The Trader's U E-Letter: Issue # 171
Thursday, January 19, 2006
Managing Your Investment Portfolio…My Stock Zoomed Or Cratered - What Do I Do Now?
By D.R. Barton, Jr., Chairman, Trader's U
"We can't always control what happens to us. But we can always control our reaction."
- My great uncle, Henry Barton III
You wake up and find that tired old stock - the dog of your portfolio - exploded upward more than 20% overnight. What's your next step in managing your investment portfolio?
What about when the opposite happens? You spew your morning coffee all over the Wall Street Journal when you read that your favorite stock has plummeted overnight.
Last week, we talked about the market's dirty little secret - that price shocks (unexpected and unpredictable moves) happen more often than traders and investors expect.
Today, we'll look at why price shocks happen and some useful ways to react to each of the scenarios.
No Need To Lock the Barn Door… The Horse Ran Away
Remember from last week's Trader's U that price shocks are so tough to deal with because they are unpredictable. Therefore, the most important thing we can do in all of our trading and investing strategies is make sure that our position size for each trade is small enough to protect us in case of price shocks.
That's the best thing we can do to prepare for unpredictable moves. But we can also minimize the effect of negative price shocks or maximize the profit of positive price shocks if we are prepared to analyze them and react appropriately.
When a negative price shocks occurs, we are already in a compromised position. The horse has already run away, so to speak. Hopefully, good position sizing practices have protected us from a catastrophic loss. But we still need to know what to do next.
On the flip side of the coin, positive price shocks give us an unexpected boost. But an emotional response can keep us from taking optimum advantage of the situation.
What we need is a systematic approach for dealing with price shocks in managing our portfolios, whether they have had a negative or positive effect on our account.
Identify the Cause - Implement a Plan
Let's look at three types of price shocks and useful response to each.
1. Major Structural or Fundamental Change. Price shocks that have concrete reasons are the easiest to understand. These are the announcements that will clearly have lasting effects on a company, commodity or currency. After the price shock, the price typically continues to move in the same direction. For example, if a company comes under SEC investigation, it will get a negative price shock that is not likely to retrace any time soon.
On the other hand, a takeover target or a company that is already receiving bids from multiple companies - or is in the process of being bought - usually sees a positive price shock that is not likely to be reversed. Siegel Systems (Nasdaq: SEBL) is a good example of this. In September of last year, Oracle (Nasdaq: ORCL) announced that it would acquire the company. Look what happened in the following chart…
Now, here's how to take action…
If the price moves in your direction: The aggressive move would be to hold the position in hopes of the expected continuing move. A more conservative approach would be to take profits on half of your position, especially if you are not certain about your analysis.
If the price moves against you: Get out if you're not already stopped out. Structural moves typically keep heading in the direction of the price shock. Get out now and come back to fight another day.
2. Overreaction To a Move That Had a Sound Basis. Price shocks often cause overreactions. People tend to punish bad news more than is warranted or reward good news above and beyond what is reasonable. This is especially true if the news only affects a limited time frame. Items like quarterly earnings and new contracts typically move the price, but do not have a structural, long-term effect.
The same can be said for weather-related news and its effect on commodity prices. After this price shock, the price usually retraces. A great example was the effect of Hurricane Katrina on oil prices. In the chart below, you'll see a price spike from $65 to $71 as the hurricane approached, and then prices retreated the day after the hurricane hit.
Here's how you handle these types of investment moves in your portfolio.
If the price moves in your direction: Take profit on all or at least half of your position. Many times, the price shock move is the most extreme you will see and prices will retreat.
If the price moves against you: If you're not already stopped out, you may be able to hold on for a retracement. This type of news may warrant tightening your stop, and don't expect to recapture all of the price shock move.
3. Overreaction To Rumors and Other "False" Moves. Price shocks can happen because of rumors. This is the most difficult type of move to identify. A general rule of thumb: If the rumor or news does not significantly affect the revenues or earnings of the company in the near term, then beware!
Items that fall into this category are takeover rumors, strategic alliances for small companies that generate no revenues, and some types of analyst comments. After this type of price shock, the price usually retraces all the way to the original price level. Take the example of Energy Partners (NYSE: EPL) that we highlighted in the Chart of the Week back in September. EPL spiked when the Mad Money TV show suggested it was a takeover target. When these rumors did not come to fruition, the stock retraced all the way back.
Here's what to do in this situation:
If the price moves in your direction: Take the money and run! Many times, you may leave part of the position in place if you can't make a firm decision on whether you are dealing with rumor or fact.
If the price moves against you: If you're not already stopped out, hold on for a retracement. Again, this type of news may warrant tightening your stop, but you have a good chance of recapturing your losses.
A Final Note On the King Of Price Shock Sectors
Biotech clearly is the champ when it comes to providing frequent and devastating price shocks. Last week, I showed a recent example from well-established Human Genome Sciences (Nasdaq: HGSI), where it lost 30% overnight.
Strategically, it is easy to see why these events happen - the nature of the biotech business produces definitive and actionable results with regular frequency. The announcement for results of clinical trials is a large part of this sector's business model. Positive results = a big move up. Negative results = a big move down. Throw in the occasional undetected negative side effect that is reported for drugs, products and procedures, and you have a sector that lives in a minefield of price shocks. Prudent position sizing is more important in this sector than almost any other I can think of.
The Chart of the Week
Human Genome Sciences (Nasdaq: HGSI) is still holding its resistance point at $10.30. Continue to watch for a close above this point, which should trigger a move to fill 50 to 100% of the gap.
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