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How To Avoid Major Losses In The Market

February 18th, 2013

bearbull21-150x1501George Leong: It’s amazing how resilient the equities market has been in spite of the concerns regarding the budgetary cuts and debt ceiling, the eurozone’s economic stalling and debt, and the earnings risk.

The current equities market has some bull legs and could advance higher, driven by more encouraging earnings and economic news; but we are also at a crux, with the S&P 500 at 1,500 and the Dow recently breaking to 14,000. The reality is that the advance we saw in January is not sustainable at the same pace, based on my technical analysis. Just think back to last year. After an equally strong start and January, stocks began tapering off in February after the first quarter.

On the one hand, I can see this market moving higher to new multi-year highs; but on the other hand, I feel that there’s chart risk, as evidenced by the potential third top on the S&P 500, which I recently discussed in this newsletter. The early success of the earnings season is already discounted into the market. The nice economic recovery in the U.S. is also discounted. We need more positive readings out of the financially challenged eurozone, as well as China.

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So while the bias remains positive, the biggest investor mistakes may be to get too comfortable and let down your guard.

Just take a look at the CBOE Volatility Index (VIX) based on the S&P 500, which is known as the “fear factor.” The VIX reading on February 6 was 14, which is well below some of the high readings since 2004, as shown on the chart below. The low VIX reading means the market is relaxed and not concerned about the current market climate; but you need to remain alert, as investor mistakes occur when you are too confident.

Volatility Index Chart

Chart courtesy of www.StockCharts.com

You always should be thinking of the risk and your situation, and you should have a good strategy in place to avoid making any investor mistakes.

Having a good investment strategy, including risk management, is the key to avoiding investor mistakes. The most important tenet in trading is preserving your investable capital via the use of risk management. The last thing you want to happen to you is to make investor mistakes by trading sloppily and losing your tradable capital.

You can avoid investor mistakes by following a simple investment strategy.

When the price of a stock trends higher, you should think about a potential exit strategy. This means protecting your profits, not liquidating profitable trades.

A strategy is to take some profits after a surge in the stock. Chances are the price will retrench, so failure to do this would result in investor mistakes.

Another key investment strategy is the use of mental or physical stop-loss limits. The reality is that no one is perfect in trading. I have made mistakes, and so have many of you.

Some of you may be wondering if the stop-loss limit should be a mental or physical stop. I prefer physical stops, as it effectively eliminates the potential influence that emotion can play when you trade that causes investor mistakes. Emotion often can destroy good trades and cause you to keep your losers, which is not a good investment strategy.

Keeping losers is counterproductive and will make you a viewer from the sidelines.

For those familiar with options, you can use a put hedge to help minimize the downside loss and avoid big investor mistakes.

If you own mutual funds, you can buy the appropriate index put by determining the type of fund it is (i.e. small-cap, blue chip, S&P 500, technology, etc.).

If you are already adhering to risk management within an investment strategy plan, good for you; otherwise, learn them. They will make you a better and more successful trader, and you will avoid major investor mistakes.

This article is brought to you courtesy of George Leong from Profit Confidential.

Related Tickers:  iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ), iPath S&P 500VIX Short Term Futures TM ETN (NYSEARCA:VXX), Proshares VIX ETN (NYSEARCA:UVXY), VelocityShares Daily Inverse VIX ETN (NYSEARCA:XIV), VelocityShares Daily 2x VIX Short Term ETN (NYSEARCA:TVIX), VelocityShares Daily Inverse VIX Medium Term ETN (NYSEARCA:ZIV).


NYSE:TVIX, NYSE:VXX, NYSE:VXZ, NYSE:ZIV


 

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