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.

2015: Resolutions in Focus

January 4, 2015

Happy New Year! The start of a fresh trading season is the perfect opportunity to refine your approach to investing. It’s crucial to think through what has gone right in your investing strategies and, just as importantly, what hasn’t. What did you do particularly well? Think through a specific thesis that proved correct; ride a trend well; capture a breakout at a predefined chart pattern entry? As the saying goes “do more of what worked, and less of what didn’t.”

We must resolve to focus on what has worked well for us and limit what has not:


  • Longer Time Frame. One aspect that we’ll focus on in 2015 is providing longer-term investment theses combined with detailed rationale. We will continue to provide compelling charts with defined entry points. But after spending time thinking about the purpose of this site and what we are trying to achieve, it became clear that we’ve been focusing our energy explaining the technicals at the expense of other investing opportunities. We trust our valuation work and will use technicals to aid in the entry and exit of longer-term positions.


  • Defined Exits. Any time emotion enters the equation, our trading has underperformed. We will continue to place contingent sell orders on options positions (or a stop loss if using shares) each and every time we trade. It takes all emotion out of trading and forces us to determine the exact entry and exit levels prior to taking a position.


  • Don’t Force Opportunities. By far, our most significant successes have come when we’re able to take advantage of a clear opportunity in the markets. Times like the October (and early December) pullback, where the markets bounced off numerous indicators that we were watching closely. Conversely, our weakest trades came when the markets were boring and we forced trades. Over-trading is a dangerous game to play in the markets.


  • Build Into Positions. One of the most pertinent messages in “Reminiscences of a Stock Operator” is the advantage of incrementally building positions. When our trading thesis is wrong, it’s usually wrong early in the trade. By keeping position size small at that point, we limit our losses and get stopped out quickly. On the flip side, this strategy allows us to add to our position incrementally if it unfolds according to plan. As Jesse Livermore opined, big movements take time to develop. As long as a stock is acting right, do not be in a hurry to take profits.


  • Dangers of External Validation. There are two types of threats posed by validation. The first is social validation, which is the tendency to look to others to decide what to do. It is during those times that we are most uncertain that we will most look to others to decide how to proceed. The second is that the more uncertain you are, the more you defend your idea. When there aren’t clear facts forcing us to change our belief, the tendency is to deny the new information and further defend our previous belief. Both of these are very dangerous in trading and investing. The more confident we are in a trade, the more we seek out information that confirms our point of view. We must strive to do just the opposite: do not look to others (especially twitter traders) when uncertain on a chart; and search explicitly for reasons why your thesis might fail.


Apple’s “Generational Low”

January 14, 2012 (2:00 pm)

We’d like to share two quick charts on Apple. There has been much talk over the past few weeks about whether the $500 level will represent a “generational buying opportunity” when we look back in a few months. Let us know what you think in the comments.

Important Trend Lines

Apple bounced off the very significant blue trend line that it has formed over the course of the entire correction. Once it’s able to decisively take out the orange trend line, which has proven to be firm resistance thus far, the correction will officially be over.

AAPL Trend Lines

Falling Wedge

Apple dipped to just under $500 this morning. This new low formed the third touch of the bottom trend line and has validated our enormous falling wedge. This new low took place with rising RSI momentum, clearly forming positive divergence. Each of the lower low’s have been established on weaker and weaker selling pressure. A test of the upper trend line is due, with a potential breakout on earnings. Due to high call option OI this Friday, consolidation near $500 would make a lot of sense until next week.

AAPL Falling Wedge

Divergence Precedes Huge Changes in Trend

The chart below illustrates the power of divergence between price and the RSI/ChiOsc technical indicators. The dramatic trend changes in April and September were both preceded by a prolonged period of divergence between price and the momentum indicators. We’re currently seeing the same trend (but in the opposite direction). While the stock has been forming lower lows, the momentum indicators have been diverging from the downward trend. The selling pressure is decreasing on each subsequent move down. We expect an enormous shift in sentiment and price action after Apple reports earnings next week.

AAPL Divergence

Administrative Update: Portfolios, New Features and Investing 101

January 11, 2013 (7:30 pm)

We plan on updating our thoughts on the markets and current positioning of our three portfolios over the weekend (I promise the charts won’t change between now and Sunday!). For now, we’d like to give our readers a quick update as to where things stand.

Portfolios: We have updated the current positions, trading history and performance of each of the three portfolios. We will update these pages every Friday afternoon, as to not distract us from the more important tasks during the week. We compare our performance in each portfolio to the SPY and QQQ. By taking bearish positions during a market upswing, each of the portfolios has lost value over the last week. The Multi-Strategy Portfolio, which is designed to be the riskiest of the three, is currently down over 7%. As we explained on the portfolios overview page, we expect this portfolio to experience significant draw downs from time to time in order to achieve outsized returns.

Investing 101: We have introduced a new concept to The Investing 101 section is dedicated to general investor education. We consolidated our ‘Investing Guidelines’ and ‘Technicals’ pages within the new section and have added a couple of new sections: ‘Risk Management’ and ‘Fundamentals’. We will continue to build out that part of the site and add to this knowledge center.

New Features: Yesterday, we featured an article that was contributed by a friend and fellow Apple investor (see the article here). We have received feedback that our readers found this useful and interesting and have more relevant articles in the pipeline. If you would like to contribute an article, please email us at

Thanks for reading, and enjoy the weekend.