by Travis Johnson, Stock Gumshoe | January 13, 2016 3:38 pm
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Travis: One last comment about stop losses today since its such a big theme this week. The wider availability of automated stop loss tools, and people following them, is possibly increasing the degree of the downside volatility. Although people of course buy investments at different prices and timing, when a stock starts to fall dramatically, a lot of stop losses are going to get hit. Too many people are heading for the exit too quickly, there are not enough buyers, and the price falls precipitously. And then the next day, the same pattern repeats itself, possibly for days.
How to counteract this potential trend? Well I have been generating most of my recent cash flow from covered calls and selling naked puts. On the downside, using put options to buy the stock at a “better price”, stocks have been getting crushed so far below the put prices that I found myself way underwater when I eventually got assigned the stock at a “great price”. Trying at that point to sell call options at a reasonable yield then often meant getting no gains when the stock rebounded.
Now I am keeping my watchlist updated, waiting for an unreasonable selloff, and then going back to the old method of “waiting for bargains” and snapping up the stocks when I think (hope) they are close to the bottom. It does not matter whether they sell off another few days or not, assuming its a good company. The stock comes back. And if I can sell a call option soon after I buy the stock, before it falls much further, than I can still get good gains when it does rebound.
The overall market selloff in the last month has tested my resolve on this approach however. Ultimately it comes back to what you have believed forever. Its not good enough to just buy a company when its fallen significantly from its recent high. It needs to fall enough to represent value at the price. Your service continues to remind me of the importance to rethink my initial reaction to stocks that have fallen “unreasonably” and look like a bargain. Are they really a bargain, or only look that way based on where they were trading before?
In the recent market environment stocks have routinely fallen 40%, 50% and more from 52 week highs, so using stop losses to cut the losses at 25% (or whatever you set) makes sense. The next step, missing from most of this discussion, is using your disciplined approach to re-evaluate the company after it continues to fall as if its a “new” investment. Take a close unemotional look at why it fell, decide if it represents enough real value to buy again, and then buy it again. For volatile companies and sectors, there is nothing wrong with buying the same company more than once, This might be the best combination of investing philosophies. Yes, the stock might not continue to fall, but my guess is the increasing use of stop losses by retail investors increases the chance we can buy the stock back at lower prices than where our stop loss is set. They have to stay on a watchlist however, and not get thrown to the trash heap, never to be looked at again.
Good points — managing your emotions and being aware of your biases is huge for investors… And extremely difficult in the face of up-to-the-second panic updates from the investing punditocracy.