4 of My Worst Stock Picks and the Importance of Risk Management

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 |  Includes: AAPL, NFLX, OPEN, RAD
by: SA Editor Rocco Pendola

I have made it a habit of publishing the results of suggestions I make, bullish and bearish, no matter how they turn out. It pays to be accountable and, even more importantly, the exercise stops me from taking myself too seriously. In addition, it can be useful to readers to see not only how a stock turned against me, but if one conception of a company's long-term story remains intact.

It's always fun to keep track of the winners, especially the big ones, but it's not quite so glamorous for losers showing up at your doorstep, trying to figure out what went wrong.

Netflix (NASDAQ:NFLX): It's easily my biggest loser. I put the date I officially went bearish NFLX at March 14, 2011. The stock closed that day's trading session at $201.20. In a Seeking Alpha article from that date, I said the following:

In particular, I will consider NFLX January 2013 puts with strike prices between $210 and $175. The premiums on these puts range from $60.75 to $38.55, respectively. I might also play a lotto ticket or two on far OTM NFLX January 2013 puts.

Yes, this is a painful reflection. As of Thursday's close, NFLX trades slightly off of its intraday and another new 52-week high of $297.35, at $292.42. The options I was considering back in March now trade in a range from roughly $26.00 to $21.30.

I will not get into the fact that I believe the long-term story remains intact. I have done so elsewhere. I will say, however, that you can be horribly wrong on a stock for a long time and still not lose your shirt, as long as you practice risk management.

OpenTable (NASDAQ:OPEN): In late March, I expressed bullishness toward OPEN. At the time, the stock traded at about $104.29. Even after rebounding from its recent lows, OPEN only trades for about $87.18 a share, as of late in Thursday's trading session.

Ahead of its August 2nd earnings report, OPEN received positive attention from a couple of analysts. The first came across Briefing.com's InPlay service this morning:

Click to enlarge
Click to enlarge

The second came in the form of an initiation with the AP summarzing the support for a Collins Stewart analyst's $108 OPEN price target:

Mayuresh Masurekar of Collins Stewart said OpenTable has a minimal amount of direct competition and has yet to tap into its potential overseas. The company also has ample opportunity to increase its online business, with Masurekar estimating in a client note that OpenTable could see online penetration of more than 60% long term.

The two notes concur. And so do I. They echo the original reasons why I expressed bullishness toward OPEN and the reason why I am not changing my mind even after the stock's relative freefall.

Rite-Aid (NYSE:RAD): In late March, when this stock had just moved north of the $1.00 mark, I hammered Rite-Aid pretty hard. After reading one of the best analyses of a stock I have ever seen anywhere, I'm not quite as bearish as I once was. To get a handle on what could happen to Rite-Aid in the future, you really should read Brad Thomas' article, Rite Aid: Is the Thrill of Victory Worth the Agony of Defeat.

Rite-Aid certainly occupies some attractive space. It should probably give up on at least one of its locations where I live in Santa Monica, California. Two exist within six blocks of one another. That's some expensive real estate. And, whether Rite-Aid owns it or leases it, it's just one example of where the company can generate serious cost savings to pay off debt and continue to carve out its niche not only as a value stock but a value destination for consumers in the retail drugstore space.

Apple (NASDAQ:AAPL): I made the correct call when I sold AAPL back in April. My bearish note to Apple investors from June 20th, however, obviously urged caution at the bottom. Since that article, AAPL has rallied from a low of $310.50 to Thursday's intraday high of $358. Some investors are understandably giddy heading into Apple's July 19th quarterly earnings call. I have no doubt that the company will blow away even its own estimates.

With all of the Apple rumors circulating around - iPhone 5 is coming, iPhone 6 will be better than iPhone 5, Sprint will get the iPhone, some sort of new iPad is on the way - it's difficult not to believe the hype. Here's the deal: We've been here before. I do not have to re-run the euphoria I felt over long lines for iPad 2, Steve Jobs showing up in San Francisco to make announcements and the blowout quarter Apple reported three months ago. AAPL bulls expect the stock to take off post-earnings. While it might take flight, I think it gives back ground, like it has all year long.

Unless something new happens. The mere continuation of Apple being Apple (as in, amazing) is not new -- investors will relegate AAPL to amazingly low P/E ratio status for the foreseeable future. Remember what a high P/E ratio indicates - confidence that a company can continue to grow earnings at a brisk clip. Between the Steve Jobs' health overhang and the human tendency to believe that Apple cannot dominate forever, I don't think investors are prepared to place the multiple the bulls want to see on Apple's stock price. As an admirer of the company, I hope I am wrong here.

Particularly in relation to the stocks that went up and down hard - NFLX and OPEN - after and as I waxed bearishly and bullishly on them, a note about what I mean when I refer to "risk management" is in order.

First, the obvious - use stops losses, whether they are hard or mental. While stops can burn you when you set them as standing orders (I got hit using a hard stop when the flash crash hit AAPL), they're basically imperative if you subscribe to the belief of welcoming small losses and avoiding catastrophic ones. The big question after you decide to use stops becomes, where should I set them?

The answer, ultimately, ends up being a personal one. It all depends on the size of your account and how much you are willing/can afford to lose on a trade or investment. Of course, time horizon comes into play. You'll come up with a different amount you're willing to risk as you go from a day trade to a swing trade to an earnings or other event-related momentum play to a long-term investment. Consider the following example and adapt it your own set of circumstances.

If you have a $100,000 account and buy 100 shares of a $100 stock, you have "spent" 10% of your account, or $10,000, excluding commission. Commenters who claim that traders and investors must have been "killed" by being on the wrong side of a trade engage in shock value. They ignore risk management. You have to ask yourself, how much of that $10,000 can I lose if I am wrong for the time being?

Everybody will come to a different number. Some might say $1,000 - 10% of the $10,000 purchase and 1% of the $100,000 account value. In this case, you would set your stop at $90. You always run the risk of selling on a pullback and missing a bounce and subsequent run. Discipline comes into play here, however.

You have to discipline yourself to not only expect, but accept and welcome that $1,000 loss. At times, this discipline will cause you to miss out on a profit after all. More often than not, though, it will save you from incurring a larger loss than you can comfortably stomach. The same theories apply to shorting a stock, buying puts and using profit targets.

Of the plays I have made on the above stocks, I have not lost my shirt on any of them. Certainly, they represent four of my biggest losers. While I am not proud of them, I am happy that they happened. It's part of the game of trading and investing. Without the small losses, you'll never see the big gains that more than balance them out.

Disclosure: I am long S.