Managing risk effectively is probably one of the most important skills an active trader or investor must learn in an active portfolio. If an investor can consistently unearth scenarios where the profit potential outweighs the potential risk by a large margin, then success will be achieved. The legendary trader Paul Tudor Jones sums up his risk management mindset with his following quote.
I'm always thinking about losing money as opposed to making money. Don't focus on making money, focus on protecting what you have.
Protecting the downside has to be key. I go against the grain of many dividend growth investors here in that I absolutely do not want to be holding paper loss positions at any given time in my account. Obviously at times it will be necessary but from a trading perspective, it limits options as one has to essentially wait for their positions to come back into profit. Therefore (whether you are a long term investor or shorter term trader), the game is to try and get in as low as you can when buying your chosen stock. This is essentially all we can control. Here are some tips and strategies that we can use in order to get the very best entry possible.
Sentiment readings of a stock, which usually tracks metrics such a short interest and put/call open interest, really have the ability to take emotion out of the game when used properly. In investing, investors usually follow the crowd which is why many times we see these blow-off style tops in many markets. Reading sentiment correctly should get you out of (sell) a particular market before a downturn occurs. Furthermore on the opposite side, sentiment readings can also train investors when to buy which again is crucial. I have seen stocks decline for months on end with their sentiment readings remaining surprisingly bullish. This was a warning sign that the selling was not complete and that is what transpired in the aftermath.
Valuation & Fundamentals
Obviously valuation is critical to make sure you are getting value. Good metrics to measure here are the given company's price to sales & price to book ratios and compare them to previous years. However if shares in a company have experienced a steep decline, it is imperative to find out why this has happened. Have the fundamentals been impaired or is it a temporary issue? This is where value investors usually come unstuck. They just monitor past financials to confirm positive trends in areas such as earnings, cash flow and top line revenues. However past performance doesn't necessarily mean a bright positive outlook even if consensus is predicting earnings growth going forward. Seeing how much skin management has in the game is helpful here and the balance sheet (especially debt) has to be in order. However professional investors will have to ascertain why the decline in earnings/share price happened and why growth will come back. If this fundamental work is not done, one could be at risk of catching a falling knife here which would adversely affect one's portfolio. Again risk can be minimized here by doing the work. If the opportunity just doesn't meet your standards, it should be a pass no matter how appealing its valuation may seem at the time.
Competitive Advantages & Growing Dividend
Buying stocks which capture both of the above definitely reduces risk over the long haul. Why? Well, concerning the dividend a growing payout means a higher yield if the stock keeps falling. This is a core dividend growth strategy as one can consistently reduce cost basis by ploughing all dividend proceeds back into the stock. Moreover companies with strong competitive advantages could have something like a monopoly in a certain sector meaning it would be very difficult for a newcomer to compete. Also a company (Walmart (NYSE:WMT) for example) could have pricing power due to the sheer scale at which it sells its products. Intangible Assets (such as brands and patents) are also a competitive advantage that competitors find difficult to compete against (as with (Coke (NYSE:KO), for example).
Volatility & Liquidity
These two are important when one wants to use derivatives to demonstrate a direction instead of buying stock. Excellent liquidity in options for example enable the buyer or seller to get the best possible price when entering or exiting a trade. Volatility also is important in risk management as it is a mean reverting metric. Buying options when volatility is low and consequently selling them when volatility is high is advisable due as mentioned to the mean reverting nature of options. Usually if a particular stock has been badly beaten down, its implied volatility will be high which basically means that option prices will be more expensive. At times like these, options traders may prefer to sell puts to avail of the theta decay instead of buying the stock outright. Selling in the money cash secured put (besides the volatility argument) also reduces risk because of the lower entry prices if the option is assigned.
Therefore to sum up, one should always be thinking of the downside risk before entering a trade/investment. Start with the end in mind and use these strategies to ensure you get the best possible entry for your hard earned dollars.
Disclosure: I am/we are long WMT.
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.