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Ocean Man
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I have been an active investor for almost 20 years. My main focus is on high-yield stocks, particularly MLPs, and high-growth oil companies in the Eagle Ford shale. I have a portion of my portfolio allocated to short-term trading, with a focus on over-reactions to company news and directional... More
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  • Position Sizing And Averaging Down

    These are two of the most important techniques one needs to master in their portfolio. They go hand-in-hand, and doing either improperly can lead to significant losses.

    Bucketing

    I like to bucket my stocks into three categories: safe, semi-safe, and risky.

    Safe stocks: I will buy an oversized position in full with my first buy. I have determined this to be a good entry point, and I don't see the stock falling more than 5-8%. Recent examples of this type are KMI, APU, BRK.B and AVB.

    Risky stocks: I will start small with the intention of adding if it falls further. These have pulled back, but the drop could still be 20-25% more. I like to use what I call the 2-2-4-7 method on these. Initial buy is 2 units, first add is 2 units, second add is 4 units, and last add is 7 units. The 15-unit total will be my max position size, and you don't want to place the last add too early, so target low with it, around that 20-25% further drop level. The first add will be 1/3 of the way to that point (7-8%), and the second add will be 2/3 of the way to that point (14-16%). Recent examples of this type are TNXP and FEYE.

    Semi-safe stocks: The strategy for these falls halfway in between the two buckets above, in two ways. First, I will only target two adds instead of three. I combine the first two buys from the risky bucket so it goes 4-4-7. Second, I see the further drop on these to also be in between the two buckets above, around 12-16%. Again, you target that low with your last add, and that puts your first add halfway there (around 7%). It is important to note that this gives you your 15-unit position down 16%, whereas the risky stocks have only reached 8 units at that point. A recent example of this type would be EXR.

    Position Sizing

    So what's a unit? Well, that's the most important question of all. There are two elements to determining this, and then you need to calculate your adjustment factor.

    The first element is how many positions do you want to have. Some people hold five stocks in equal amounts, some hold ten, and some hold forty of varying amounts. I typically hold 20-30 stocks, but some are higher-conviction than others and some are safer than others, so I like to have some half-positions, some double-positions, and from time to time a triple or much larger position. So I will choose to partition my portfolio into 50 positions, so that some can be dry powder, and some stocks can be double or triple positions.

    The next step is determining the dollar size of your position. Let's say my portfolio is $100,000. You divide that $100,000 by 50 positions, and you have $2,000 per position. Your higher-conviction stocks would then see $4,000 (double position) or $6,000 (triple position) invested. If your portfolio is smaller, say $20,000, you may choose to only have 10 or 20 positions instead, so that you can still invest $1,000 to $2,000 per position.

    Now you have your number of positions, and your dollars per position, but we still haven't defined a unit. This is very important, and is the second element. You don't want your first buy on a risky stock (2 units) to be a full position, or you will have a 7.5X position by the time you get your 15 units. Similarly, you don't want the 15 units to be a full position, or your initial buy will be about a 1/8 position. You can experiment with where you'd like to set this, but I set my 15 units equal to a 3x position. That makes each position 5 units, it puts your initial buy on a risky stock close to a half-position, and it puts your initial buy on a semi-safe stock at 80% of a full position. You would hope that it's a fairly rare occurrence that your picks continue to drop to the max downside you expected, so you shouldn't be hitting those 3x position levels too often.

    Using the example above, with $2,000 per position, your first buy on a risky stock would be $800 and your first buy on a semi-safe stock would be $1,600. You then need to determine your adjustment factor. You will find yourself with more conviction on one risky stock vs. another, or on one semi-safe stock vs. another. You might want to apply a 0.75 factor on the lower-conviction ones and a 1.25 factor on the higher-conviction ones. This will allow you to keep the 2-2-4-7 ratio, and the % drops triggering your next add, but you'll invest more in some names than others as you see fit.

    If you have one of the smaller portfolios discussed above, and have it partitioned into just 10 or 20 positions, you may want to set your 15 units at a 2X position or limit yourself to just one or two risky stocks to manage your risk.

    You then need to determine your conviction level on your safe stocks. Some might be double or triple positions and some might be even larger. This will be influenced by how many stocks you own at the time, how many safe stocks you own vs. semi-safe and risky stocks, how large your semi-safe and risky positions have become, and how many positions you want to keep open as dry powder.

    Examples:

    1) Let's say you only like four safe stocks at the moment, but you'd like safe stocks to make up 40% of your portfolio in the current environment. That would require 20 of your 50 positions, so you'd need a 5X position in each. That may seem like a large allocation, but this is exactly what I do most of the time. The beauty of this, is that an 8% gain in one of these safe stocks will be equivalent to a 40% gain in one of your risky single-position-sized names.

    2) Let's say we've just seen a correction and you think there's a good chance it's over. You may want to adjust so that you have fewer positions devoted to dry powder, and only 20% of your portfolio devoted to safe stocks. You could buy more semi-safe and risky names, increase your adjustment factor, and/or set your 15 units equal to a 4X or 5X position size rather than the 3X size discussed above.

    Additional Thoughts

    Selling: that is a topic for another day, however you should consider reducing your position size, as an alternative to selling it in full, as your conviction and risk outlook changes on each position.

    Changes in Thesis: you do NOT average down as a matter of course, you only do so if your thesis remains intact. If new news comes along that damages your thesis, or reduces your conviction, you do not continue buying on your pre-determined course. If you have to sell for a loss, do it, and make it back on another name. The golden rule is: if you wouldn't make an initial buy here, don't add.

    Impact of a Losing Pick: the point of this exercise is to avoid a bad pick killing your portfolio. You want your stockpicking skills to average out over time. You don't want one bad pick to outweigh six or ten good picks. With this system, a bad pick will have a 3/50ths, or 6%, weight in your portfolio. If a bad pick drops by 40%, the impact to your portfolio would be maxed at a 2.4% loss of total capital (0.06 x 0.40 = 0.024). Even four picks that went horribly wrong would hit you by less than 10%. A lot of people are exposing their portfolio to a lot more downside than that, and that is the purpose of this discussion.

    Good luck, and post questions in the comments section below. This is simply my strategy, I'm sure there are plenty of variations out there, and plenty of successful traders and investors who disagree with my methods completely. But for anyone who has been following my trading style, these may be some helpful ideas about how to manage risk between positions.

    Apr 04 9:27 AM | Link | 68 Comments
  • How I Like To Play Earnings

    Have you ever heard someone say "I don't like to play earnings."? I agree with where they're coming from. If you buy a stock on Thursday that reports Thursday night or Friday morning, it could open down 10% or worse. That's a lot of risk. A much less risky way to play earnings, is to see what the earnings are first, and buy after the open with a stop that lets you limit your losses. A lot of people have asked me to describe my methods around this type of play, so I'll describe the details here.

    Finding the Companies to Play

    What you're looking for are the overlooked companies while all eyes are on the bigger names that day. I'll use Friday, August 9th, 2013, as my example. You'll want to implement this on a day with more than 20 companies reporting earnings, so mostly during "earnings season" each quarter. First, read through Seeking Alpha's Market Currents Friday morning. Ignore any companies that missed on EPS or revenues or both. For companies that beat on both, look for the companies that beat on revenues by more than 10% or close to it. EPS can be inflated by buybacks, one-time benefits, and creative accounting gimmicks, but sales are sales. Consumers either bought a company's products and services, or they didn't. In recent quarters, a lot more companies have beat on EPS than on revenues, and even fewer beat revenue estimates by a large amount. The companies that reported Thursday night sometimes work too, but don't work as well for reasons that I'll explain below. You'll mainly want to target companies that are not trading in the pre-market. This play can work with companies that have traded that day in the pre-market, but it doesn't work as well.

    Setting Your Opening Bid

    The starting point for your opening bid will be 1% higher than the prior day's close. This can be adjusted higher for several reasons. First, I'll put the bid a little over the prior day's high if that's higher than my 1% starting point, but no more than 3% over the prior day's close. This is because you're trying to snag sell orders that were left open from the previous day. Second, you want to look at the pre-market bid. If that's higher than your 1% starting point, you may want to move up your bid to just above the pre-market bid, but again, no more than 3% over the prior day's close. Third, if the company absolutely blew away estimates by an astounding amount, or if the company is more well-known, you may want to start your bid at 2% or 3% over the prior day's close. You are not attempting to buy the stock in the pre-market, but you are placing your order before the open so that it is live at the open.

    Researching the Company

    This step will determine how large a position you want to play each company with, or which company to play if you've identified more companies than you're willing or able to play. First, take a look at the recent price action. Companies that have run up into earnings may have been expecting a beat. Companies that didn't run up into earnings will work more often, and for larger gains. Second, take a look at the short interest. I use Key Statistics on Yahoo Finance for this. The higher the short interest, the better this play will work, in most cases, as the beat could trigger a short squeeze. Third, and this is the most important step, scan the recent headlines on both Yahoo Finance and Seeking Alpha's Market Currents. You are looking for any recent bad news that could outweigh the beat's good news. Examples could be a CEO resignation, a recent acquisition that could require a secondary offering, a credit downgrade, or anything that could suggest that stockholders are looking to get out on the next jump. If you find a red flag like this, cross the company off of your list. I also tend to ignore MLPs, as they tend to not react as much to quarterly earnings reports.

    You may have noticed that a proper due diligence was not part of this exercise. That could be a controversial point to some people, and a deal-breaker for others. In performing this play, you are assuming that good or bad findings in a proper due diligence are already priced into the stock price by the market. You are saying, all else equal, this new news is going to take the stock up. However, part of the reason this strategy works is that the news came out shortly before the market opened, and you are buying before all of the people who buy later in the day after doing their due diligence first. This is also the reason that companies that report Friday morning work better than those that report Thursday night.

    Next Moves After the Open

    First, if one of your bids fill, place a stop 2% below the price you paid. You can set whatever risk limit you want, or vary it by how volatile the stock is, but I have chosen 2%. Second, if a company is trading just above your bid for the first few minutes of trading, go ahead and move up your bid.

    If you get stopped out, the play is over. Don't try to get back in. Some will dip and then take off again, but that action is outside of this strategy. If a stock gaps up more than 3% and stays up there, cancel your order. Some will gap up big and take off much higher, but those are also outside of this strategy. Be prepared for a lot of your bids to not fill, and some days where none of your bids fill. The reason this strategy works is because you are patient for the ones that start off slow and then make you a lot of money.

    When to Sell

    You are going to sell sometime the same day. If you hold past the close, you expose yourself to a gap down the next day far greater than your 2% stop loss. The safest strategy is to keep moving up your stop as the stock gains. However, this can lead to always selling 2% off the highs to that point of the day, which doesn't maximize gains. Also, how soon you choose to start moving up your stop can be a crucial decision. Moving it up quickly can limit gains in some cases and protect gains in others. I tend to move mine up slowly early in the day to give the stock a chance to run. Some traders will choose to try to sell a peak at some point of the day to get a little more, although that can lead to selling too early. It is a trade-off that is left up to each trader.

    Returns

    I have had great success with this strategy. I've also had countless near-misses where my bid didn't quite fill and the stock took off. The great thing about this strategy is that you don't even need a 50% success rate for it to be profitable. Even if you lost 2% on 2/3 of your attempts, if you averaged over 4% on your gains on the other 1/3, you would make money. I suggest paper-trading the strategy first to hone your skills before playing for real money.

    Real Examples From Friday, August 9th, 2013

    The first example is Power Solutions International (NASDAQ:PSIX). PSIX reported a revenue beat of $5.2M over an estimate of $53.9M. I'd call this close enough to 10%. EPS beat an estimate of $0.21 by $0.02. The stock closed the prior day at $46.39. An opening bid 1% higher would have been $46.85. The stock did not trade higher than $46.85 the prior day, nor was it a beat by an astounding amount, so I would not have adjusted the bid up from there. The stock had not run up by a large amount into earnings, nor did I see any red flags, so it was in play. The bid would have filled at the open for $46.00. If it didn't, the stock still traded around $46.97 for about 15 minutes, so I would have moved up my bid to that level if needed (only 0.25% higher). If you filled at $46.00, your stop would be placed at $45.08. Less than an hour later, the stock was at $50 (up 8.7%). Your stop would have moved up to $49, and an hour later you would have stopped out for a 6.5% gain.

    The second example is Performant Financial (NASDAQ:PFMT). PFMT reported a revenue beat of $7.2M over an estimate of $62M, more than 10%. EPS beat an estimate of $0.21 by $0.02. The stock closed the prior day at $11.07. An opening bid 1% higher would have been $11.18. The stock did trade a little bit higher the day before, up to $11.18, so I would have adjusted the bid up by five or ten cents, let's say $11.28 (less than 1% more). The stock had not run up by a large amount into earnings, nor did I see any red flags, so it was in play. The bid would have filled five minutes into trading for $11.20, although if you were trying to buy more than $8,000 worth, you may have only received a partial fill. Your stop would be placed at $10.98. Ten minutes later, the stock was at $11.66, and if you're really fast at moving your stops by the minute, you might have been stopped out as it dipped back to $11.43 about 15 minutes later for a 2% gain. Personally, I don't move my stops that fast. I'm watching a lot of stocks each day, and I like to give these room to run, and $11.66 wasn't that big of a jump, so I wouldn't have moved it up yet. Your stops are trying to limit your losses; protecting gains is a secondary priority. Four hours later, the stock was at $12 and stayed there a while. I would have moved my stop up by this point, eventually settling into $11.76. It never dipped back to that point, so I would have sold near the end of the day around $11.85 for a 5.8% gain.

    The third example is Consumer Portfolio Services (NASDAQ:CPSS). CPSS reported a revenue beat of $33M over an estimate of $37M, more than 90%. EPS beat an estimate of $0.14 by $0.01. The stock closed the prior day at $6.42. An opening bid 1% higher would have been $6.48. The stock did trade a little bit higher the day before, up to $6.56, plus I would consider this an astounding beat, so I would have adjusted the bid up the full 3% max to $6.61. The stock had not run up by a large amount into earnings, nor did I see any red flags, so it was in play. The bid would have filled at the open for $6.59. Your stop would be placed at $6.46. Again, if you were really fast at moving your stops by the minute, you might have been stopped out as it dipped from $7.08 back to $6.94 about 20 minutes later for a 5.3% gain (not bad). If you hadn't moved it up yet, the stock moved up to $7.23 an hour later and you may have been stopped out from there a while later at $7.09 for a 7.6% gain. Either way, a nice gain.

    Another example that fits our strategy from Friday morning is Tremor Video (NYSE:TRMR). Our bid would not have filled however, as it gapped up 12% at the open. It's a good thing our strategy tells us not to chase these gap-ups, as 40 minutes later the stock had given back the entire opening gain.

    Closing Thoughts

    First of all, this is a day-trading strategy, not an investment strategy. Second, Friday was a day where this strategy worked really well. It doesn't always work this well, but it has been a winning strategy for me over a long period of time. Try paper trading it first, try adjusting your stop loss limits, or your max bid amount to catch a few more 4% or 5% gap-ups, see what types or sizes of companies it works best with, and you might come up with an even better set of rules.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: CPSS, PFMT, PSIX, earnings
    Aug 12 7:09 AM | Link | 177 Comments
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