Sound Trading Rules Eliminate Need For Hedging Strategies

Investor's Business Daily

Individual investors are best off keeping investing simple.

Simplicity, however, shouldn't be confused with easy. Following the IBD approach to investing is hard work. It takes time to learn the rules, time to research stocks, and time to monitor positions in the stock market today.

Some investors think they have to add something else — hedging strategies to limit downside risks.

Yet, traditional hedging strategies — such as buying covered calls or using an options strategy to limit downside risk — aren't necessary if you follow the IBD approach.

Hedging strategies can limit downside risk but at the price of capping upside potential.

If you study IBD's investing rules, you'll see something quite different. Here are a few ways the IBD approach cuts risk without capping the upside potential.

Pyramiding into positions: This involves three steps when opening a new position. The first buy should be 50% of the desired total exposure. If the stock rises 2% to 2.5%, buy an additional 30% of the position. If it rises another like amount, complete the buy. If the breakout begins to stall and fail, you cease adding shares.

Depending on the circumstances, you might unwind the earlier buys or decide to give the stock more time. This method pertains to breakouts. If you are adding a small amount of shares in a secondary buy zone, there is no point in pyramiding.

Buy back on strong action after a shakeout: What if the stock begins to fail, persuading you to sell, and then rebounds off the 50-day line or past the original entry in big volume? You buy it back to avoid missing out on a winner. Sometimes winners start with a downside head fake.

Limit losses to 8% below your buy point: This will protect the investor from losses that are difficult to erase. A 9% gain in your next trade can wipe out your 8% loss. However, if you let a loss run to 50%, you will need a 100% gain to get to break even.

What about the stock that gaps down more than 8% below your entry? This is rare, but it happens. Sell immediately. A big loss is often the start of bigger losses.

Listen to the market: No strategy can protect you if you don't listen to the market. You can lose 35% in a stock by holding a loser as it spirals down, or you can lose roughly the same amount with five losses in a row of 7% each.

Nobody should keep investing if they keep losing. Failure comes either because the market is bad, or stock selection is poor.

Each time you suffer an 8% loss, it's wise to stop and study the trade and the market. You need to know what went wrong.

Take most profits at 20% to 25%: Heeding probabilities can help protect gains. Since most stocks begin to consolidate after a 20% to 25% gain, taking profits there makes sense. However, a stock that surges 20% or more in the first two or three weeks after a breakout should be held eight weeks and then re-evaluated. Truly big winners often begin with a fast move.

Buy stocks only in a confirmed uptrend: This is the ultimate risk reducer. In a market downtrend, roughly three of every four stocks will fall. Why play those odds

Many of the rules outlined above are things not often thought of as hedging. However, they serve as protection in two ways. The downside risk is reduced, and the risk of missing a winner is reduced.

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