- This is a good time to reinforce trading discipline. I concentrate on "cash management."
- By focusing on generating cash I remove myself from emotion about taking profits or losses.
- Keep trading in a separate account. Don't mix trading with investment. Investment is thinking like an owner. This is a very different behavior than trading.
- We are close to the bottom of this sell off. That doesn't mean the volatility is over. It's in times like these that having a strong trading discipline will help you generate alpha.
What I'm NOT saying is to sell right now
I started writing this note when the market was up. It has been chopping around all day, and I want to get this advice out there in preparation for the next upmarket move. That could easily be as soon as tomorrow as I suggest later in this article. If you are trading equities I believe that you should take a “cash management” approach in trading equities. I have talked about this in the past but I think that now would be a good time to review.
A Word About A Cash Management Discipline
If you are trading equities your raw material is cash. Without cash, you can’t initiate positions to create “inventory.” Cash is the least risky and cheapest hedge. There's a reason why people say “cash is king” because with cash available you have the room to maneuver when times are tough. I also turn to a cash management discipline as a way to manage my emotions in taking profits and losses. In my experience, if you don’t have a set of rules for these actions then trading can be a chaotic and emotional process. Trading is a performance skill, in other words, it’s akin to high-pressure sports, so as to quote Yogi Berra: "Baseball is ninety percent mental. The other half is physical." For me, trading is 90% mental and 90% fundamental and 90% market mechanics. If you can eliminate emotions in taking profits and especially taking losses you have removed a big impediment on seeing the markets, your stocks and your positions most clearly. I don’t want to make this “discipline” into a big deal, all you have to do is grow your cash when the market is rising and participants seem complacent. Then you deploy that cash during the inevitable sell-off. The goal is to focus on growing your cash and not selling the stock. We do this by “trimming”, sell 2 to 5 shares at a time for each “old” position of stocks that you have been holding for a while. You do this every day until you meet your cash balance goal. That doesn’t mean you stop creating new positions, just in order to grow the cash you sell more old inventory to make room for new ones. In generating cash you trim winners and losers equally, and since we are talking about a few shares at a time, taking the losses then don’t hurt as much. What you don’t want is to cut back your winners to take profits and end up holding only positions that are not working. In my past, I would hold on to the losers for dear life. Then as the market dives you feel you have no choice and “puke them out” (trading term) at the worst time. That’s not the worst part. The worst part is the fear, uncertainty, doubt and self-recrimination for your mistake afterward. Concentrating on building cash is a positive action, and it removes the indecision of taking a profit, and the whole seller’s remorse issue as well. Otherwise, these negative thoughts build up and make trading a very un-fun exercise.
The goal is to always work toward building 25% to 35% cash in your trading account
Imagine you had 25% cash going into last week, or even 15%. I know that in the depths of the sell-off last week I was calling for you to buy. If you bought say Microsoft (MSFT) at 157, it is now trading at 172 to 173. Do you sell and take profits, or let it ride up another 10 points? This occupies your thinking when you should be paying attention to where the market is going, or maybe looking for the next opportunity. So, instead, you trim off a few shares, and it goes back into cash. Tomorrow, you can decide to trim off another 2-3 shares, and so on. Meanwhile, if you were dithering about this the Dow today went from up 300 to down 900. These are extreme times, but this is the perfect time to talk about this. If you had a great profit on Microsoft (MSFT) and it evaporated that could have reverberations in future profit-taking decisions. Does this make sense?
This note is not about long-term investing or options trading
This discipline has nothing to do with keeping cash on hand for emergencies. Many people smarter than me. Advise that you hold an equivalent of one year of expenses in cash, or at least six months. They also advise not carrying a credit card balance. These are wise pieces of advice. If you are sitting with $25K in credit card balances you should stop investing or trading in stocks, and use whatever available money you have to pay off those balances. You also should look to refinance your mortgages with interest rates so low. If you haven’t done that, please stop reading this, and go to a good online mortgage provider and refinance. Use the resulting free cash to fund your monthly allocation to your investment account. So let me stress, I'm not telling you to sell any long-term investments, EVER.
Always keep your investments separate from your trading account
You should actually keep your trading account separate from any long-term investments. You should approach investing as an owner. An owner doesn’t buy and sell their business, but an owner needs to be paid. So you should be looking for long-term investments that generate income. Dividends should be your first filter, I'm not a big fan of companies that just buy back stock and don’t issue a dividend. Be very wary of companies that use debt to pay dividends, and you don’t want a company that's losing revenue and paying a dividend. So sorry for this digression, but I wanted to set the record clear that investors should NOT trade their investment account, they should not be selling their shares ever unless the company's business model is broken. You need to be very careful in selecting a long-term investment. Once you start a position you should be adding to that position over time. For your trading account, dividends don’t matter, all that matters is capital appreciation. The faster, the better.
So what about today, do you sell?
Again, I'm not saying sell, I'm saying trim. Wait for the next up-market day to take off a few shares here and there, perhaps even now when the indexes are down so hard, trim off a share or two. Why do I say this while it's clear that the market is selling off? A discipline should operate in “good” times and bad. Look, maybe right at this moment, you don’t want to sell. I get that, but now is the time for me to talk about it. I say this because we are at the beginning of the end of the bottoming process. We’ll cover that later in this piece. So if you can’t bring yourself to sell today, keep it in mind for the next moment that the indexes are in the green.
That said, the volatility is not done
We are not yet done with sharp sell-offs, but they will start tailing off. Today is a retest, we are not breaking into new lows, and that is giving me a strong positive feeling. We are probably going to have a double “V” shaped recovery. Do I have proof? No. I do have experience. At the beginning of writing this, the market was up sharply, and then there was the Fed announcement of a ½ point cut which caused the market to sell off. So there's your proof. I suspect that the market will move higher either by the close, or perhaps tomorrow. The question is after reading the prior paragraphs, do you have enough cash to ride this out? Again, I would suggest that you go through your portfolio and take off a few shares from each position. You don’t need to get to 25% cash this second. Wait for the market to take a few percentage points higher, perhaps tomorrow or the day after. If you have the guts to do it today, you will be ready to do it when the market is moving higher. That is how you reinforce discipline.
I'm still operating on the theory that this epidemic is not as deadly as advertised
I don’t want to repeat myself, you can consult the last several notes I have put out there. I firmly believe that this virus is more like the flu than the “Black Death.” With all due respect to Bill Gates, this is not the global pandemic that will threaten the world order. I expect this all to peter out in the coming weeks. The thing that's going to have an effect on our economy and stocks are the actions to limit social interaction, travel and going to the office or school. To that end, I hope the government takes action to support small businesses in travel, entertainment, hotel industries and the like. Perhaps they will give the community banks some incentive to support small businesses and home mortgages. Whatever can be done to prevent good businesses to go bankrupt only because of temporary cash flow issues. That isn’t the purview of this writer, however if the Fed or the president can take action via their bureaucracy or executive order I think the stock market would react very positively. I would not be surprised in reference to the Fed’s extraordinary half-point cut that other policy shifts to counteract the depressive nature of this epidemic would be mooted.
If I'm correct then this drop is something to be taken in stride.
It makes total sense for the “weak hands” to get shaken out of their positions and sell out. Who are the weak hands? Those individuals who are trading on margin, they can wait out such volatility. If you are a trader who is using margin and isn’t a professional, please don’t! Besides weak hands there also are hedge funds that are shorting stocks that are high priced. They can pile onto shorting a particular stock without waiting for a “up-tick.” In the old days, you can’t short a stock that's already going straight down, you need to wait for a “tick” up. Now if a hedge fund identifies a stock that's going down on high volume they join in on the fun. You can win by waiting out the nonsense, hopefully you have sold calls against your largest positions. Also hopefully in reference to the beginning of this article, you sold some shares yesterday. The good news is it makes sense that the market is down today, after that historical jump in the averages yesterday. I expect that we are close to the end of this correction. I think we are creating a double “V” correction, like so, here.
All bets are off if the last leg of the second “V” goes below the first one. So far that isn’t the case. Again the good news is that today’s action as hard as it is to participate in is not breaking to new interim lows. Also, the other cause for optimism is the VIX is well below the peak of last week which was at 50. It is now in the upper-’30s. Hang in there, people.
I would suggest that you think about stocks that don’t need physical inventory as your first filter for new trades. That said we are getting close to the time that China will advertise that it’s back open for business. Probably China is at 35% to 40% manufacturing capacity and then by next week, they will be meaningfully higher. Why do I say that? It’s because China is reporting lower infection rates than the rest of the world. You can be cynical about the veracity of this pronouncement, as I am. But you have to take into account that China has to get its shops and factories open so they will do it.
My Trades: I'm holding onto my previous trades, I'm just adjusting my spreads to stay in the game. I did close out my Microsoft (MSFT) only because I had some decent gains and wanted to preserve them. I only wish I was long Amazon (AMZN) so I'm looking to get long there and to get back into MSFT. I express all my trades via CALL spreads.
This article was written by
David H. Lerner is an analyst with a decade of experience utilizing his professional background in software consulting and technology to identify market trends and provide long and short trade ideas. David employs a combination of technical analysis and market psychology to capitalize on narratives for outsized returns. He also utilizes “Cash Management Discipline,” a simple trading style to hedge against the volatility of today’s market climate.
He leads the investing group Group Mind Investing where he uncovers actionable trading and investing ideas nearly every day. Other features include: long and short swing trade alerts, daily macro analysis, weekly articles, and chat for community interaction and questions. Learn More.
Analyst’s Disclosure: I/we 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.
I am long Shopify (SHOP), The Trade Desk (TTD), Alphabet (GOOGL) via CALL spreads, I am also short the VIX via puts, with a 20 strike and an April 1 Expiry. I want to get long AMZN and MSFT if conditions are right.
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