Daily Archives: March 14, 2015

Thinking About Risk / Reward

March 14, 2015

“Every once in a while go to cash, take a break; don’t try to play the market all the time.” – Jesse Livermore. Deciding not to trade is sometimes the best decision a trader can make. That’s especially true after a string of winning trades, at the point when our ego’s grow and we think we’re better than we really are.

For the last three weeks, we’ve largely been sitting on our hands. As we detailed via our blog posts ($AAPL in 2015) and twitter, we allocated significant capital to AAPL positions in the $106-$109 range in mid-January. We sold those positions four weeks later in the $128.60 – $129.40 range for a variety of reasons, detailed in our post.


As you can see in the annotated chart above, we didn’t catch the exact top – we were $3 short. Similarly in late November, we exited at $116 after a significant rally from our $102 entry. That was, again, $3-$4 below the top tick. What do these have in common?

In both cases, we entered the positions as the risk/reward was skewed strongly towards “reward”. The downside risk was significantly lower than the upside risk (of course we had stops in case we were wrong). But as shares reached our target price, the risk/reward was no longer skewed toward “reward”. At that point, it was at best a 50/50 trade. And why participate in a trade or investment that is a 50/50 venture? We want the odds to be skewed in our favor. And we’ve learned that the next low-risk entry is always just a few days or a few weeks ahead.

There are two ways to react to price hitting your target. Either (a) exit the position, or (b) continue raising your trailing stop until the position is stopped out. We took the former approach with these trades. And interestingly, we took a lot of flak for selling when we did. There were a number of surprised and sometimes angry messages when we closed our positions. “How could you exit here?? The rally is just beginning!”

What the people making those comments fail to understand is that we don’t care if we miss out on part of the rally and the stock continues to run higher. In our eyes, the meat of the rally had already taken place. We almost doubled the value of our portfolio with the one-month Apple trade and have been sitting primarily in cash for the past three weeks. We can’t say we’ve totally resisted taking some small trades; but for better or worse, we’ve been stopped out of almost all of them with small losses.

It has proven to be a very good time to be sitting in cash (as long as it’s US dollar-denominated!). Not only have the equity markets stalled over the past two weeks, but the dollar has been raging higher at the expense of almost all other currencies. Turns out that our “investment” in the US dollar has been a solid store of value, as our purchasing power continues to increase as the dollar increases in value and stocks continue to pull back. But as always, we’re on the lookout for the next low risk / high reward entry opportunity.