Long-term investments and short term trades should be kept completely separate; or so conventional wisdom tells us. The new generation of hybrid investors who invest for the long term but attempt to juice returns with some risk controlled short term positions are all too aware of this. Wall Street firms are quick to tell us that trading of any kind is bad for our wealth and should be kept to a minimum, but if we must, then our long term investments should be kept separate from our trading portfolio.
Incidentally, this Wall Street aversion to individuals trading should, in and of itself, be an indication that incorporating some degree of it into our portfolio may not be a bad thing. Remember, back when restricted information flows and high commissions made it virtually impossible for an individual to make money those same firms were often encouraging people to trade.
Now that low commissions have made that activity less profitable for the big banks, and real time news is available to individuals as well as floor traders, the evidence from times gone by is used to convince us that we should just buy and hold. Maybe I am a little cynical, but when a large Wall Street firm tells me that they are looking out for my interests rather than their own I am a little suspicious.
The fact that Wall Street seems to be against it is probably reason enough to take a slightly contrarian stance and begin incorporating some trading techniques into our portfolio management, but it is also just common sense. Even committed buy and hold investors understand that a) where you buy something can be almost as important as whether you buy it, and b) that hanging onto losers forever waiting for a turnaround is not a good idea. A limited amount of trading into a position can help with a), while stop-losses can be used to protect against b).
In the first instance, what I mean by limited amount of trading can be seen by an example. Let’s assume for a moment that you have listened to me when it comes to Facebook (FB). You would not have bought the stock on its first run-up, but would have bought in at around $25 about a year ago.
Obviously, you would be pretty pleased with the result of that purchase. Over 150 percent profit in a year is not bad however you look at it, but if you did make that investment I would suggest a little trading right around now.
I still believe that the long term prospects for Facebook are good. They may be in the inherently trendy social media space but the company has become very good at monetizing popularity, and have then used some of the cash that they have generated to explore or acquire different sources of revenue.
That said, however, the trendiness of their core business will catch up with them. If there is evidence of declining popularity in the next few months, then a sharp reaction, probably an overreaction, will come. Even if not, every move to a new high in the broader market is making many nervous and positioning yourself to take advantage of a correction, even if only in one stock, can bring a lot of peace of mind.
The fact that you have made 150 percent already gives you a lot of flexibility in this example, though, and you can now use the possibility of a drop to enhance your position at little cost. Selling say half of your original position now makes sense, providing that you treat that as an entirely new short trade. By that I mean that you should set parameters. In this case, I would be looking for a drop to around $50, so I would accompany the sale with a limit order to buy back at that level.
If FB continues up, however, a stop loss to buy should the all time high be broken (at, say, $73.50) would limit potential “losses” to around 11%. Keep in mind that this is for half of your original position, so this would represent losing around 5.5% overall, or around 3.5% of your profit to date. Should a correction come, either in FB or in the broader market, and your $50 target be reached you would be making around 25% on half of your original stake (12.5% overall) and your original position would be restored, but now with a healthy looking overall cost basis of $17.
Of course, the chances are that you are not a fan who hangs on my every word and that you didn’t buy FB exactly when I told you too. That isn’t the point, though. It is simply that when you buy into a stock and it moves, whether that move is up or down, you have options other than just sitting and watching, despite what Wall Street would have you believe.