don't want it. Take what's left and buy a different stock, one now making new highs. Your money will be better employed and your account won't end up looking like the dog pound.
A Trading Rule for Bear Market Insurance
In any trading system, the most important thing is to preserve your capital. Capital preservation is all-important because if you seriously deplete your trading capital, it becomes very difficult to get back even to where you started out, much less make a profit since you are then working with a smaller amount of capital.
The two main sources of capital depletion are from whipsaw losses (rapid-fire in and out trading, which almost always results in lots of small losses and large commission expenses) and from failing to cut losses on poor investments. The Reverse Scale Strategy already has many capital-preserving mechanisms built into it. Among these are diversification among many securities, our loss-cutting decision rules, and the fact that we do not add to positions until they are showing us a good profit. Also, our decision points are set far enough apart (50%) so that whipsaw losses are extremely unlikely, especially when applied to stocks selling for more than $15 per share.
However, for good measure we need to address the worst-case scenario in order to short-circuit the prospect of several losses coming in quick succession. These types of events tend to occur during bear markets. Since bear markets are a reality and are unpredictable, we need to add the following trading rule to ensure that we can survive those inevitable times when the market goes down for an extended period, pulling almost all stocks down with it:
Trading Rule #4: When you've been forced out of a stock position (by applying trading Rule #2), do not reinvest the proceeds of that sale into another stock until the Standard and Poor's 500 stock index (commonly referred to as the S&P 500) makes a new 52-week high.
The purpose of this trading rule is to force us to wait until the market as a whole is showing signs of positive momentum before recommitting funds. In other words, we do not want to get into a situation where we are buying a new stock, selling it for a loss, using the proceeds to buy another new stock and then being forced to sell it for a loss, and so on in quick succession. This can happen during very severe market downturns. That's why we want to wait until the market has shown some strength before recommitting funds to a new position. Your win to loss ratio will be much better if you observe this rule.
Since the market (as measured by the S&P 500 index) is commonly making 52-week highs, most of the time you will not have to wait too terribly long to reinvest proceeds of a sale. If Trading Rule #4 does prevent you from reinvesting for a long period of time, there is a very good reason for it, and you will no doubt be glad that you were patient in waiting for a new 52-week high for the S&P 500 before recommitting funds.
Of course, it goes without saying that any stock you would pick for reinvestment needs to be chosen using the criteria from Chapter 4.
Step 9
As your account value grows, you will have to periodically adjust the size of the initial positions you are taking in a stock. For instance, if our $15,000 account equity grew to $25,000 and we sold one or two stocks, we probably wouldn't want to take new initial positions to replace them that were as small as we originally took. Instead of taking $1,625 initial positions, we might decide to take positions that were proportionally in line with our new account equity balance, say $2,700 in this case. With any successful investment plan, these types of adjustments need to be made as the amount of money you have to invest grows.
The other thing you could do in such a case is to stick with the $1,625 initial position size and simply work with a larger number of stocks. For diversification purposes, this is the preferred route to take, at least until you reach the goal of having ten stocks.
The main thing to beware of is that you don't over-commit yourself. When you sell a stock, don't invest more in new stocks than you received in proceeds from the one you've sold. If you adhere to this rule, you will never overcommit yourself.
Now that you have a good grounding in the Reverse Scale Strategy, we are ready to review the steps needed for you to implement it. Obviously, going through these steps the first time will take more than five minutes, but after you are set up it should only take five minutes a day to maintain and execute the strategy.
Step 1: Determine how much you can afford to commit to this strategy.
All stock market investments involve some degree of risk, no matter what your approach to the market. Bear markets, national emergencies, and other factors are unpredictable and cause most stocks to decline temporarily when they do occur. Because of this unpredictability of short-term stock market performance, you should only invest capital which you will not need for at least five years. Therefore, it's necessary to establish exactly how much you can afford to commit to a longer term strategy such as the one we've just developed - your pool of "risk capital." The term "risk capital" means different things depending on the psyche and risk tolerance of the individual involved, and determining that number for you personally is outside the scope of this book. You alone must determine how much you can commit, but the following are some things to consider when making that decision:
1) Investment experience.
If you have never before traded stocks, start small in using the Reverse Scale Strategy until you are very comfortable with the Strategy and with your understanding of the mechanics and practices of stock trading. If you lack confidence, there is no use compounding your discomfort by adding the stress of trading with the lion's share of your money. You will learn things as you trade that will give you confidence in handling larger amounts. Be patient and give yourself time to learn before committing big money.
2) Establish an emergency fund.
By definition, if you are not going to commit funds which you will need in the next five years, then you must establish an emergency fund. No one, no matter what position they are in, can rule out the possibility of a personal emergency over the next five years. Most financial experts recommend six months' living expenses, and I would consider that the minimum amount necessary.
3) Age.
The older you are, the less years you have to recover from reverses in the stock market. If you are only five or ten years away from retirement, it goes without saying that you may want to be a little more conservative in the amount of capital you devote to an actively managed stock portfolio. More predictable investments such as bonds, CD's, convertible securities and such may need to compose the majority of your holdings.
Using these factors, you need to take an honest look at your situation and assess just how much you want to commit to a relatively risky, longer-term investment program. I do not recommend that you trade on margin with the majority of your money!
Do not speculate in stocks with money that you will need to consume within the next five years.
Step 2: Choose an Appropriate Brokerage Firm
As I see it, there are several criteria to use in choosing a brokerage firm to handle your account: 1) Commission structure, 2) Insurance, and 3) Attitude.
1) Commissions.
With this method (or any other, for that matter), it is vital that you cut your commissions to the bone in order to maximize net returns. In most instances, this will mean using a discount broker instead of a full-service broker. To enhance net returns, commissions should total no more than 1% to 2% per trade, or else you are paying too much. The techniques in this book work with accounts of any size above $5,000. But the smaller your account size, the harder it becomes to maintain reasonable diversification without incurring large commissions as a percentage of your account value. So if you have a relatively small account and are buying stocks in $2,000 increments, choose a broker which will handle your trades for less than $40. You should have no trouble finding a discount broker that will handle your trades for less than that amount actually, and I recommend you do so. My broker charges $25/trade and I get a level of service that has always been more than adequate. The smaller your account size, the more closely you'll have to pay attention to finding a broker who can keep your commissions down to 1% to 2% of the principal amount per trade.
2) Insurance.
Make sure your brokerage account is insured in case they should go bankrupt. Before you open an account, ask to see (in writing) what would happen in the case of the brokerage firm's bankruptcy. The vast, vast majority of firms these days have adequate insurance in case of failure through the Securities Investors Protection Corporation (SIPC), but the possibility that a firm wouldn't have insurance exists and it's good to inquire about such things before committing your funds.
3) Attitude.
Discount brokers are essentially order-takers who offer no advice, which is precisely what we want and need. Even so, before you open an account it is good to call the firm's customer service department and ask a few questions, even if you have to make some up. I believe that you can learn a lot about the attitude of the brokerage firm and its employees by speaking with them personally. This provides a good reality check on whether you will be able to do business with them or if there will be a clash between their culture and your personality.
Step 3: Determine how many stocks you will invest in.
It's best to pursue the Reverse Scale Strategy with ten stocks or more if you can, with five stocks being the absolute minimum number to achieve adequate diversification. Because of the practical constraint of trying to minimize commissions as a percent of the value of your portfolio, the goal of owning ten or more stocks is probably only realistic with accounts of $20,000 or more. If your account is small (between $5,000 and $20,000) you may have to settle for five to nine issues and get a very inexpensive discount broker in order to keep commission expenses manageable.
Amount of Capital Available Recommended Number of Stocks
$5,000-$10,000 Five
$10,000-$15,000 Six or Seven
$15,000-$20,000 Seven to Nine
$20,000 & Up. Ten or More
If you are adequately capitalized, though, ten issues represents an acceptable level of diversification and is a manageable number of issues to track daily. This number is not critical, though. If you feel you have time, and a fairly large amount of risk capital (say, more than $100,000) you can have fifteen or twenty stocks in your portfolio. I would not try this method with less than five issues, because the volatility in your account will likely be emotionally taxing. One thing to keep in mind is that the more stocks you have, the better your chances of finding an exceptionally good-performing stock.
To determine the dollar amount you will invest in each position, take the number of dollars in your trading account and multiply by 65%. Then, take this results and divide by the number of issues you will be trading in your account. This will yield the dollar amount you will initially invest in each issue.
As an example, let's say you have $15,000 in your trading account. Multiplying $15,000 by 65% yields $9,750. $9,750 represents the total amount that you will invest to begin with. Now, if we tried to split $9,750 up into ten stocks, we would only be investing $975 per stock. Since we would have a hard time keeping our commissions down to the 1% to 2% of principal level on a $975 trade (for instance, if our commission was $25 per trade we'd be spending $25/$975 or nearly 2 1/2%), we opt to trade six issues instead of ten, after referring to the chart above. $9,750 divided by 6 yields about $1,625 per stock. This amount, $1,625, is the amount we will invest in each of our six issues.
The reason we are using only 65% of our capital at first is that we want to abide by the margin trading rule we developed in Chapter 8:
To control our use of leverage, We will choose our initial position size in a stock so that we will always have enough cash on hand to make our initial purchase and half of our second purchase without borrowing anything.
Using no more than 65% of our capital for our initial positions in our six stocks ensures that we are in compliance with this part of our trading strategy.
Step 4: Determine which issues you will invest in
Keep it simple. Use the criteria for stock-picking presented in Chapter 4, which is essentially:
1. Restrict your stock picking to the 52-week highs list (better yet, use stocks making new all-time highs in price).
2. Weed out defensive issues such as precious metals, oils, utility companies, closed-end mutual funds and food/grocery issues.
3. Weed out stocks selling for less than $15/share.
4. Lean toward the smaller-capitalization stocks remaining on your list that meet criteria 1 through 3 above.
5. To maintain adequate diversification, select stocks from several different industries.
6. Check out the chart of the stock for clues on goodness of trend, volatility, and whether or not a buyout situation is responsible for its being on the 52-week highs list.
You can be assured that these stocks are high-potential and they will have a excellent chance of leading the market in a bullish environment. If we use this criteria to choose the six stocks we will buy and follow in our example, our chances of having some really big winners will be increased dramatically over just about any other method. Why? Because we are getting our recommendations directly from the market, where investors are voting with their dollars. Not from a broker who may not even have his own money invested in the stock he's selling to you. Remember, stock brokers are successful because they know how to get people to buy stocks, not necessarily because they know how to make money.
To continue our example, after applying the criteria above, let's say we end up choosing the following six stocks (these are hypothetical examples only):
Stock Purchase Price
Zeneca $56 3/4
Hummingbird $50 3/4
CUC International $31 1/8
Tiffany $46 3/4
First Data $69 1/2
Imperial Bcp $24
As we determined earlier, we will purchase $1,625 worth of each stock.
Step 5: Buy your initial positions in each stock
Now that you have chosen which stocks to build positions in, calculate based on the most recent closing price of each stock how many shares you will initially buy in each issue. Don't worry that they are not in even 100-lot quantities, which they almost certainly will not be. Instead concentrate on buying an equal dollar amount in each issue purchased. For example, we previously calculated an initial position of $1,625 for each of our six issues. Therefore, if one of the stocks on our buy list is Zeneca and it is selling for $56 3/4, we would place an order to buy 29 shares ($1,625 divided by 56 3/4, rounded up to the next even-number share quantity) at the market price. This calculation would be repeated for each of the other five stocks you are buying using their specific closing prices from the previous day.
Here's a helpful hint: Try to place the orders well before the 9:30 AM market opening so that you will receive the day's opening price. Odd lot trades (less than 100 shares) are usually upcharged some amount for a handling charge, but this is often waived if the order is entered before the market opens. Also, you'll be more likely to get a price closer to the previous day's close by getting in when the market first opens. As always, use market orders and not limit orders.
Once your orders are filled, be sure to make a note of the price per share you actually paid for each position.
Step 6: Construct your predetermined entry and exit plan matrix.
Now that we have taken our initial positions, all that is necessary is to finish filling out the Reverse Scale Strategy Decision Chart, as shown in the example below. In this chart, we define the first few Decision Points (more can be added later, for those stocks which make hefty advances) for each stock based on your initial entry point into that stock. The number of shares we acquire at each decision point can be penciled in as these acquisitions occur, as well as the total number of shares owned. For each stock individually, the sell point is always one level (33%) below its highest Decision Point reached, as covered in Chapter 7. Once we have constructed this worksheet we can carry it with us and pencil in acquisitions as our decision points are reached. Then we will know which Decision Points have been reached, and hence we will also know just by looking at the chart what our current sell point is for each stock, as well as the next buy point. In keeping with our example, here is how the chart would be filled out for the six stocks we picked out for our example portfolio, once we've taken our initial positions:
Reverse Scale Strategy Decision Chart
Company Zeneca Company Hummingbird
Symbol ZEN Symbol HUMCF
Target
Price/share Shares
Purchased Total Shares
Owned Target
Price/share Shares
Purchased Total Shares
Owned
Initial sell point 37 7/8 (n/a) (n/a) Initial sell point 33 7/8 (n/a) (n/a)
Inital entry point 56 3/4 29 29 Inital entry point 50 3/4 32 32
Decision point 1 85 1/8 Decision point 1 76 1/8
Decision point 2 127 3/4 Decision point 2 114 1/4
Decision point 3 191 1/2 Decision point 3 171 1/4
Company CUC Int'l Company Tiffany
Symbol CU Symbol TIF
Target
Price/share Shares
Purchased Total Shares
Owned Target
Price/share Shares
Purchased Total Shares
Owned
Initial sell point 24 3/4 (n/a) (n/a) Initial sell point 31 1/8 (n/a) (n/a)
Inital entry point 37 1/8 44 44 Inital entry point 46 3/4 35 35
Decision point 1 55 3/4 Decision point 1 70 1/8
Decision point 2 83 1/2 Decision point 2 105 1/4
Decision point 3 125 1/4 Decision point 3 157 3/4
Company First Data Company Imperial Bankcorp
Symbol FDC Symbol IBAN
Target
Price/share Shares
Purchased Total Shares
Owned Target
Price/share Shares
Purchased Total Shares
Owned
Initial sell point 46 3/8 (n/a) (n/a) Initial sell point 16 (n/a) (n/a)
Initial entry point 69 1/2 23 23 Initial entry point 24 68 68
Decision point 1 104 1/4 Decision point 1 36
Decision point 2 156 3/8 Decision point 2 54
Decision point 3 234 5/8 Decision point 3 81
Step 7: Monitor your positions
After we have taken our positions, it's pretty much a game of waiting to see what happens next. We must check performance of all the issues in our portfolio after the close of every trading day in order to see if you need to add to any of your positions or sell any of them. If you can, check twice a day, but this is not a requirement for success. Even though our decision points are placed far apart, under certain market conditions large moves can happen in a single day, so it's critical to keep on top of developments - and so the necessity of checking in every day. The way to accomplish this is by using a discount broker that offers a touch-tone quoting and order entry service, which should bring the time necessary to check up on things down to about about two or three minutes a day. Who knows, we may become a "Less Than Five Minute" Investor! If your discount broker does not offer this service, find one who does and save yourself a lot of time. These services allow you to set up a list of stocks whose closing prices will be automatically reported to you at the end of the day when you call. With this type of service, monitoring your stocks can easily be accomplished by even the busiest persons. I like the touch-tone quote retrieval services because even if I am on a business trip, I can check my investments at 10PM in my hotel room, and I don't need a computer to do it. If a buy or sell point has been reached, I can enter the necessary orders right there on the telephone, without talking to anyone or having to wait until the broker gets in in the morning.
I strongly recommend that when you have built a fairly large size position in a successful stock, use good-til-cancelled stop-loss orders, which were described in Chapter 8. I use these whenever I have made two or more purchases in a stock, because at that point I have enough invested in the stock to warrant protecting myself with such a mechanism. However, there is no reason you can't choose to use a stop-loss order on every position in your account. This helps to avoid the situation where you call in at the end of the day only to find that your stock has fallen to substantially below your Decision Point for selling. Stop orders give you peace of mind for keeping your mind on your job during the work day, without the distraction of needing to watch your investments. One necessary discipline for the use of good-till-cancelled orders of any kind is that you must keep meticulous records of your orders, so that you know exactly which orders you have entered and which ones you have canceled. Otherwise, you may end up executing orders which you did not intend to execute.
Step 8: Know and Apply the Trading Rules
As you monitor the stocks in your portfolio, eventually one or more of the stocks will reach the next decision point above where you got in, or will decline below the decision point previously reached. In either case, action on your part is required. Thus it is good to review and know the trading rules well so that you can apply them decisively.
Trading rule #1: Whenever a stock advances so that it touches a Decision Point not previously achieved, add a dollar amount to your position in that stock approximately equal to the dollar amount originally bought.
In our example, we bought $1,625 worth of Zeneca at $56 3/4, so if Zeneca rises to touch $85 1/8, we will call the broker and add 19 shares ($1,625 divided by $85 1/8) to our position. We would update the Zeneca portion of our decision chart as follows in the highlighted area:
Company Zeneca
Symbol ZEN
Target
Price/share Shares
Purchased Total Shares
Owned
Initial sell point 37 7/8 (n/a) (n/a)
Initial entry point 56 3/4 29 29
Decision point 1 85 1/8 19 48
Decision point 2 127 3/4
Decision point 3 191 1/2
No other stocks' decision charts are affected by this change. We are making decisions for each stock separately, based on the performance of that stock alone. Now that the chart has been updated, we can see all the information we need to know: We can see that the Decision Point of $85 1/8 has been reached, that we now own 48 shares, and that in order for us to sell our entire position Zeneca would have to decline to $56 3/4 or lower. This scenario is covered in the next trading rule.
Had Zeneca risen to $191 1/2 or higher over the next several months or years, we would have added positions at $127 3/4 and at $191 1/2, for a total position of about 68 shares. At that point, the new sell stop for all 68 shares would be at $127 3/4.
Trading rule #2: Whenever a stock declines to touch the previous Decision Point, sell the entire position.
If, instead of advancing, Zeneca had declined instead of advancing and had dropped as low as $37 7/8 after we took our initial position, we would have to sell out the initial position (29 shares) for a loss. Obviously, we never got the signal to add to the position because we are assuming here that it reached $37 7/8 before it got the opportunity to hit $85 1/8.
Once one of the sell points is reached, do not hesitate. Sell. Likewise, do not hesitate to buy whenever a new decision point is reached during an uptrend. Sometimes the best stocks rise very quickly, so to act decisively is all-important whether buying or selling. He who hesitates is lost. If you believe in your plan, there is no reason to be hesitant.
Trading Rule #3: Once you have sold a stock, recommit the proceeds of that sale to a different stock (or stocks) than the one you've just sold. To pick this new issue, use the same criteria used in choosing your original list of stocks.
As we've reviewed, some people, once they've taken a loss on a stock, take it personally and they keep trying to "get even" with the stock by looking for an opportunity to buy it again. Don't fall into this trap, because if you do you are acting like the Ego-Driven Investor described earlier in the book. Forget the loss and the stock. If a stock has fallen far enough from its highs that it's now down at least 33% from the peak (the percentage difference between every Decision Point and its next lower Decision Point), then it may be entering a downtrend, and you don't want it. Take what's left and buy a different stock, one now making new highs. Your money will be better employed and your account won't end up looking like the dog pound.
A Trading Rule for Bear Market Insurance
In any trading system, the most important thing is to preserve your capital. Capital preservation is all-important because if you seriously deplete your trading capital, it becomes very difficult to get back even to where you started out, much less make a profit since you are then working with a smaller amount of capital.
The two main sources of capital depletion are from whipsaw losses (rapid-fire in and out trading, which almost always results in lots of small losses and large commission expenses) and from failing to cut losses on poor investments. The Reverse Scale Strategy already has many capital-preserving mechanisms built into it. Among these are diversification among many securities, our loss-cutting decision rules, and the fact that we do not add to positions until they are showing us a good profit. Also, our decision points are set far enough apart (50%) so that whipsaw losses are extremely unlikely, especially when applied to stocks selling for more than $15 per share.
However, for good measure we need to address the worst-case scenario in order to short-circuit the prospect of several losses coming in quick succession. These types of events tend to occur during bear markets. Since bear markets are a reality and are unpredictable, we need to add the following trading rule to ensure that we can survive those inevitable times when the market goes down for an extended period, pulling almost all stocks down with it:
Trading Rule #4: When you've been forced out of a stock position (by applying trading Rule #2), do not reinvest the proceeds of that sale into another stock until the Standard and Poor's 500 stock index (commonly referred to as the S&P 500) makes a new 52-week high.
The purpose of this trading rule is to force us to wait until the market as a whole is showing signs of positive momentum before recommitting funds. In other words, we do not want to get into a situation where we are buying a new stock, selling it for a loss, using the proceeds to buy another new stock and then being forced to sell it for a loss, and so on in quick succession. This can happen during very severe market downturns. That's why we want to wait until the market has shown some strength before recommitting funds to a new position. Your win to loss ratio will be much better if you observe this rule.
Since the market (as measured by the S&P 500 index) is commonly making 52-week highs, most of the time you will not have to wait too terribly long to reinvest proceeds of a sale. If Trading Rule #4 does prevent you from reinvesting for a long period of time, there is a very good reason for it, and you will no doubt be glad that you were patient in waiting for a new 52-week high for the S&P 500 before recommitting funds.
Of course, it goes without saying that any stock you would pick for reinvestment needs to be chosen using the criteria from Chapter 4.
Step 9
As your account value grows, you will have to periodically adjust the size of the initial positions you are taking in a stock. For instance, if our $15,000 account equity grew to $25,000 and we sold one or two stocks, we probably wouldn't want to take new initial positions to replace them that were as small as we originally took. Instead of taking $1,625 initial positions, we might decide to take positions that were proportionally in line with our new account equity balance, say $2,700 in this case. With any successful investment plan, these types of adjustments need to be made as the amount of money you have to invest grows.
The other thing you could do in such a case is to stick with the $1,625 initial position size and simply work with a larger number of stocks. For diversification purposes, this is the preferred route to take, at least until you reach the goal of having ten stocks.
The main thing to beware of is that you don't over-commit yourself. When you sell a stock, don't invest more in new stocks than you received in proceeds from the one you've sold. If you adhere to this rule, you will never overcommit yourself.
Chapter 10: Getting Started
If you are a beginner in the world of investing, it is natural to be a bit apprehensive about getting started investing in stocks. Even though you now have a good strategy, you may want to see this strategy work before committing a major amount of funds to it. After all, bear markets are an unpredictable reality and it could so happen that you will begin trading at just the wrong time. For those who are fearful of this and may wish to begin by taking a very conservative stance in the market, it is a fine thing to do especially if you have limited experience in investing. You can never err by giving yourself time to learn something before plunging headlong into it. It's a fairly safe bet that if you don't feel like you know what you are doing, then you are probably right and would be well advised to start on the conservative end of the scale.
Once you are comfortable with these concepts and your ability, you can start getting more aggressive. Until then, the following chapter addresses some ideas for adjusting our system in order to accomplish a more careful approach when you are just starting out.
Start Small
One of the simplest ways to reduce your risk as a beginner is to implement the Reverse Scale Strategy with just 50% of your capital. So if you have $20,000 available for stock investing, you may want to just pretend you have $10,000, pick five stocks using the procedure in the text, then invest just $1,500 in each one of them. This will leave you with $12,500 in cash to begin with which will earn interest for you as you are learning. Should you have the misfortune of entering the market as a bear market is beginning, your interest earnings will help to offset any temporary losses or worries. From this cash-rich position, you can learn while remaining comfortable that you won't lose your entire stake.
Time-based Diversification
Another way of reducing risk is by gradually implementing the Reverse Scale Strategy one stock at a time. Suppose you have $20,000 in your account and your long-term goal is to have your money spread out over seven stocks. So, in this case you employ the formula from the last chapter and multiply your $20,000 times 65% and then divide that number by seven. This means that your initial position in each of the seven stocks would be about $1,885. There is no reason you have to rush out and buy all seven stocks at the same time. Instead if you are a little nervous, add one position each month. This will mitigate the possibility of starting your investment program at the beginning of a bear market and make it unlikely that you will have a bad experience right out of the gate. So, the first month of your program you would only have one stock, with $1,885 total invested and $18,115 in cash. The next month, you would at that time choose another stock that is making new highs in price and meets our other criteria, leaving you with $3,770 invested in two stocks, and approximately $16,230 in cash, and so on until you have your seven stocks. Since we manage each stock separately in this Strategy, if your first stock does well and hits its next Decision Point before month two, you may actually end up having $3,770 invested in the first stock before having purchased the second issue. This will be relatively rare, but if it happens it is cause for celebration, not panic, and you should implement your strategy just as you would if you were starting with all seven issues right off the bat. That is, do not let the success of the first purchase hinder you from adding your second issue in month two, even though you may already have $3,770 invested in the first one. In either case, you will have your seven positions in hand when month seven finally arrives.
Needless to say, if you want to be very careful, you could add one position every two or three months, instead of one every month. It all depends on what makes you feel most comfortable given your own personal level of risk tolerance.
If you are a beginner in the world of investing, it is natural to be a bit apprehensive about getting started investing in stocks. Even though you now have a good strategy, you may want to see this strategy work before committing a major amount of funds to it. After all, bear markets are an unpredictable reality and it could so happen that you will begin trading at just the wrong time. For those who are fearful of this and may wish to begin by taking a very conservative stance in the market, it is a fine thing to do especially if you have limited experience in investing. You can never err by giving yourself time to learn something before plunging headlong into it. It's a fairly safe bet that if you don't feel like you know what you are doing, then you are probably right and would be well advised to start on the conservative end of the scale.
Once you are comfortable with these concepts and your ability, you can start getting more aggressive. Until then, the following chapter addresses some ideas for adjusting our system in order to accomplish a more careful approach when you are just starting out.
Start Small
One of the simplest ways to reduce your risk as a beginner is to implement the Reverse Scale Strategy with just 50% of your capital. So if you have $20,000 available for stock investing, you may want to just pretend you have $10,000, pick five stocks using the procedure in the text, then invest just $1,500 in each one of them. This will leave you with $12,500 in cash to begin with which will earn interest for you as you are learning. Should you have the misfortune of entering the market as a bear market is beginning, your interest earnings will help to offset any temporary losses or worries. From this cash-rich position, you can learn while remaining comfortable that you won't lose your entire stake.
Time-based Diversification
Another way of reducing risk is by gradually implementing the Reverse Scale Strategy one stock at a time. Suppose you have $20,000 in your account and your long-term goal is to have your money spread out over seven stocks. So, in this case you employ the formula from the last chapter and multiply your $20,000 times 65% and then divide that number by seven. This means that your initial position in each of the seven stocks would be about $1,885. There is no reason you have to rush out and buy all seven stocks at the same time. Instead if you are a little nervous, add one position each month. This will mitigate the possibility of starting your investment program at the beginning of a bear market and make it unlikely that you will have a bad experience right out of the gate. So, the first month of your program you would only have one stock, with $1,885 total invested and $18,115 in cash. The next month, you would at that time choose another stock that is making new highs in price and meets our other criteria, leaving you with $3,770 invested in two stocks, and approximately $16,230 in cash, and so on until you have your seven stocks. Since we manage each stock separately in this Strategy, if your first stock does well and hits its next Decision Point before month two, you may actually end up having $3,770 invested in the first stock before having purchased the second issue. This will be relatively rare, but if it happens it is cause for celebration, not panic, and you should implement your strategy just as you would if you were starting with all seven issues right off the bat. That is, do not let the success of the first purchase hinder you from adding your second issue in month two, even though you may already have $3,770 invested in the first one. In either case, you will have your seven positions in hand when month seven finally arrives.
Needless to say, if you want to be very careful, you could add one position every two or three months, instead of one every month. It all depends on what makes you feel most comfortable given your own personal level of risk tolerance.
Market Momentum
An additional line of defense is to wait until the broader market is showing signs of strength before beginning. Bull markets usually do not end overnight, so if you wait until the S&P 500 makes a new 52-week high before you select and purchase your stocks for the first time, you will have a good chance of success as you start. In the last Chapter, Trading Rule #4 was added to keep us from recommitting funds from a sale until the S&P 500 makes a new 52-week high. There is no reason that you can't apply the same principle in order to determine a reasonable time in which to start your investment program. In fact, I think that this is a very good idea.
Remember the Basics
As you enter the world of stock investing using the Reverse Scale Strategy, I wish you the best of results. I could wish you luck, but luck has nothing to do with investing. Once you start applying the principles in this book, you will find that your luck will improve greatly.
If you are ever confused about what to do, reread the sections on Stock Market Myths (Chapter 1) and Investor Mistakes (Chapter 2). Avoid the mistakes and the myths and you will find that you can figure out on your own what to do. The best policy is to understand the principles and trading rules of the Reverse Scale Strategy, not to memorize them. If you let this be your guide, your results will be much better than they would be otherwise.
An additional line of defense is to wait until the broader market is showing signs of strength before beginning. Bull markets usually do not end overnight, so if you wait until the S&P 500 makes a new 52-week high before you select and purchase your stocks for the first time, you will have a good chance of success as you start. In the last Chapter, Trading Rule #4 was added to keep us from recommitting funds from a sale until the S&P 500 makes a new 52-week high. There is no reason that you can't apply the same principle in order to determine a reasonable time in which to start your investment program. In fact, I think that this is a very good idea.
Remember the Basics
As you enter the world of stock investing using the Reverse Scale Strategy, I wish you the best of results. I could wish you luck, but luck has nothing to do with investing. Once you start applying the principles in this book, you will find that your luck will improve greatly.
If you are ever confused about what to do, reread the sections on Stock Market Myths (Chapter 1) and Investor Mistakes (Chapter 2). Avoid the mistakes and the myths and you will find that you can figure out on your own what to do. The best policy is to understand the principles and trading rules of the Reverse Scale Strategy, not to memorize them. If you let this be your guide, your results will be much better than they would be otherwise.
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