We first noticed it a few years ago, when we outlined the Chicago City Council’s attempt to ban smoking at all bars and restaurants. Of course, smoking in any large buildings and workplaces had already long since been outlawed.

Score one for the socialists. Thanks to opportunistic local politicians and an aggressive lobbying effort from liberal think tanks, the smoking ban passed, making it illegal to smoke cigarettes — a legal substance — in any bar or restaurant within city limits. Public-health advocates have heralded the move as a major score for the best interests of smokers and nonsmokers alike.

As usual, however, these immoral do-gooders miss the point completely. Despite the fact that they serve the public, bars and restaurants are private establishments, meaning that their smoking policies are only the proprietor’s to determine. Some restauranteurs might choose to permit smoking in certain areas or throughout the entire establishment. Others might choose to ban smoking completely. The point is that it is not the public’s (read: politicians’) right to interfere with legal activities taking place on private property. It is quite simply none of their business.

Nobody is forced to patronize a bar or restaurant that allows smoking, and nobody is forced to work at one either. If you are concerned about second-hand smoke or hate the way your clothes smell after a night out drinking at the bars, you should simply avoid those establishments that permit smoking. The onus is on you to modify your behavior, not the law-abiding businessman to accommodate you on his private property.

Pragmatists argued against the economic ramifications of the ban, although the real issue here has nothing to do with whether or not local businesses will be affected or if waitresses will lose tips. Plain and simple, the issue is property rights. Does the government have the right to micromanage your property, your business, your life for the benefit of the “public good?”

But it isn’t just smokers Chicago has sought to target. In recent months, the Windy City has become the nation’s second-biggest municipality to ban motorists from using hand-held cellphones while behind the wheel. Putting a cellphone up to your ear while driving in Chicago is now illegal. Those caught violating the ordinance face fines and a court appearance.

Fact: It’s illegal to run a red light, drive recklessly, or crash into someone else’s car. But using a cellphone while driving doesn’t infringe on anybody else’s rights, be it other motorists or pedestrians. If I’m able to safely operate a car while talking on the phone, what business is it of the city to prohibit this otherwise legal activity?

The truth is that holding a conversation on a cellphone while driving is no more distracting than talking to a passenger, tuning the radio or adjusting the rear-view mirror. Consider that the alderman didn’t see fit to ban drinking hot coffee, disciplining your kids, putting on makeup or styling your hair while driving, all of which are significantly more distracting than simply talking on the phone. In a free society, a driver should be able to determine if he is able to safely speak on the phone while driving. What’s illegal is causing an accident, not innocently carrying on a conversation on the phone. The law is just another “get tough” stunt designed solely to exert more control over the lives of otherwise law-abiding citizens.

Moreover, now motorists have to drive while grappling for an ear bud, which many find even more distracting than simply using the standard handset with which we’re all familiar. Some motorists report the headset cord gets caught in the gear shift, which could lead to a dangerous inability to control the car in an emergency.

Forget the total lunacy of talking on the phone in a neighboring suburb, then being forced to either terminate the call or fumble with a headset as you cross into city limits. Forget the fact that the ban imposes a multimillion dollar tax on excellent drivers who are now forced to buy headsets they didn’t want and would rather not use. Once again, the real issue here is how activist local governments are increasingly determining the lifestyle choices of citizens, sacrificing the rights of the individual in the name of a “public good.”

Once you permit government to begin regulating your life, it’s just a matter of time before they’ll start mandating just what you can eat. And continuing down this collectivist path, last week Chicago became the first major city in the country to ban foie gras, the fatty liver of geese that is considered world-wide to be a gourmet delicacy.

Environmental activists and animal lovers oppose the dish, which is made by force-feeding birds until their livers fatten to abnormal proportions. “Our city is better for taking a stance against the cruelty of foie gras,” Alderman Joe Moore, who sponsored the ordinance, told a local paper.

Our city is better? Well, I suppose it is as long as you didn’t like the occasional piece of foie gras! Like the smoking ban, the foie gras ban is another example of how the majority is able to trample on the rights of the minority. Few people eat foie gras or smoke — which makes restricting those activities an easy lay-up for politicians looking to score points as “doing something” for the community. If you don’t like foie gras, don’t order it! But banning it allows our Constitutional Republic to be turned into simple majority rule.

Forget that the vast majority of Chicagoans have never even tasted foie gras or that the city’s gourmet restaurants will have a disadvantage over neighboring cities that are able to offer the fare. What’s most amazing about the ban is that the alderman who supported it, in effect, grants greater rights to wild, plentiful, nonendangered birds than to his living, breathing human constituents. The human being’s right to eat — or not eat — foie gras has been superseded by the “rights” of the animal who doesn’t vote, pay taxes, or contribute anything to society besides the occasional bird dropping.

Although Al Capone is long dead, it’s apparent that Chicago is once again becoming a city of mob rule. Once a city famous for its scrappy support for capitalism and individual rights, the slow creep of socialism is transforming it into a highly regulated paternalist state where what you eat, where you shop, and how you drive are all up for grabs. In Chicago, providing you can get enough votes in the city council, anything goes.

And maybe you don’t eat foie gras, smoke or enjoy talking on a cellphone. But the point is that individual freedoms are being slowly obliterated. And although Chicago’s City Council is oblivious to the fact, one need not be a Constitutional scholar to understand it’s a trend that has significant long-term implications for our economy, our liberty and the very essence of the American way of life.

– Originally on May 01, 2006 by Jonathan Hoenig

The problem is that falling in love is easy. It doesn’t take much energy or critical thinking to quickly find oneself completely head-over-heels for a beautiful girl. The attraction is usually immediate and irresistible: Without warning, she becomes the sun who brightens up your entire world. In your mind, you quickly make plans to share a future and can’t imagine another day without her by your side. That’s love. And that’s where the trouble begins.

Love is equally as hazardous when it comes to your investments, where we often find ourselves falling for a particular stock and, thus, utterly devoid of the rational objectiveness that’s required to successfully manage a position or portfolio. Love in relationships can break your heart, but love in your finances will devastate your bottom line.

How do we fall in love with a stock? Sometimes we’re attracted by the profits an issue has provided over the years. For example, after rising many hundreds of percent during the 1990s tech boom, many investors couldn’t fathom the thought of selling Dell, Cisco Systems or Intel simply because the stocks have become almost members of their family, reliably churning out double-digit gains year after year. A winning stock, especially one held for a number of years, can be quite difficult to divorce oneself from even when the market’s price action suggests it’s time to bid farewell.

Oftentimes, we’re attached to the personal history behind a particular investment. So if your late father or dead great aunt left you 500 shares of General Electric (GE), you might be hesitant to exit the position out of respect for the deceased. The stock becomes a proxy for the real-life feelings for the individuals involved. Of course, it was the money they wanted you to have, not necessarily the shares in any one particular stock. Yet we personify them into a scrap of paper which might not have the same investment merit as when it was purchased 10 years back. My own grandmother gave me shares of Ford Motor (F) back in 1987. Considering the shares have fallen back near those late 1980s levels, I’m thankful to have long since exited the trade.

Most commonly, however, we’re in love with the idea of a particular stock — the fundamental rationale behind an investment which is often completely divorced from the actual price action occurring in the market. For example, for much of the last five years, patient investors have held onto shares of big pharmaceuticals like Merck (MRK) and Pfizer (PFE) because they were convinced the demographic “graying” of America would result in greater demand for prescription health care. And while demand for health care has grown, shares of two of the biggest players in the sector have fallen sharply for a myriad of legal and development-related issues. When we fall in love with an investment idea, we become preoccupied with believing a trade should work even when it isn’t. We hold onto hope even in the face of a rapidly weakening stock price.

And while it’s easy to fall in love, extracting yourself from its powerful grip can be an immensely difficult process. Although stocks are simply pieces of paper, we feel an emotional attachment to them that transcends a simple financial transaction. In most cases, we’ve not only invested our money into XYZ, but we’ve devoted our time as well. When you’re in love with a stock, you’ve likely pored over the annual reports, listened intently to quarterly conference calls and dug through the company’s financial statements.

Moreover, assuming it’s a well-known issue, we are reminded of the company at every turn, seeing it mentioned in magazines, on financial TV programs and all over Internet message boards. You can easily avoid taking calls from your ex-lover, but ubiquitous names like Nokia (NOK) or Boeing (BA) are usually harder to avoid.

Because love should be a selfish act, the best relationships are those in which the parties put themselves first. Unrequited love isn’t love at all, and if a relationship, be it with a person or a stock, isn’t serving your needs, try to rationally push yourself to cut the cord. Dow Chemical (DOW), for example, used to be a strong, well-known stock. Now it’s weak, with little indication a reversal is imminent. From my perspective, it’s an ideal time to kick it to the curb and move on to another dance partner.

A loveless life is tough to achieve. But you should most certainly drive for a loveless investment routine. The market isn’t a girlfriend or wife, and when it comes to the bottom line, it’s your head that should give the orders, not your heart.

– Originally on Apr 10, 2006 by Jonathan Hoenig

There is no sure thing. But after trading everything from stocks on the screen to futures on the floor, I’ve come to believe that the most simple and effective way to put the odds on your side when allocating assets is to follow what I believe is the golden rule: Don’t fight the tape.

Deciding whether a stock is “overvalued” or “undervalued” is totally subjective. Price, on the other hand, never lies. The tape is the tape and determining weather a security is strong or weak is easily visible to even the uneducated naked eye. When a market is strong, you might not want to invest in it, but I think you’re a major fool to stand in its path.

If you’re interested in fighting the market — friend, you’re going to lose. The market has an unlimited supply of capital and patience. We don’t. We harbor these fantasies that, now that we’ve bought our 500 shares, XYZ is likely to bottom out and rebound to all-time highs. Certainly my few thousand shares aren’t going to affect the price of IHOP Corporation (IHP), and even big players like Kirk Kerkorian — who lost a quick $300 million on a position in super-weak General Motors (GM) — can’t influence a market before it reverts to the laws of supply and demand. Unless you’re prepared to take a company private and have unlimited resources, the market can outbox you with one hand tied behind its back.

Of course, “the tape” refers to price action, which should be of dear concern even to those who evaluate a company’s fundamentals. While you can follow a company’s earnings or underlying economics, at the end of the day, it’s the stock we actually trade. And, yes, satellite radio has potential and I love Howard Stern, but that hasn’t stopped Sirius Satellite Radio (SIRI) and XM Satellite Radio (XMSR) from dropping up to 20% over the last six months. And, while the sector could easily stage a formidable rebound, for my money, I’d wait to see some sign of strength before fighting a persistent trend toward lower prices. If XM is worth $37, why not at least wait until it can trade at $22.50 first? Why do people insist on betting on the old, sickly horse instead of the young, strong stallion?

And that’s where my money goes. Opinions are unlimited but trading capital isn’t. The disciplined player only puts money into those few high-probability trades in which the odds are on his side. Fighting the tape is always an inherently low-probability trade.

Take, for example, the Dow Jones Transportation Average, which we profiled back in 2003. In recent months, the Transports have become major market leaders, driven by massive gains in stocks such as FedEx (FDX), Norfolk Southern (NSC) and even airlines like AMR (AMR).

Maybe you own the sector and maybe you don’t. You might think the gains will continue or that the real money has already been made. Regardless of your outlook for future prices, any rational person has to respect the fact that — for now — the Transports are strong. So don’t fight the tape. As long as the price action climbs higher, shorting them, which one could easily do with a security such as iShares Dow Jones Transportation Average (IYT), is lunacy. It’s a perfect example of a low-probability trade.

And perhaps this is the high for Transports. But if you’re bearish on them, I’d say wait until at least you see some signs of weakness before putting dollars on the line by shorting the stocks. For example, as we pointed out recently, you didn’t need to short Nasdaq at 5000 in order to make money on its decline. You could have easily waited until the first big break before initiating short positions and still come out with a grand profit in due course.

Bizarrely, it’s human nature to fight the tape even on a much shorter time horizon. Armed with a freshly funded E*Trade (ET) account, we naturally become hell-bent on standing in front of a moving freight train just to see if it bothers to stop. (Hint: It doesn’t.)

So with XYZ down four points within the first 10 minutes of trading, why am I instinctively drawn into the fantasy of buying a few hundred shares at the market and hoping to sell a point or two higher by the time “Morning Call” turns into “Power Lunch”? My experience is that, if you want to make trades, that’s by far your best approach. If you want to make money, that eagerness to stand in the market’s path is downright insane.

For one thing, as we always point out, playing for the short-term swings — a point here, a quarter point there — is by definition a loser’s game. What inevitably happens is that, because you’ve clipped your winning trades at such insignificant amounts, even a few big losers wipe out all the wins. The only winner in these “scalper” type of accounts is the broker, who, of course, earns his commission on every trade.

Moreover, what’s inherently problematic about this approach is that, by stepping into a stock that’s suffered a recent and large decline, you’re fighting the tape, trying to catch a falling knife that literally hasn’t stopped. And when you look at the sustained fall taken recently by stocks such as Mills (MLS) and PXRE Group (PXT), one is reminded of the danger of the “it’ll-bounce-back” mentality. Those who bought the weakness hoping for a quick two-point pop were likely stuck with losers that dropped 50% or more in a matter of weeks. Again, no strategy is perfect, but on average, you generally have less of them when you focus on following the tape, not fighting it.

– Originally on Mar 27, 2006 by Jonathan Hoenig

A market spends the vast majority of time rising, falling or trending nowhere. So I start with the notion that, out of the hundreds of days in which I’ll hold a trade, there’s only going to be one or two of them that actually constitute a top or bottom. From a purely statistical perspective, an investment strategy that banks on being able to pick those few days has the odds stacked against it from the start.

In truth, you don’t need to sell the top or buy the bottom in order to make money on a trade. The real scratch isn’t made on the top or bottom 20% of a move, but within the vast middle 60%. To that end, the disciplined investor should always opt to play for the big moves — essentially, an overall valuation shift — much more than a simple three-point pop in Google (GOOG) or Amazon.com (AMZN).

The patient approach simply puts the odds on your side: When a big move takes place, such as we saw in technology during the late 1990s, bonds in the early 2000s or commodities in recent years, there’s almost always enough gravy so that, one need not buy the bottom in order to make money on the trade.

Moreover, not worrying about catching the bottom allows one to become much more selective. Instead of chasing after every dead-cat bounce, traders should forgo the first few percent and wait for a market to show legitimate signs of strength before putting money to work. In my experience, this philosophy tends to keep one out of the impulsive, whim-driven trades with less-than-ideal probabilities of success. For example, although they have recently come back to life, hundreds of millions were lost calling bottoms in Merck (MRK) and Pfizer (PFE) over their protracted bear rout. The disciplined player lets a security get bullish before he does, waiting for positive price action ahead of committing capital. Truth be told, if you’re right in your analysis, the first 10% or 20% won’t matter anyway.

Conversely, if I believe a market is overextended or ripe to decline, no matter how bearish I might feel, I’ll wait for some price action to indicate that a decline is under way before moving forward and taking a short position. The best example is Nasdaq, which — despite many pundits’ revisionist history, didn’t exactly plummet from 5000 to 1200 in a day’s time. You didn’t have to sell the peak on March 10, 2000, in order to preserve capital or even make money on the short side — only to wait until the persistently weak price action confirmed your bearish outlook.

And although trying to buy bottoms (or sell tops) is foolish, millions of pompous SOBs do it, not because they want to actually make money on XYZ, but because they’re looking to bolster their own self-image. It’s an exercise that’s more focused on feeding their ego than their pocketbook — those who do it are looking primarily for a story to boast about at a dinner party or with drinking buddies. If it’s accolades and attention you crave, you’re better off just buying a Porsche or fancy watch. Over time, trying to pick tops and bottoms will be a much more expensive proposition — with nothing to show for your effort.

Because we only know through the benefit of hindsight if a top or bottom has been made, it’s also helpful to make sure the behavioral indicators support a position before you go ahead and pull the trigger on a trade. At the bottom of a market, the security isn’t necessarily hated…but virtually ignored. Volume is light, and the major prevailing attitude toward the security is doubt. Even when presented with evidence of strong price action, most investors are uninterested in getting involved. When an idea is working, and the herd isn’t involved, it’s usually a good bet the trend hasn’t yet run its course.

On the other hand, by the time a market has reached the top 20% of its move, the herd has usually picked up the torch, glorifying the trade’s unbridled potential on message boards or in the pages of glossy financial magazines. Volume, once sleepy and intermittent at best, is now significantly higher, and a security that once traded a few thousand shares a day might now do a million or more. By this late date, mutual fund companies and other financial intermediaries are probably just starting to roll out a bevy of new products specifically designed to target that particular sector or asset class, and the general tone amongst investors is that taking a position is safe, with perfectly plausible fundamentals supporting the bull case. When this sort of enthusiasm reigns — while the market’s price action isn’t confirming the crowd’s outlook — is when I run for the exits. The top might not be in. But, chances are, it’s close.

– Originally on Mar 20, 2006 by Jonathan Hoenig

But for the active trader, the notion of diversifying should move beyond simply spreading around your assets to more than a solitary fund. There are a number of smart ways to use a diversified approach that you might have never even considered.

The most basic way to diversify your portfolio is by time. Most people invest as if they were burying a time capsule. They commit their entire risk capital in one day, usually as soon as the check clears or the brokerage account is actually opened. If they have $50,000 on March 1, they invest $50,000 on March 1. Six months later, they dust off their IRA statement from the bottom of a pile of mail and see if there’s any buried treasure to be found.

Bull and bear markets don’t turn on a dime, and just as the ocean is made up of many waves, the market is really a number of smaller markets in varying stages of maturity. It’s not a static still-life, but an ever-changing watercolor that never dries.

And because the investment landscape can shift, you always want to maintain some liquidity in order to capitalize on the next big thing. The point isn’t to always be sitting on cash, but rather to pace the deployment of your assets over time. Today, the market looks strong. A week from now, it might be an entirely different picture altogether. Trading capital shouldn’t come sloshing into the market in an afternoon, but dripped in on an ongoing, continual basis. I picture a portfolio as dead wood being cleared away while mature trades thrive and promising newborns are just being born.

Less obvious, but an even more important way to diversify a portfolio, is by varying the liquidity of the instruments in which you invest. Most trades are disillusioned by a quiet stock. Personally, as I’ve written before, I think less liquid trades are where the best opportunities are often found. A trader’s job is to provide liquidity. As long as a market is acting right, it doesn’t bother me to account for a big part of the daily volume. For example, some of the best utilities trades I was fortunate enough to own over the last two years, names like BIW (BIW) and International Power (IPR), have been rather illiquid stocks. The correct approach isn’t to avoid risk, but to mitigate it by diversifying your exposure.

So when putting money to work, I like to mix up the relative liquidity of my exposure by offsetting one illiquid trade with a trade in a deeper market somewhere else. For example, take the variable-rate preferreds I mentioned late last year. Like most big ideas, this group’s liquidity ranges from names like HSBC USA Inc., Adj Rate Dep Shares Cumul Preferred Stock, Series D (HBA-D) (average daily volume 1,700 shares) to the comparatively active Merrill Lynch & Co. Inc., Floating Rate Dep Shares Noncumul Pfd Stock Series 2 (MER-H), which lately trades well north of 300,000 shares each day. Rather than choose between the two, my approach is to own a piece of both. The idea is to expand the exposure, but do it in a prudent way by varying the liquidity risks of the overall trade.

As I pointed out last week, active markets are vibrant markets, where buyers and sellers can easily hedge or assume any types of risk they choose. And despite a ridiculously inefficient regulatory burden it takes to develop them, the presence of new financial products (and the active investors willing to trade them) has been a major benefit to the stability and growth of markets world-wide. They allow one to diversify by product with an efficiency that was impossible only a few years ago.

And for an active investor, these are absolute boom times for portfolio management. Beyond simply buying stocks, you can tailor exposure using options, futures, and a host of exchange-traded and open-ended funds. And while the best approach is usually the most simple, I do usually opt to own a number of products within one particular idea or theme.

For example, take some of the telecoms I last mentioned a few weeks back as showing some leadership. A long position in Qwest Communications (Q) or Hungarian Telephone & Cable (HTC), for example, might be coupled with an “index” exposure using a security like Vanguard Telecommunication Services VIPERs (VOX) or Telecom HOLDRS Trust (TTH). Or if you’re still waiting for Verizon Communications (VZ) to turn around, you might consider augmenting the trade with an international twist with iShares S&P Global Telecommunications Sector Index Fund (IXP) or Emerging Markets Telecommunications fund (ETF), or selling a put option on AT&T (T). The idea is that you’ve expanded your exposure to the trade but diversified the product used.

An obvious benefit of using this approach is that it can often save your hide if you pick the right race but wrong horse. Too often we end up owning the weakest stock in a sector where everything else seems to jump higher. By adding another equity or even broad index exposure, you “cover your bases” in case your particular pick ends up being the runt of an otherwise winning litter.

Moreover, having two different exposures, even through options or mutual funds, gives you the chance to manage your risk more closely. For example, instead of just owning Barrick Gold (ABX), you might consider adding a position in Goldcorp (GG) or ASA (Bermuda) (ASA) as well. It’s quite likely a rising tide will lift all boasts, and if one trade gets stopped out, you are still “in the game” with the other allocation. This approach often keeps me participating in trades where losses in one particular name would mistakenly prompt me to cut and run altogether.

– Originally on Mar 06, 2006 by Jonathan Hoenig

Unfortunately, the effort to develop new markets in recent years has been severely hampered by the regulatory tentacles of overreaching government. Between Sarbanes-Oxley, the SEC and the Commodity Futures Trading Commission, just to name a few, bureaucratic red tape has slowed innovation even as technology has pushed trade far past the Buttonwood tree. Thankfully, a few pioneers have created exciting new marketplaces in which I see gobs of profit opportunity. These are two of my favorites.

Prosper.com
Prosper.com, a lending marketplace, offers probably the most exciting and innovative development in online dealing since the Iowa Electronic Markets pioneered presidential futures contracts over a decade ago. Here’s why.

Online banks like ING Direct and Bank of Internet have come to offer comparatively higher savings rates thanks to less overhead. Without having to maintain the expense of physical branches, Internet banks are able to offer significantly better returns on savings accounts and CDs. To get a loan, however, you’re still at the mercy of banks’ rather traditional loan departments. In other words, submit your credit information and cross your fingers for a positive outcome. Banks lend money on their terms and their terms alone. The system is closed, uncompetitive and inefficient.

Prosper.com turns that paradigm upside down by running an open marketplace where anybody — from the urban Fat Cat to the rural grandmother — can become a banker. Essentially, Prosper has created a marketplace for unsecured consumer loans that connects those looking to borrow directly to those looking to lend. An individual seeking funding for anything from home repair to a college education creates an online ad, describing the size of the loan he’d like, what interest rate he’d be willing to pay and how he intends to use the money.

The listing in essence sells the loan, and although some borrowers prefer to stay anonymous the smart ones provide email addresses and links to web pages in order to better assuage lenders’ fears. Just as a loan officer at a bank would frown on an applicant who came in wearing unkempt clothing, Prosper.com loan listings with misspelled words or shoddy design don’t receive much attention.

Lenders also evaluate loans based on an applicant’s debt-to-income level as well as a credit rating provided by Experian. (Ratings range from a pristine AA down to HR, or high risk.) Just like a traditional bank, your credit ranking affects the rate at which people are willing to lend you money. Right now on Prosper.com, highly rated borrowers are paying as little as 6% for loans, while those with lower marks are paying 15% or more. The loans are unsecured and all carry a three-year term.

If you don’t need money, but rather have some extra to lend, you can click through pages and pages of loan requests, deciding for yourself what risks you feel comfortable in taking. Amounts range from a few thousand dollars up to $25,000, and you can fund the entire loan yourself or contribute as little as $50. Because a number of lenders band together to fund one loan, you’re able to diversify your exposure. If a high-risk borrower skips payment for a $10,000 loan, you might only be on the hook for $75 of it. Payments are made monthly, and Prosper.com handles all loan servicing for a nominal fee.

Because loans are made through a competitive bidding process, borrowers might find themselves paying less interest than they originally thought. A listing that started at 10%, for example, might end up being made at 8% as Prosper’s community of lenders competitively offers better rates. As volume of business and depth of user base grow, you’ll see bigger loans being made at more competitive rates, benefiting lenders and borrows alike.

HedgeStreet
Another breakthrough market worthy of your page views is HedgeStreet, a small but rapidly growing futures exchange specifically designed for retail (read: small) traders. Less than two years old, the CFTC regulated marketplace’s focus on small, limited-risk contracts is unique. With the exception of the Chicago Mercantile Exchange’s e-Mini futures franchise, most of the recent developments in derivatives trading have sought to attract the big-money hedge players with billions to wager.

HedgeStreet is different. You can open an account with as little as $100, and trading is done directly through a web-based interface with no separate commodity brokerage account required. Two types of contracts are offered, binary options and capped futures. Both are referred to as “Hedgelets.”

Binary options are short-term, small-size bets on any number of underlying instruments including precious metals, currencies, energy and short-term interest rates. Often referred to as “yes-no” contracts, the options pay either $10 or nothing, depending on whether the underlying asset settles above or below the strike price at expiration.

For example, the exchange listed a “Gold > $554.00 (Feb 27 2006)” option, which as of Friday was trading around $7. The underlying asset is the Comex April 2006 future, the strike price for the option is $554.00, and the expiration was today (Monday) at 1:30 p.m. ET.

Since the price of gold stayed above $554, the option paid off at $10 per contract. If the price of gold had fallen below $554, then the option would’ve paid nothing. So assuming you bought the contract at $7, you made $3 because gold stayed above $554. If gold had dropped below $554 by Monday’s close, then you would’ve lost your entire $7.

The exchange also offers “capped futures,” which allow you to potentially profit based on how much an asset rises or falls before the expiration date. Similar to the binary options, the potential loss (or gain) on the capped futures are limited, so you know going into a trade exactly what your potential risk or reward might be.

For example, the exchange is currently trading a “Crude Oil $43.00 to $73.00 (Feb 28 2006) Future,” which as of Friday was trading around $62.91. The underlying asset is the April NYMEX Crude Oil contract and the expiration date is Tuesday at 2:30 p.m. ET.

If you believe the price of crude is going to rise, then you’d buy. Assuming you bought one contract at $62.91, the most you could potentially make would be $10.09, the difference between the price paid and the upper “cap” on the contract. The most you could lose would be $19.91, representing the difference between the price paid and the lower “floor” of $43.00. Knowing many of their target users have never traded futures before, HedgeStreet offers a simple interface that details the potential gain/loss on every trade.

Unique to HedgeStreet, even among the large professional exchanges for now, are contracts based on residential real estate. Using either options or futures, traders can speculate on the price of single-family homes in Chicago, Los Angeles, Miami, New York, San Diego or San Francisco. Think Chicago housing is undervalued? You can get exposure to the asset class without even buying a plane ticket to the Midwest. Or if you’re worried about a drop in the price of your Manhattan walkup, you can sell short a futures contract that will pay off if the East Coast real-estate market tanks.

Last week, the firm received a major vote of confidence in signing a strategic alliance (along with a sizable equity investment) with the Chicago Board Options Exchange, which pioneered listed options trading more than a quarter century ago. The CBOE not only plans to jointly develop new products, but also to market HedgeStreet’s existing contracts as well. You’ll undoubtedly see more liquidity, tighter spreads and even better opportunity in the months to come.

– Originally on Feb 27, 2006 by Jonathan Hoenig

For example, although you’ll never hear this at Wharton or Kellogg, one of the biggest ways investors trip over themselves is through the altogether pointless exercise of trying to determine if a company is “overvalued” or “undervalued.” And while I know the implication is that undervalued stocks will eventually rise as the market discovers their worth and that overvalued stocks are bound to come crashing down, friends, if you want to make money…and that’s your shtick, I can unequivocally promise that you’re barking up the wrong tree.

What this sort of fundamental analysis misses is the obvious reality that a company and its stock are two different entities altogether. The truth is that oftentimes perfectly lousy companies have outrageously bullish stocks. CMGI (CMGI), for example, was $160 back before the company had anywhere near the revenue it enjoys today, when it trades near $1.50 a share. Conversely, it’s not uncommon that a highly profitable firm’s stock is downright moribund for years. Wal-Mart Stores (WMT), for example, is a venerable money machine, yet the stock rests not far from where it did back in 2000.

As is our philosophy here at Tradecraft, the correct way to look at a security isn’t as overvalued or undervalued, but as strong or weak. Strong instruments get funded, weak ones are avoided or cut. It’s really that simple. Warren Buffett would grimace to hear it, but opining on valuation is a parlor game with very little bearing on what actually counts — the stock itself.

The second way a trader should change the way he or she thinks is by getting out of the habit of establishing a “time horizon” for each trade. Bizarrely, some people enter trades with a predetermined amount of time they expect to be in them. Some investments are “short-term trades.” Others they’re confident enough to anticipate holding onto for “the long term.” All told, it’s a fiscally ruinous way to look at the world.

The way to think about trades isn’t in terms of how long they take — but how they act while you’re in ‘em. I go into every trade with the hope of being able to hold onto it for years, but with the humility to know that — regardless if it’s next week or next decade when XYZ drops 20% below my initial purchase price — I’m going to kick XYZ to the curb.

The problem with classifying an investment as being a “short-term trade” is that you’ll inevitably end up leaving the real gravy on the table for no other reason than you were itching to go ahead and make another trade. Imagine if you bought Chicago Mercantile Exchange (CME) back in 2004 at $100 and sold it $50 higher a few months later, just because it was a “short-term trade.” The stock eventually surpassed $400, but you missed it because the reason for dumping shares was totally subjective and without any connection to the price action of the security itself. You can’t let your winners run if you’re constantly turning over your short-term trades.

Conversely, suppose you bought Alcoa (AA) six years ago in the mid-$30s with the intention to hold the stock as a “long-term” investment. Although the stock has been down as much as 40% — and generally has been dead money at best — you’ve held onto this “solid company.” Why? Because you bought it for the “long term,” even though the market never confirmed your deeply held conviction in the company’s shares.

You should absolutely research, evaluate and stress test until you’re blue in the face. But once a position is taken, the disciplined trader lets the market take over and decide how long the trade will be held. Because losers are a fact of life, it’s quite likely many trades will be gone in a few weeks or less. But when you’re patient, others will plod higher, often for several years at a time. You always want to be open to the possibility a trade might be more profitable, and take longer, than you had originally expected.

Finally, as unnatural as it might feel, the experienced trader doesn’t perceive trades as being “safe” or “risky” simply because of the industry or asset class to which they belong. We feel comfortable and secure making “safe” bets, buying widely owned or highly rated picks, yet it’s precisely those situations where the biggest losers usually unfold.

For example, there’s a sense of safety in buying something you’ve seen profiled in glossy finance magazines or talked about at cocktail parties. The problem is, in the market, the more people who’ve already capitalized on an idea, the more risky it actually becomes. For example, the biggest inflow of money came into equity mutual funds in February of 2000, just as the tech bubble was at its peak. By that time, everybody owned the major indexes, making a position seem like a conservative sure thing. Rather than chase popular and widely owned instruments, the independent trader has to be comfortable as a lone voice in the wilderness, avoiding the emotional security that comes with buying the same list of names that everybody already owns.

Moreover, how you perceive an investment will perform usually has no bearing on how a trade actually turns out. For example, during the big bull market in large-cap stocks, the S&P 500 index was often marketed as a “conservative” investment for slow and steady returns. Same thing about Merck (MRK), which for years was perceived as a “safe” pharmaceutical even as it slid from $70 in 2001 down to $30 just four years later.

The truth is that you want to seek out high-risk situations because that’s usually where the real fat profits are found. Most people feel confident knowing that their money is riding on the stock with the best odds, i.e., the best chance of “winning.” Yet the seemingly risky bets usually have the best returns. Assuming you’re using appropriate position size, the actual risk in buying either the “risky” or “safe” stock is actually quite similar. What’s riskier: General Electric (GE) or emerging-markets telecom play Turkcell Iletisim Hizmetleri (TKC)? If you use a reasonably sized trade at a 15% stop loss, the quantifiable risk is actually about the same.

The truth is that what most people think of as good odds are actually lousy odds. In reality, the stock that’s perceived to be “safe” has all of the downside of a “risky” stock with a fraction of the upside. The less you classify investments as “safe” or “risky,” the more you’re able to concentrate on what matters most — how XYZ is acting in the here and now.

Traders don’t just battle the markets, but their own minds and natural instinct. How you trade starts with how you think. And as difficult as it can be, consistent success usually comes not by getting better information, but by thinking about the same information in a slightly better way.

– Originally on Mar 13, 2006 by Jonathan Hoenig

With its infectious groove and pop-country appeal, it’s easy to understand why the song remains a popular tune. And while there’s a big difference between trading and gambling, investors can certainly benefit from the sage advice given throughout the song’s lyrics. Click here to view the song’s entire lyrics.

The story, you’ll recall, involves a young man “on a train bound for nowhere” meeting up with the gambler, a hard drinkin’ and smokin’ legend who scraped a rocky career “out of reading people’s faces.” Although the gambler probably wouldn’t know preferred stock from livestock, many of his tidbits are just as pertinent to corralling the markets as they are the cards.

One of the most memorable lyrics comes toward the beginning of the tune, where the gambler makes it clear that “if you’re gonna play the game, boy, ya gotta learn to play it right.” Indeed, whether it’s gambling or trading, there’s an appropriate way to approach dealing with risk. Gambling, when done in proper fashion, is a methodical, almost automated affair. You always split aces, double down on 11, and follow a mathematical formula for tilting the odds in your favor.

The same applies to trading. From fundamentals to astrology, there are innumerable ways to divine the market. Most influential to your bottom line, however, are a small handful of portfolio-management skills that constitute the “correct” way to trade. Opine all you want on the next move for Google (GOOG) — but it’s the boring stuff, like using consistent position sizes, setting stop-loss targets and maximizing winning trades, that matters most.

So everyday I ask myself: Am I trading with the trend or fighting it? Am I using consistent position sizes or just shooting from the hip? Am I taking losses early or dragging them around like old wine nobody wants? Am I trading products that are appropriate to my account or simply stroking my ego? Am I taking a smart risk or a sucker’s bet? In other words, am I doing the right thing?

Those who typically lose money in the markets usually approach it as a game, armed with “mad money” to burn and a desire for nothing else but quick action. You shouldn’t trade for fun, but for profit. The seasoned player doesn’t invest based on “feel” or going with his “gut”, but sticks with the nuts-and-bolts discipline that best mitigates the inherent uncertainty of markets.

The wisest quip in the song is also one of its least memorable. At the beginning of the second verse, we’re told how “every gambler knows that the secret to survivin’, is knowin’ what to throw away and knowing what to keep.” This overlooked line brilliantly encapsulates how every trader should approach his portfolio.

The public cares about being “right,” not making money, so they inevitably rush from one hot play to the next, desperately trying to land a win. But the gambler — or, in this case, trader — is adept at dealing with the cards he is dealt, not those he wishes or thought would have been dealt.

We analyze the markets to the best of our ability, but nobody knows the future. Ultimately, XYZ is just going to do whatever the heck it damn well pleases. This is the problem with the vast majority of research and market analysis. Because it’s centered on the security — not how to play it — one is left completely in the dark as to how to approach taking a profitable position.

The answer isn’t so much to analyze where the market is heading, but how you will react to any number of possible scenarios. Good traders instinctively know to “throw away” their losers and keep their winners, just as the gambler plays his strong hands and folds the weak ones. If there is a “secret to survival,” that most certainly is it. Yet you’d be surprised how many investors always seem to cut their winners and let their losers run, usually for years at a time.

Finally, one of the smartest pieces of advice comes in the chorus. Both gambling and trading involve the movement of capital, to which the gambler advises “you never count your money when you’re sittin’ at the table…there’ll be time enough for countin’ when the dealin’s done.”

I remember my first job as a clerk for an S&P trader on the floor of the Chicago Mercantile Exchange. Although my boss was a big swinger, often winning or losing tens of thousands of dollars a day, he never referred to dollars, but “ticks” — the minimum price fluctuation of a futures contract. If it was 11 a.m. and he was up 30 or so ticks, we’d head down to the Merc Club to eat lunch and smoke cigarettes for a few hours. If he was down any number of ticks, he’d likely stay in the pit trying to make it back or simply take off for the day and try again tomorrow.

The point is that although the job of a trader is marshalling money, in the emotion of the moment, he must be able to divorce himself from thinking of a portfolio as actual cash. You buy 1000 shares of XYZ at $50 and it goes to $48. While the disciplined trader would be able to cut the two-point loss and move on to a higher-probability trade, the amateur thinks about the reality of seeing $2,000 dollars evaporate. He loses his nerve, hopes for a comeback, and most likely ends up selling much lower — sunk by the inability to stomach even a modest loss that is, in reality, simply an everyday part of the game.

The same goes for gains. When I’m on a hot streak, I find it helpful not to focus so much on how many dollars I’ve made, but the strength and price action of the positions themselves. Just as “counting your money” in a loss can lead to poor decisions, thinking of the actual monetary gain of your winners usually ends up making you a much weaker hand, unable to withstand the natural volatility inherent in almost any publicly traded security. It usually happens like this: You buy 1,000 at $50 and it goes to $55. The stock then falls back to $52, shrinking your $5,000 to a mere $2,000. When it ticks down another 50 cents, you buckle and sell out for a $1,500 win because you didn’t want to see your gains disappear and, heck, “you never go broke taking a profit.”

Of course, the stock ends up bottoming that afternoon, and three days later XYZ is at $60. You should have made $10,000, but because you were so worried about losing the $1,500, the majority of the move was left on the table. Best to focus on the position so as not to be emotionally distracted by the actual dollars involved.

It’s worth noting that, while both the trader and gambler make a profession out of dealing with risk, trading is not gambling. Unlike speculative activity in the financial markets, gambling serves no economic purpose. Risk isn’t transferred from one party to another; it’s simply manufactured out of thin air for a quick thrill. When you trade a stock, bond, option or futures contract, someone is taking the other side of that bet, and, thus, actually playing an intimate role in the functioning of capital markets world-wide. Blackjack occurs between you and Caesar’s Palace. There is no economic benefit or transfer of risk. Worst off, even for the best of players, the odds are always on the house’s side.

– Originally on Feb 13, 2006 by Jonathan Hoenig

Up until fairly recently, evaluating a stock’s price action wasn’t such an easy task. In the old days, exchange employees would write prices onto chalkboards on the trading floor. The information was then manually input into crude reporting systems and eventually spewed out onto small strips of tickertape in brokerage offices around the country.

In the ’60s and ’70s, active traders frequently kept charts by hand, noting prices out of the newspaper and plotting data each night on large sheets of graph paper. One could also order charts or price data through research firms such as CRB, which would “promptly” arrive weeks later. “Day trading” just didn’t exist.

Even as late as the mid-1990s, almost all of the electronic stock data was delayed by 20 minutes or more, making it near-worthless for use in actually responding to a market move. For active investors, quotes were routinely retrieved by either calling your brokers’ 1-800 number or using some “advanced” tools like the QuoTrek FM receiver I used to carry around with me to class during my senior year of college. As you might imagine, the two-foot antenna and rudimentary LCD display were a big hit with the sorority coeds.

Nowadays, the task of monitoring markets has become a lot easier, thanks to the rapid advancement of technology that allows pricing information to be immediately disseminated world-wide. And while I’ve since updated my own system to a new top-of-the-line CQG, even nonprofessional investors have access to more instantaneous price data than they’d ever be able to watch, let alone trade.

So if you’re committed to watching price action, what exactly should you be keeping your eyes on? Historically, a stock’s closing price was the most important. It “printed” in newspapers and was what most market observers actually saw. But as the capital markets have become a truly 24-hour affair, many instruments never really close at all. Stocks are traded “after hours” and “premarket,” often making dramatic moves based on earnings or other fundamental announcements. Volume in these alternative sessions has grown quickly, and for the well-known stocks of the Nasdaq or S&P 500, liquidity is usually sufficient to trade at least a few thousand shares.

I don’t necessarily need to trade after hours, but I do need to know how a stock is moving. If a stock drops precipitously, I want to know how far it falls. If it rallies back, I want to know where it spends most of the session and how much of the gain is recouped.

But more than anything else, I want to see how XYZ acts during the day. I put a lot of emphasis into observing intraday patterns, watching to see how different capital markets respond and move with each other. This often helps illuminate the “quiet” trends that are unfolding but not yet newsworthy enough to be splashed above the fold in The Wall Street Journal.

Some correlations are obvious. For example, gold stocks such as ASA Bermuda (ASA) or Barrick Gold (ABX) tend to be highly correlated with gold prices. The S&P 500 and the Dow are highly correlated, as are the shares of Qualcomm (QCOM) and the Nasdaq 100. When the major market indexes are rallying, you can bet the major components of these indexes, like General Electric (GE), Citigroup (C) or Johnson & Johnson (JNJ), will be strong as well. Because they are the largest issues within the indexes, they are what the arbitrageurs trade to get quick exposure when trading against index futures or ETFs.

But I’m most interested in what other instruments are moving in concert with a strong or weak market — specifically those stocks or sectors that may not necessarily be large components of the major indexes. I believe that intraday, this sort of price action is a terrific indicator into the underlying state of various securities.

For example, I remember that when I owned utilities in recent years, I was always mindful that the group would seem to outperform intraday when the general market was rallying. In fact, after bullishly profiling the sector since the fall of 2004, I wrote about my observation in a May 2005 column entitled “Now That’s Amore”: “I’d swear that when the market does rally, it’s lately been utilities like TXU, FirstEnergy and Allegheny Energy that are leading the way. That type of leadership — even on an intraday basis — is a big part of what I like to see when putting money to work.”

Indeed, utilities were in the midst of a strong trend — one that would see them rise double digits even from May, and see the sector end as one of the best performers of 2005.

And even if names like Black Hills (BKH) and Duke Energy (DUK) weren’t great percentage gainers for the day, the fact that they showed positive price action while the broad market was rallying was my sign they were among the strongest equities on the board. To that end, nonprofessional investors will most certainly want to examine intraday charts after the close to observe what groups were rallying, or lagging, as the broad market happened to rise.

And when I’m intrigued by a particular price action, I don’t hesitate to follow up with additional inquiry to either confirm or dismiss my hypothesis. So, if I happen to notice that AT&T (T) seems to be rallying with the broad market, I’ll follow up by looking at similar issues such as BellSouth (BLS) or Qwest Communications (Q), which are also showing recent strength. I’ll look at the company’s exchange-traded debt such as AT&T ABS Corp Bkd Trust Certs 2001-33, 7.25% (XKJ) or AT&T ABS Corp Bkd Trust Certs 2001-21 , 7.40% (CJO) to confirm they’re also holding up.

In short, I’ll try to become as informed as possible about the state of AT&T’s securities. Because that’s what we trade. That’s what matters. And as much as it might horrify the fundamental analysts, a company’s actual underlying business doesn’t mean a darn thing. Watch the stock. That’s what counts.

– Originally on Feb 06, 2006 by Jonathan Hoenig

Although 2005 was a relatively flat year for the broad stock indexes, there was plenty of upside in foreign stocks, gold, real estate, energy, utilities technology and even industrial names. You simply had to be quick, agile and more active than buying the major markets and holding out on for the long haul.

It’s a wide world out there beyond the Dow or S&P 500, which is why diversifying among strategies makes perfect sense for all portfolios. While manager A is chasing down one area of the capital markets, manager B could be making money using an entirely different approach.

To that end, it’s worth noting that last year, despite constant scapegoating in the press and the looming threat of new government regulations, hedge funds were still able to outperform the S&P 500. The CSFB/Tremont Hedge Fund Index rose by roughly 6% in 2005, surpassing the widely watched S&P 500. Isn’t it odd that while Bill Miller gets lauded on the cover of Barron’s for barely topping the S&P 500, hedge funds beat it handily and all they get is nasty press and more onerous government oversight?

I’ve been supportive of hedge funds for many years and remain so. For even the most conservative investor, investing in a number of different actively managed hedge funds would be ideal. The approach boils down to diversifying among a series of independent, alpha-seeking portfolio managers to achieve superior, risk-adjusted results regardless of the macroeconomic or market climate. Why is that such a shocking concept for Securities and Exchange Commission do-gooders to accept?

As I’ve written before, government regulation eliminates hedge-fund investing for all but the wealthiest accounts. Yet any investor can benefit from adopting a hedge-fund mentality when putting money to work. It doesn’t necessarily mean buying esoteric instruments, using leverage or trading up a storm; rather, it means taking calculated risks, thinking independently and focusing on absolute return.

First off, successful investors pick their points and focus on taking specific risks. There are plenty of times when even a “dangerous” hedge fund might decide to be less than fully invested. Personally, I don’t understand the overwhelming need to be 100% committed to anything, especially stocks. Many of the best trades are the ones you decide not to make.

Yet even among the sophisticated (read: rich) investors with whom I deal there often exists this highly impulsive, gut-driven mentality that cycles between greed and fear. One moment, clients want to be fully invested, either trading on margin or buying into leveraged bull funds from Rydex or Profunds. Days later, they’re either dumping their entire account and putting the proceeds into CDs or withdrawing hundreds in cash from the ATM just to hold hard currency in hand. Like a pendulum, they swing back and forth between these two extremes. Folks, I’ve been there, and I can attest that bouncing between greed and fear is a tiresome and self-destructive way to run money.

Second comes the ability to think independently — not caring what someone else’s positions are or what they might happen to think about yours. Despite the fact I appear regularly on television and opine frequently in the financial press, I’ve always maintained that the best approach for portfolio mangers is “don’t ask, don’t tell.” The more I speak with other investors about the market, the more I’m likely to be influenced or biased by their opinions. The best decisions are those that are solely prejudiced by the market itself.

And while many investors are resigned to hold onto a plummeting XYZ simply because it’s some white-shoed investment bank’s “top pick” for 2006, a hedge-fund mentality is loyal only to protecting the bottom line. I’ve always been of the mind that in the market or in life, pain is the body’s way of telling us that something’s not right. I don’t ignore my losers; I embrace them. It’s that discomfort that’s the motivating force behind taking the loss and getting me out. When that happens — and it happens to everybody — I try and take a breath and reassess what part of my market outlook is flawed. Am I fading the herd or following it?

Thinking independently also means a willingness to trade in new products or lesser-known securities. I can recall how, back in the early 1990s, many investment pros boasted of demanding “NYSE-only” executions. Too bad they were so myopic. While they were waiting for their fills from the floor in New York, the real gravy was being made on Nasdaq and the ECNs. Also, have you noticed how after years of outperformance that investing overseas has come decidedly into vogue? It certainly wasn’t that case back in 2002, which is why it can pay to look beyond the well-beaten path.

Finally, the best embodiment of the hedge-fund mentality is to focus on absolute — and not relative — return. Indeed, almost six years after the Nasdaq collapse, most investors now realize that making 30% doesn’t mean much if you give back 25% of it the following year. Turns out the real money comes not from having one great quarter or picking one week’s top-performing fund, but from being able to repeatedly compound money over time. From a hedge-fund manager’s perspective, beating some index in any given year isn’t as important as consistently achieving absolute (read: positive) return.

And as 2005 fades into history and 2006 just starts getting underway, that’s exactly what you should focus on. In the months ahead, I’ll unpack the strategies, trades and trends I’m using to successfully navigate the market. It’s my honor to have you along for the ride.

– Originally on Jan 09, 2006 by Jonathan Hoenig

Now, years later, the deutsche mark is gone, replaced by a single European currency used by 400 million people in 22 countries. The euro is the world’s most liquid and actively traded currency behind the U.S. dollar. It’s also the benchmark for a new New York Stock Exchange-listed security that I believe is poised to become a huge success.

Three years ago, I heralded the launch of fixed-income exchange-traded funds as a major breakthrough. More recently, I covered gold ETFs as a huge development in portfolio opportunity. Last week, Rydex Investments introduced the Euro Currency Trust (FXE), a currency-based ETF that trades on the NYSE. Although only recently launched, this landmark innovation represents a major victory for capital-market participants world-wide. That’s why it gets my vote as perhaps the best trade of the new year.

Simply put, this new ETF offers an effortless way to bet on (or against) the euro. Trading under ticker symbol FXE, each share represents 100 euros plus accrued interest. If the euro strengthens relative to the U.S. dollar, then the price of FXE will rise. If the euro weakens, then FXE falls. Because euros held in the fund earn interest, the fund also boasts a dividend (although a portion of the yield will be lost to the 0.4% annual fee paid by investors to the fund’s sponsor, Rydex). The ETF can be sold short or bought on margin, with investors paying a brokerage commission to trade it just like any other similar security. Both the prospectus and fact sheet are worth reviewing.

The opening up of foreign exchange to individual investors represents a landmark achievement. The forex market is huge, trading more than $1.8 trillion each day with a quarter of that occurring between the dollar and euro. Yet unlike equities, forex trading occurs “over the counter” with no centralized marketplace. Most transactions range between $5 million and $50 million, making it impossible for all but the biggest players to participate. Spreads and commissions in the opaque “spot” market are also difficult obstacles to profitably overcome.

Currency futures, while exchange traded and more readily accessible to the retail customer, present their own shortcomings, including the need to constantly roll positions forward as contracts expire. FXE, on the other hand, trades on the NYSE and never expires, so it can be held for as long as a trader’s capital allows.

Like the gold and fixed-income ETFs, FXE democratizes an entire asset class that, for the average investor, was almost impossible to directly participate in. In recent years, foreign-bond funds like Templeton Global Income (GIM) and American Century International Bond (BEGBX) have become popular ways to play a weakening U.S. dollar, although those funds presented additional exposures in the forms of credit and interest-rate risk. FXE offers a “pure play” on the euro and makes getting specific exposure as easy as buying shares in General Electric (GE).

Most of us are familiar with the need to diversify our equity and fixed-income portfolios. Yet the difficulty in playing the dollar has kept us from having to think too much about currency risk — the potential that the value of the dollars in your pocket (or bank account) might fall in value relative to other world currencies. And while there are thousands and thousands of mutual funds that own the same handful of large-cap U.S. stocks, this is one of the few products that allows individual investors to diversify into an entire new asset class.

As I wrote a while back, more than stocks, bonds or any other asset, Americans live, think and breathe in dollars. We hold them in our pockets, and in savings and checking accounts. Our paychecks and bills are paid in dollars. So regardless of your view on the economy or President Bush, most of us are “long” dollars in a big way. This new ETF offers an efficient and easy way to diversify that risk.

For the more active investor, I predict the security will likely become a major trading vehicle. It’s already off to a busy start, averaging roughly 400,000 shares traded a day. Even more notable, the market has been incredibly liquid, with five- to 10-cent spreads and markets 50,000 shares deep. If you ask me, it won’t be long before FXE, not unlike StreetTracks Gold Shares (GLD), will be routinely trading a million shares a day.

Although it has recently weakened, much to Warren Buffett’s dismay, the U.S. dollar mounted a strong recovery against the euro in 2005. (One euro currently equals about $1.20.) Regardless of what 2006 has in store, I believe FXE is on the road to becoming the first of a series of widely successful currency-linked ETFs. Unlike the dozens of copy-cat funds mirroring large-cap benchmarks, the security presents investors of every size an effortless entry into a particularly important yet cumbersome corner of the capital market. It is certainly a ticker to watch in the year ahead.

– Originally on Dec 19, 2005 by Jonathan Hoenig

Fundamental analysts would suggest selling a stock when the company’s prospects begin to deteriorate. When the CFO quits, or the new, whiz-bang product fizzles, or if earnings miss expectations, investors should eliminate the holding from their portfolios. It’s a traditional, quaint and money-losing approach.

A company and its stock are two different things. Because it’s the stock that you trade, the company’s performance should be the least influential part of your decision-making process. It’s the stock — and, more specifically, the stock’s position in your portfolio — that should drive the decision-making process.

Also, as we often point out, fundamental news tends to trail price action, not precede it. This is precisely why investing is called speculation. Once the news is out, it’s usually too late for investors to capitalize on it.

So when do you kick an investment to the curb? One time to consider selling is on those few occasions when an investment has grown to become a dominant part of your portfolio — say 10% to 15% percent. However, even at that point, I don’t advocate indiscriminately dumping shares. I’d stagger some stop-loss orders — predetermined levels below a stock’s current price at which the stock is automatically sold — below the market price. With XYZ at $50, for example, I might opt to sell a third of the position at $46.31 and another third at $43.31. This approach allows me to reduce my risk if the stock weakens, yet remain in the trade should the bullish trend continue.

Of course, such an embarrassment of riches isn’t a frequent occurrence. When it comes to selling an investment, you should be more familiar with tossing the losers than the winners.

Thanks to Martha Stewart, most investors have learned about setting stops. Some people use a percentage decline; others use a particular technical indicator. What matters isn’t the particular strategy you use, but that you use a strategy in the first place. No matter how “risky” or “safe” an investment may be, an experienced trader always predetermines and limits potential losses.

Once a position has become legitimately profitable, by a minimum of 10%, the next goal is to make sure that profit doesn’t turn into a loss. The most natural stop order should rest one “round turn” (the cost of two commissions) above your entry price — essentially at a level that would net a breakeven on the overall trade. As a result of my discipline, I’d estimate that as many as 50% of my total trades end up being scratches. While the profits from a winning trade evaporate, the trade itself — the initial capital investment — never becomes an outright loss.

For most investors, the prospect of missing a chance to grab profits isn’t easy to swallow. It’s my belief, however, that the profit itself isn’t as valuable as the winning position. The most powerful, highly probable place to be in the market is to hold an open winning trade. At any given moment, it’s the one asset the vast majority of players don’t have. Most people hold their losers. Over time, that’s a doomed approach.

Every loss hurts. But there’s something about watching a profit turn into a loss that’s especially painful. All traders deal with the continually haunting echo of “coulda, shoulda, woulda.” But the emotional debilitation of watching a 20% winner turn into a 20% loser will throw off even the most disciplined hand. Unfortunately, it’s a lot easier to say “let it ride” once you’re down on the trade and are desperate to believe that shares are simply “oversold.” That’s rarely the case.

But, of course, you should stop a 20% or 30% loss. There’s no more sense in holding onto XYZ after a 35% decline just because you used to own it at a 25% win.

Case in point: Just take a look at how many portfolios still hold Microsoft (MSFT), Lucent Technologies (LU), Time Warner (TWX) and Sun Microsystems (SUNW) — all the washed up growth stocks from the 1995-2000 bull market. While virtually no investors have made money in these stocks in years, they are still in plenty of portfolios, no doubt in part because we remember buying them at such comparatively high prices. They were winning stocks once — so the belief is that they’ll be winning stocks again. And maybe they will be eventually. But traders must focus on the here and now. In order for Sun Microsystems to regain its 2000 high, the stock has to gain more than 1,500%. It might happen, but probably not in my lifetime.

Another nuance I’ve added to my sell technique over the years is to add a time-stop element to profitable trades. Essentially, I tweak my breakeven stop based on the length of time I’ve held the trade, relative to a cash-equivalent benchmark. The longer I hold a trade, the less I’m willing to let a profit slip away.

For example, say I’ve held XYZ for two years, over which time the stock is up 20%. Estimating the risk-free rate at averaging about 3% over the last two years, the absolute latest I’d be out of the trade would be at 6% above my purchase price. This approach ensures that, although I might lose much of a profit on the trade, the return will still end up at least matching the risk-free rate I would have made sitting on the sidelines.

Naturally, your stops get tighter as time moves along. And although you might not necessarily sell the investment, each year that goes by you quietly move another few dollars into the profit pile.

Not only does this protect a gain, but it also helps to keep capital focused on timely trades. If you’ve held a stock for five years that hasn’t moved significantly beyond your purchase price (or stopped you out along the way), you have to begin to question if the original analysis was correct. This trick keeps returns pegged to at least the risk-free rate, and helps to keep capital from going stale in trendless, go-nowhere trades.

– Originally on Nov 14, 2005 by Jonathan Hoenig

The Bush administration’s follies have helped to animate the efforts of political rivals. Consider the misguided and un-American legislation proposed in recent weeks by Senator Chuck Schumer (D., N.Y.).

Schumer has called for a 50% tax on the profits of oil companies, the money being used to help pay for Hurricane Katrina relief as part of a proposal he has dubbed the REPAIR Act, or Recapture Excess Profits and Invest in Relief. According to Schumer, the largest oil conglomerates might reap $80 billion in windfall profits. “If we took half of that, $40 billion, that could go to Katrina relief, and that would be money taxpayers wouldn’t have to pay,” he said at a recent press conference.

This is socialism. In Schumer’s world, profits earned by law-abiding companies are his to confiscate and dole out as he sees fit. Schumer believes it is his right to rob those who’ve earned a living and redistribute the proceeds to those who have not. “Oil companies who are making excessive profits because of Katrina, and perhaps Rita, should, at the very least, shoulder a share of the burden with taxpayers,” he said.

Why? The oil companies didn’t cause the hurricanes, nor did they dissuade people from insuring their homes. The oil companies didn’t force Americans to buy SUVs that get eight miles to the gallon. All Big Oil has done is provide a safe, reliable commodity to millions of Americans, most of whom, unlike Sen. Schumer, understand that prices shouldn’t be set by Congress, but rather by supply and demand.

Economically speaking, it’s obvious why Schumer’s extortion attempt should be laughed out of Congress. There is no such thing as “excess profit.” Oil doesn’t appear magically out of the ground. Major investment and expenditure are required to extract crude oil, turn it into gasoline and deliver it to your local service station. Big Oil makes money, yes, which is reinvested in its business, developing new technologies, improving infrastructure and paying dividends to shareholders.

The moral case for supporting Big Oil is even more compelling. Oil companies are not owned by the federal government. They are owned by their shareholders and run by managers who have the full right to act in its best interest — not in the interest of a publicity-seeking senator.

In a free market, a company has the right to offer goods or services at whatever price it chooses. Consumers can accept or refuse the price. The fact is, oil companies have earned their profits by providing a useful product that many Americans are happily willing to buy, even at $3 a gallon. By way of comparison, a gallon of White Out would cost you about $254.17.

“Katrina has hurt everybody. There’s only one small group that has benefited — the oil companies,” said Schumer, politicking in front of a gas station. “Why shouldn’t they take some of that benefit and return it?” Well, Senator, because they’ve earned it. Did Schumer offer tax breaks in the mid-1990s, when sub-$20-a-barrel crude prompted Big Oil to undergo major retrenchment and belt tightening? Of course not. That sort of thing doesn’t play well in Poughkeepsie.

If he actually wanted to bring down gas prices, perhaps Schumer should take a look at the taxes paid at the pump. According to the American Petroleum Institute, Schumer’s home state of New York boasts the highest gasoline taxes of any state in the union, with 62.9 cents of tax levied on every gallon.

Schumer has decided that not only is a company’s profit subject to confiscation, but so is the private intellectual property that it has spent hundreds of millions of dollars to create. Earlier this month, Schumer called for the temporary suspension of the patent owned by Swiss pharmaceutical company Roche Holdings covering Tamiflu, which fights the avian flu. Roche’s patent on the drug expires in 2016, but by suspending it, Schumer would allow generic drug manufactures to produce the drug, supposedly adding to supply.

Schumer scolded Roche for “putting profits ahead of world safety.” But while Schumer was busy putting out press releases, it was Roche (or Gilead Sciences (GILD), which in 1996 granted Roche the exclusive rights to manufacture and distribute the drug) that made the effort to produce Tamiflu in the first place.

The government’s job is to protect private property — not to confiscate it for the benefit of the so-called public good. Those who take the time and put forth the effort to create life-saving drugs should be free to profit from them. To suspend Roche’s patent simply because it isn’t providing the drug in a manner that suits Schumer is akin to breaking into the company’s bank account and stealing millions. It’s thievery.

This type of maneuver is old hat for the senator. Four years ago, Schumer pulled a similar stunt with Bayer (BAY), which held the patent on the Anthrax-fighting antibiotic Cipro. In the midst of a national paranoia over Anthrax-tainted mail, Schumer tried to suspend Bayer’s patent on the drug, arguing that “one company should not be able to stand in the way of the health needs of a nation.”

The economic rationale against Schumer’s actions are obvious. Why should investors or drug companies spend billions to develop breakthrough treatments if politicians can effectively steal their secrets just as the value begins to rise? Such a policy discourages development, innovation and research. You’ll note the senator hasn’t been in the private sector since 1974. Perhaps he has forgotten that the profit motive doesn’t work without the profit.

More important is his philosophy. Schumer’s proposals run directly counter to the basic capitalist principles on which this country was founded. The Declaration of Independence presents our rights to life, liberty and the pursuit of happiness as unalienable. They can’t be revoked, suspended or struck down by the majority mob.

Yet that’s exactly what Sen. Schumer seems willing to do. Free trade, for him, exists up to the moment he gets antsy for a photo-op. In an effort to bolster his own public image, Schumer targets large corporations who’ve done nothing more than legally provide goods and services to the free market. He does it all with a smile on his face, claiming to serve the “public good.”

His party and constituents should be ashamed.

– Originally on Oct 31, 2005 by Jonathan Hoenig

There are a million different theories on how to employ stop-loss orders. Some recommend a technical indicator, such as placing stops at the 200-day moving average or trendline support. Others use a percentage stop, selling an investment after it falls, say, 20% below the purchase price or a recent high. As with most disciplines, the key isn’t the approach you choose but rather being able to stick with it.

The main complaint I always hear about stops, and why many traders refuse to use them, is that they believe their stops are indiscriminately targeted by specialists. At the New York Stock Exchange, trading is overseen by firms, known as specialists, that make a market in particular stocks. That involves overseeing trading, matching buyers to sellers, and even buying and selling shares themselves when there are order imbalances. Conspiracy theorists — the same people who believe there was a second shooter in the Kennedy assassination or that rapper Tupac Shakur is still alive — suggest that specialists purposely allow markets to drop to levels where stops get hit, only to then allow prices to rally back almost immediately to previous highs.

I don’t buy it. Specialists are an easy target for our anger when we get washed out of a trade, but the truth is they don’t control a stock’s price. Orders to buy and sell securities are constantly being placed in the market. Some traders use stop orders. Others prefer market orders, which can take place between the investor and a specialist, or between two investors.

Naturally, the market tends to gravitate around the biggest — and thus slowest — wolves in the pack. When I was a floor trader at the Chicago Board of Trade, I learned not to try and force the market, just narrow it a little. Whether it was soybeans or Treasury bonds, us “locals” would observe where large public limit orders were placed, and make their markets around the “paper.” The same notion exists in trading stocks, or in any free market for that matter.

For example, if a big institution places an order to buy 20,000 shares of XYZ at $50.25, then the specialist can sure feel confident about bidding $50.27 for a mere hundred shares. Maybe they get filled, maybe not, but either way they’re able to lean on their knowledge of the 20,000-share buy order. There’s no sure thing in the markets, but an order of that size would help support the market if it rallied, and give the specialists a quick way to easily lay off their exposure if prices fell.

So if the market is bid 20,000 shares at $50.25, then specialists will price their bid off the standing limit order. After all, if I could get filled a few hundred shares at $50.27, then perhaps the 20,000-share buy will turn from limit to market and I can scalp them off at $50.40. Or if I buy XYZ at $50.27 and the market starts to fall, then I know there are 20,000 shares being bid just two cents below where I bought them. That’s plenty of liquidity for me to be able to get out with my measly round lot.

The point is that the specialist is there to add liquidity, not to prevent volatility. You can’t rely on the specialist to prevent a drop in price of any stock, especially thinly traded ones. Just because a stock is trading at $50 a share doesn’t mean the specialist should have to buy 10 million shares at $49.99 if the highest public order is at $49.01. The specialist trades around public orders by improving the market, not controlling it.

Markets are unpredictable. If a stock breaks sharply lower and stops me out, then I live with it. And if the stock rallies back and I’m still bullish on the trade, then I’ll usually end up getting back in. Experienced traders know that’s not collusion — just the cost of doing business. After all, similar moves very often occur in Nasdaq stocks, where there’s no specialist at all. (Computers, not people, match buy and sell orders on the Nasdaq.)

The real reason for a stop isn’t to save you a few cents on a trade, but to act as a risk-control mechanism for those occasions when a large trend shift might be underway. With XYZ at $50, I don’t care how promising the company’s prospects might be. Chances are, your stop at $49 is going to hit. Stocks fluctuate; that’s what they do. But with XYZ at $50, a slide to $43.28 — a drop of about 13% — would indicate a greater likelihood that a major trend change is in the process of occurring. If so, then it makes sense to place a stop somewhere around that level.

One technique I use when placing stop orders is to avoid round, or what I think of as “simple,” numbers. In the market, the public tends to generally act as a herd, even when trying to be unique. Plenty of folks, especially the herd that we so desperately seek to avoid, tend to choose the most painfully obvious numbers when setting their stops.

So if XYZ is at $32.22, then they’ll put a stop at $30, or maybe $30.50. Both are big, round numbers. After years of watching stocks gravitate toward those “obvious” prices, I’m downright certain it’s because those are the favorites of lazy, nonprofessional traders. There’s plenty of scholarly research to support the hypothesis. A 2003 study by academics David Ikenberry and James Weston concluded that “investors appear to be naturally drawn to certain prominent numbers when faced with making decisions under general uncertainty.” Their research indicates that, roughly 48% of the time, the last digit of the closing price of U.S. stocks is either “0″ or “5.” It’s just psychologically easier to place orders for $30.00 or $30.25 than $29.93.

When picking the placement of stop orders, my technique is to incorporate a little bit of chance. I start where I’d initially think to set the stop and end up widening it based on a random number. So let’s say XYZ is trading at $32.22, and I wanted to set a 10% stop. Seeking to avoid obvious numbers, I wouldn’t leave my stop at $29.00, even though that would constitute a 10% decline. Rather, $29.00 would become my starting point. But to achieve the exact stop price, I’d literally roll the dice to find two individual random numbers. Let’s say I roll 7 and 1. My new stop would be at $28.71. That’s much less obvious, thus making my trade less likely to be grouped in with the herd’s.

It’s not a foolproof approach, but the truth is that we are creatures of habit. Using a set discipline in strategically setting the stop, yet allowing the final determination to be chosen by a randomizing event, is a unique way of regulating your risk while hopefully steering clear of the slow-moving public.

– Originally on Oct 24, 2005 by Jonathan Hoenig

Why should bulls want to see fear? While it’s uncomfortable to experience, when it comes to stocks fear is a great contrarian indicator. In the market, significant fear usually marks a reversal. By the time we get fearful, it’s usually too late to capitalize on the trend that prompted our concern. So if today’s markets were exhibiting more signs of fright, a bullish argument could be made that the major indexes’ fortunes were close to turning. As I’ll outline in a moment, I have yet to see any indication that’s occurred.

Let’s review a bit of the damage that’s transpired recently. Since the beginning of October, stocks across the board have weakened, quickly slipping from the summer highs that saw the Dow near 10700 and the S&P at 1240. Year-to-date, all major indexes are now firmly in the red, with the S&P 500 down 2%, the Dow off 4.6%, and the Nasdaq 5% lower. Leading the way downward have been many widely held financial stocks, with JP Morgan Chase (JPM) and Bank of America (BAC) both lower more than 10%, and mortgage lender Fannie Mae (FNM) off by more than 35%. Dow 10,000, last nipped in mid-April, once again looks well within the market’s immediate reach.

While stocks have been falling, interest rates, both short and longer term, have made demonstrable progress higher. The five-year Treasury now yields 4.3%, nearing levels not seen since 2002. The yield on the 10-year bond, stuck in a range between 4.0% and 4.5% for more than two years, now appears ready to challenge the upper ceiling of that range. Money-market funds that paid under 1% 18 months ago now yield 3% or more. As I wrote last week, cash is no longer trash.

Bonds of the auto makers, namely Ford Motor (F) and General Motors (GM), have been rocked in recent days, with the yield on their debt now well into the double digits usually reserved for risky banana republics or bankrupt debtors. And we’re still watching the implosion of derivatives broker Refco (RFX), whose bonds now trade at 29 cents on the dollar, and whose market capitalization has dropped by a cool $2 billion in just a week’s time.

Even with recent consolidation, energy prices are still sharply higher year-to-date, and the Reuters CRB index is resting near peaks not seen since the early 1980s. Gold, often cited as a “safe haven” during economic turmoil, isn’t far from 18-year highs.

Indeed, judging from the capital markets there’s plenty of reasons to be fearful. Yet there’s scant evidence that the market has yet really experienced the fright that would prompt one to believe a bullish reversal is underway.

Take, for instance, the CBOE Volatility Index, known as the VIX, the widely followed indicator that, since its introduction in 1993, has come to be known as the “fear gauge.” The VIX measures market expectation of near-term volatility conveyed by stock index option prices. Since 2003, the VIX has been calculated using options on the S&P 500, although the original VIX (still calculated on some trading platforms under symbol VXO) used options on the S&P 100. The principle is still the same: During periods of financial uncertainty, the VIX tends to rise; the greater the fear, the higher the VIX level. Because there’s more data available, for the purposes of illustration, I’ve chosen to look at the original VIX.

From 1997 to 2003, the original VIX rarely dipped below 20 and experienced several spikes above 40, including the Sept. 11, 2001, attacks that prompted a move above 50. Since 2003, however, directionless markets, along with an increased interest in selling option premium, have prompted volatility to drop. This summer, the index dipped below 10, not far from an all-time low. And while fear is up slightly in recent weeks with the original VIX touching 17, from a historical perspective it remains quite low.

The same complacency is evident in technology stocks, as illustrated by even a cursory glance at the CBOE Nasdaq Volatility Index, or VXN. Calculated using the same methodology as the VIX, the VXN represents the implied volatility on the Nasdaq 100, giving traders a quick-glace indication of the fear being priced into tech. Once again, with the VXN near 17 we can see that fear has climbed slightly in recent weeks, but is still nowhere near the 40, 50 and 60 levels seen through most of the early 2000s.

When we get scared, we sell stock. To that end, another fear indicator worth noting is the cash level of equity mutual funds, which gives an immediate snapshot of how fully invested (and thus, bullish) active stock-fund managers happen to be. The data are published monthly by the Investment Company Institute, a mutual-fund industry trade group.

In the mid to late 1980s, the ratio rested in the high single digits, with mutual-fund managers routinely holding 9% to 10% of their portfolios in cash. It peaked at the height of the early 1990s recession, with 11.4% of assets sidelined in cash. In recent years, professionals have held significantly less cash, and besides a bump higher after the 2000 market rout, cash levels have again dropped, now scraping multiyear lows under 4%.

This tells me that, despite the weak markets and worrisome economic indicators, most active mutual-fund managers aren’t yet frightened enough to raise the amount of cash held in their portfolios. It also suggests there isn’t a great deal of buying power waiting in the wings to support stock prices should they continue their recent decline.

And if that doesn’t worry you, well, maybe it should.

– Originally on Oct 17, 2005 by Jonathan Hoenig

There’s always a bull market somewhere in the world. But there are plenty of times when a trader should consider being less than fully invested — that is, to know when not to fight.

At any given moment, even after-hours or overnight, traders consciously decide which risks, if any, they wish to bear. I certainly empathize with owners of Delphi (DPH) stock, Worldcom (MCI) options or Northwest Airlines (NWB) bonds, but let’s not forget there is no constitutional obligation to hold them in a portfolio. Successful traders bet only on situations in which they believe the odds are in their favor. The golden rule: When in doubt, stay out.

The trades you should avoid like the plague are whims, distractions or trades made “for fun.” Friends, don’t trade for fun — trade for money. The positions I put on when I feel bored are almost always guaranteed to wreak havoc on my bottom line.

Because many of us are motivated by the excitement of uncertainty, we naturally end up taking foolish, stupid, low-probability trades. An IPO comes out and we buy a few thousands shares, hoping to ride a point or two of the first-day-pop. Or a reinsurance stock drops after hurricane damage is released and we sell a few puts for amusement and the thrill of making 50 cents on the dead cat bounce. Or the market opens sharply lower, and we buy a couple of e-mini futures in an attempt to jump out as quickly as we jump in. I’ve never had much luck with any of these impulsive, whimsical trades.

*Doubtful Trades*

# Trades made “for fun.”
# Positions held in lieu of cash.
# Poorly sized positions, bad technique.
# Losing positions, regardless of fundamentals.

Every brokerage account in the world comes standard with a cash or money market account in which to hold assets waiting to be invested. Yet even when faced with losing, doubtful or low probability trades, many investors avoid exiting a position simply because they don’t know where to put the proceeds. They are bizarrely uncomfortable with the idea of holding cash because, in their words, their money isn’t “doing anything.”

Unlike milk or bread, money doesn’t go stale if not used within a few weeks. The decision to sell one investment is totally separate from the decision to buy a different one. If it’s time to exit a trade and there are no new opportunities that catch your eye, simply keep the money in cash and wait for greener pastures to appear.

Consider that, even if you got stopped out of your positions in mid-2000 and sat on cash for three years, you would have still outperformed the vast majority of fund managers who fought a bear market because they felt they had to be invested in something. When you can’t find anything that meets your purchase criteria, it’s better to go to the beach than to park your assets in a subpar trade.

Moreover, holding cash has become a lot more palatable lately thanks to the persistent rise of short-term interest rates, which now offer richer yields than the dividends paid by many widely held, large-cap stocks. According to Bankrate.com, the average yield on money market accounts is now 2.26%, roughly double from where rates stood through most of 2004. Shop around to find a high yielding money market mutual fund, and the payouts get even juicier. For example, the Payden Bunker Hill Money Market fund (PBHXX) currently sports a seven-day effective yield of 3.46%, almost a full percentage point higher than the dividend yield on General Electric (GE). The Vanguard Prime Money fund (VMMXX) isn’t far behind with a 3.44% current yield, roughly 2.5% greater than the annual dividend being paid by IBM (IBM). For the first time in a long time, cash ain’t trash.

When buying XYZ, a little nervousness is healthy. But if I’m doubtful about the way I’m buying it — if I can objectively say the trade is recklessly sized or weighted — I’m much more apt to move to the sidelines quickly and reassess the situation. For example, you might feel skittish in buying shares of streetTRACKS Gold Shares (GLD) — after all, gold has had a huge run lately and could be seen as overbought. What should prompt doubt, however, isn’t necessarily the stock, but your position in it. Are you trading a 5% position, or 15%? Are you using a “mental stop” or a real one? Are you making a bet, or betting the farm? Traders who over-leverage or under-diversify their portfolio will face eventual ruin, no matter how savvy their stock picking might be.

Finally, as I always point out, the best indicators come from the market itself. Nothing should raise your level of doubt in a particular trade as much as how it’s acting once you’re in it. Generally speaking, it’s the losers that should be escorted to the door.

Yet when the fundamentals are bright and the analysts are cheery, many investors are content to hold on to loses month after month, even though the price action isn’t confirming their investment hypothesis. Bottom line? Projections and analysts are often wrong, but the market never lies.

If you’re bullish on XYZ, fine, be bullish and buy XYZ. But harbor some doubt about your timing. When the market isn’t confirming my bullish outlook, I’m inclined to find a way to exit the position. Losses prompt doubt. And doubt gets me out.

– Originally on Oct 10, 2005 by Jonathan Hoenig

There was a time in the 1990s when the thought of investing in anything other than Cisco Systems (CSCO), Microsoft (MSFT) or the major U.S. markets would’ve seemed downright daffy. Foreign stocks? Commodities? Small caps? Who needed ‘em when Sun Microsystems (SUNW) and the S&P 500 went up a tidy 20% every couple of months.

But in the markets, change is the only constant. And while American shares have long been the locomotive that pulled the world’s train along, lately they’ve been more like the caboose. Right now, the market seems to be showing a preference for most anything besides U.S. stocks. Because equity markets are the best gauge of economic growth that we’ve got, this underperformance bodes ill for both America and its currency.

The biggest fear most people have when putting money into a market is a dramatic, 1987-style crash. It’s a largely irrational fear: The Nasdaq didn’t go from 5000 to 1130 overnight, nor did Nikkei. It took roughly 14 years for the Japanese market to drop from 39000 to 7600, while the rest of the world, especially the U.S., steadily passed it by. U.S. markets aren’t plummeting, it’s true, but the truth is that it’s the slow, trendless markets that are usually even more dangerous than the massive one-day drops.

And while American shares have been largely stagnant this year, world-wide shares are leading the charge higher. The Dow, Nasdaq and S&P 500 are anywhere from 10% to 58% off their record peaks. Meanwhile, stocks all over the world — in New Zealand, Australia, South Africa, Vietnam, Saudi Arabia, Brazil, South Korea and India — are at or near their all-time highs. You can’t just write off stocks as a weak asset class nowadays. The fact is that equities in general do have a bid. The only problem is they don’t have bid here in America.

Stocks are hot, but so are hard assets, which doesn’t bode particularly well for the dollar, of which we’ve grown very accustomed to being a strong and secure store of value. Along with the widely reported record prices in oil and natural gas, various metals have also shot higher lately. Copper and platinum, for instance, aren’t far off from record highs and gold, bullishly profiled in this space last month, has now outpaced the Dow by a cool 11% year-to-date. Gold has usually been thought of as a novelty or diversification, but talk to someone who’s lived through currency devaluation, and they’ll swear by it as their core holding.

And what of U.S. stocks? While energy shares continue their bull run, many other widely owned domestic names appear downright sick. Fannie Mae (FNM) and Freddie Mac (FRE), along with every mortgage REIT under the sun, look like death — not a huge vote of confidence in the housing boom that’s helped propel the economy forward in recent years. Several Dow components like DuPont (DD), International Paper (IP) and Wal-Mart Stores (WMT), names you’d expect to prosper in the face of economic growth, are instead plumbing multiyear lows. It’s the same story for many bank stocks. Bank of America (BAC) and JP Morgan Chase (JPM), two widely owned benchmarks, have lost much of their oomph lately. The most successful domestic plays have come from betting on a few winning sectors like utilities and energy, or by using option-writing programs that benefit from flat or trendless markets. Considering how many other equity markets are sharply higher, that’s not exactly a major vote of confidence in the good ol’ US of A.

How to approach such an uncertain market? As I wrote last week, before taking new positions, the best course is to deal with the ones you already have. And when it comes to existing, winning positions, your instinct should always be to preserve gains rather than take them. Stocks discussed in this space that I hold at a gain, such as Warner Music Group (WMG) and MarketAxess (MKTX) will be kept. Same goes for my positions in several utilities, especially the international ones like Brazil’s CPFL Energia (CPL) and Chile’s Enersis (ENI).

In addition, I’ve added exposure to a few areas that, despite the last of a clear fundamental story, appear to be on the verge of showing new leadership. The metals boom has benefited gold and copper shares such as Glamis Gold (GLG), Goldcorp (GG) and Freeport McMoRan Copper & Gold (FCX), so I’m again dipping my toe back into the palladium market. Regular readers will recall that the white metal was a winning trade a couple of years back, and if current trends persist, palladium operators like Stillwater Mining (SWC) and North American Palladium (PAL) could end up big winners again. Of course, the usual bevy of risk factors, including lack of liquidity, should be considered before putting money to work.

I love this country dearly. But despite my devout patriotism, I’m objectively ready to accept the notion that, for whatever reason, the U.S. might not be the economic leader in the future that it has been in the past. Just as we couldn’t think of sending our money overseas in the 1990s, in this century, we might not imagine doing otherwise. If the commodities boom ends up a harbinger for a weak U.S. dollar, then holding metals plays like StreetTracks Gold Trust (GLD) or iShares Comex Gold (IAU) might become as common as Time Warner (TWX) or General Electric (GE).

The point is that everything is on the table. Successful traders should keep their eyes open, their heads down, and be ready to expect the unexpected.

– Originally on Oct 03, 2005 by Jonathan Hoenig

Getting out of a trade, especially at a loss, can be an enormously difficult trigger to pull. Equally thorny is simply standing pat and having the patience to let the market move unfold. Yet knowing when to hold ‘em and when to fold ‘em forms the basic framework on which successful portfolio management is built.

Forget Sharpe ratios and exotic options techniques. In trading, there’s nothing new under the sun. The golden rule — cut your losers and let your winners run — hasn’t changed since the beginning of time. And when following up on a trade, that’s precisely the philosophy that you should engage. Winners are preserved. Losers get kicked to the curb. End of story.

I moved quite a bit of money around this summer, so it’s worth following up on some recent columns to best illustrate how, even in this brave new world, the old saws still apply.

While I had high hopes for getting back in the saddle, right now it appears my return to floating-rate funds was a bit premature. Despite their monthly dividends and compelling fundamental story, I must be objective enough to admit that the price action has weakened. Trades that were once green with profit are now bathed in red.

That’s the only indicator I need to prompt me to make a change. Because while the investment hypothesis is still intact, it’s the market that should influence trades. Whether it’s Enron’s implosion or the dollar’s decline, the story almost only comes out after the real move has been made. For now, I’ve once again left most of my positions in this asset class behind.

Of course, taking a loss hurts. And if not approached with the proper perspective, the emotional toil of dealing with a loser can derail an entire investment program. For years, after selling a loser, I’d beat myself up, questioning how I could’ve been so stupid as to buy XYZ right before a precipitous decline. And it’s at those moments, when morale is weakened, that trading discipline can easily go straight down the tubes. Because we want to be right, because we want to win, our ego can’t stand the reality that, at least this time around, we’re wrong.

In a frantic gasp to “get even,” we recklessly double down or start day-trading the Nasdaq 100 (QQQQ) — anything to avoid dealing with the painful reality that we lost money on the trade. Friends, I’ve been down that road, and I promise you that it ends only in even more severe — usually cataclysmic — losses.

So instead of chastising yourself for having a loser, it’s a heck of a lot more productive — and profitable — to simply take the loss, remove the ticker from your trading screen, and move on to another idea. Every wrecked portfolio started with a small loss and a stubborn trader who just had to be right.

While not every trade will be a winner, put enough lures in the water and eventually you’ll get a bite. Thankfully, I’ve had a few, with most of the other ideas I’ve put forth lately having fared much better than the unprofitable foray into floating-rate funds. Gold bullion, which I bought into in August, is up roughly 5%. And of the three recent initial public offerings that I profiled a month back — MarketAxess Holdings (MKTX), Warner Music Group (WMG) and Stonemor Partners (STON) — two are in the winner’s column so far. MarketAxess has climbed 30% since Aug. 22, and Warner is up more than 6%. Stonemor, like the S&P 500 index, has traded flat over the past month.

And how am I following up the winning positions? As a trader, what am I doing to maximize my profit potential? Nothing. I’m doing absolutely nothing at all.

I’m not selling covered calls or scalping around the trades. I’m not taking a quick profit and planning to buy back the positions a few bucks lower. I’m not scouring the message boards or Securities and Exchange Commission filings looking for a reason to jump ship.

The quiet secret of investment success is that too often the best move is no move at all. When you have a winner on, it’s usually just sitting on your hands and having the patience to let a trade run its course that produces the best results.

Yet letting the winners run can be even more difficult than cutting the losers. As traders, we’re anxious to win. We crave success. And there’s nothing as satisfying as taking a position, watching it climb and then making the cash register ring. The feeling puts sex and drugs to shame.

But provided it hasn’t grown to dominate your overall portfolio, the proper way to follow up a winning trade is to let it be. Just as taking a loss stops a loss from growing, taking a profit kills a portfolio’s profit engine right in its tracks. Just consider how many people sold Microsoft (MSFT), Cisco Systems (CSCO), Sun Microsystems (SUNW) or CMGI (CMGI) during their growth spurts because they had made a nice 15% to 20% profit, only to watch the stocks spiral skyward by thousands of percent?

The old lessons are still the best. And after taking a position I follow up by worrying about the losers — usually finding a way to cut them short and move on. The winners I try and leave well enough alone. They tend to take care of themselves.

Investing is a messy affair, with even the best ideas and most well-conceived trades often not working out. Every trader has the occasional loser; the successful ones are those disciplined enough to follow the rules. Clip the losers and allow winning trades to run, and over time you’ll make money. And while both the professional and the amateur know the rules, it’s the pro who actually follows them. That’s precisely what makes him the pro.

– Originally on Sep 26, 2005 by Jonathan Hoenig

After all the debris, sewage, waste and wreckage is cleaned up, a good chunk of the $100 billion rebuilding effort will go toward the region’s infrastructure, much of which was demolished in the hurricane and subsequent flooding.

Infrastructure businesses are the skeletons of economic activity, the essential things we use everyday but don’t think much about. Generally, they’re assets where a natural or near-natural monopoly exists, such as a toll road or power grid. Parking lots, water utilities, roads and airports, even cellphone towers are all considered infrastructure assets.

The appeal of infrastructure investment is obvious. High barriers to entry make direct competition difficult to impossible. Imagine the cost of building a new airport to compete with an existing one. Plus, the assets are all physical and localized — you can’t outsource a toll road to India, or use the Internet to offer cut-rate pricing on a gas pipeline. This makes infrastructure assets much less susceptible to the natural competition faced in almost every other industry.

Because infrastructure assets are economic necessities, have highly predictable revenue streams and require huge capital expenditures to build, they can provide excellent long-term income with reasonably low volatility. Although infrastructure assets are usually highly regulated, user fees for businesses such as toll roads or airport parking can be raised, making the asset class comparatively well-insulated from inflation.

In recent years, in almost every country besides the U.S., there has been a trend of government privatization of big-ticket infrastructure assets. In the U.S., however, most infrastructure assets are still owned by government-related entities. LaGuardia Airport, for example, is owned and operated by the Port Authority of New York and New Jersey. In contrast, Auckland Airport, New Zealand’s largest, is owned by a public company that’s actively traded on the New Zealand stock exchange. American investors, therefore, are relatively unaccustomed to the notion that, from toll roads to hydroelectric dams, large infrastructure assets can be attractive investment vehicles.

The international leader in infrastructure investments is Macquarie Bank, a fast-growing, $10 billion Australian company that has almost single-handedly spearheaded a major market expansion of infrastructure as an asset class. Typically, Macquarie buys a collection of infrastructure investments, bundles them into a fund, and sells them to yield-hungry investors anxious for predictable dividends and stable returns.

A few examples of its funds include the A$7.1 billion Macquarie Infrastructure Group (ASX: MIG), one of the largest private developers of toll roads in the world with 12 of them across six countries. Macquarie Airports (ASX: MAP), also listed in Australia, owns interests in airports in Sydney (Australia), Rome (Italy), Copenhagen (Denmark), Birmingham and Bristol (both U.K.). Macquarie Communications (ASX: MCG) invests in communications infrastructure such as satellites, broadcast and wireless towers. Shares have risen more than 50% during the past 12 months.

Unfortunately, the vast majority of the firm’s infrastructure funds trade only in Australia, making them essentially unavailable for U.S. investors. Only three of the bank’s vehicles are directly listed in the U.S. Despite the recently renewed strength in U.S. equity markets, savvy traders — especially those focused on income — might consider including them as part of a diversified, global portfolio.

When we first profiled the Macquarie/First Trust Global Infrastructure/Utilities Dividend and Income fund (MFD) last fall, the fund traded at a cavernous 12% discount to its underlying net-asset value. Since that time, the discount has been cut to around 8%, with shares rising some 20%.

True to its name, the fund invests primarily in utilities and pipelines, both of which have been exceptionally strong amid an environment of rising energy prices. Foreign assets are emphasized, with less than 10% of the fund’s holdings domiciled in the U.S. Many holdings, such as the U.K.’s AWG plc and Kelda Group plc, are unavailable to U.S. investors as American depositary receipts.

Also benefiting the portfolio: a 26% allocation to senior secured loans, an asset class in which I re-established positions last July, along with Canadian income trusts like Northland Power Income fund (NPIFF) and the Consumer’s Waterheater Income fund (TSX: CWI.UN), which have responded favorably to higher commodity prices. At a recent $23.21, the fund sports a yield of 5.69%.

For a true pure-play on infrastructure assets, U.S. investors should consider Macquarie Infrastructure (MIC), a trust that owns a diversified group of infrastructure businesses world-wide. Launched in December 2004, the company pays quarterly dividends and currently sports a yield of 7.08%. Like other infrastructure assets, MIC tends to be uncorrelated to major U.S. stock indexes, making it an ideal diversification for portfolios heavy on equities and short on income.

Among the company’s assets are a 50% interest in Yorkshire Link, a 19-mile highway in England, and Macquarie Parking, which, with more than 32,000 spaces, is the largest provider of off-airport parking in the U.S. Other holdings include Thermal Chicago, which operates the country’s largest district cooling system, a British water utility and a position in the aforementioned Macquarie Communications Infrastructure Group, which owns 600 transmission sites located across Australia. Still expanding, the company announced plans last month to acquire 100% of Hawaii Gas Utility, the island’s only full-service gas energy company, for $238 million.

The Macquarie Global Infrastructure Total Return fund (MGU), a newly organized closed-end fund trading on the New York Stock Exchange, came public less than a month ago. According to the prospectus, the majority of the fund’s assets are to be invested in the publicly traded securities of global infrastructure assets, with up to 15% of assets being pledged to unlisted infrastructure securities. In an effort to increase total return, the fund can also write call options against existing positions to generate premium income, a strategy that has worked well in recent, relatively trendless markets.

I’m bullish on infrastructure. But given the fact that MGU hasn’t yet disclosed its portfolio or dividend, I’d call this one to watch rather than one to run out and buy. ETFconnect.com, run by Nuveen Investments, remains the web’s best source for detailed information on closed-end funds.

– Originally on Sep 12, 2005 by Jonathan Hoenig

Trading, however, is one of the few activities in which more is not always better. If you want to make money, trading more positions more frequently and with more leverage is hardly a stellar strategy. The opposite — fewer positions, fewer trades, less leverage — often yields considerably better results.

Today’s international markets trade around the clock, offering more opportunity than one individual would ever be able to capitalize on. But what many investors, especially the most competitive, often forget is that to be successful, one need not master the market, but only catch some of its waves along the way.

In our fantasy we buy every bottom and sell every top, but here in the real world, it’s the middle 60%, not the bottom and top 20%, where the real money is made. Some people like to think that returns can be improved by trying to milk a trade to the last drop. In my experience, however, results improved dramatically once I began to focus on grabbing a big fat chunk out of the middle — avoiding a trade’s early and late stages.

Because the big money is made on the big moves, it’s the most dominant trends that offer investors the highest probability of success. A 10% pop in Taser International (TASR) or CMGI (CMGI) might warrant a bulletin on Briefing.com, but it doesn’t do much for your bottom line unless you’ve already established a sizable position. A real bull market, where valuations significantly expand, offers the best chance to grab a meaningful return. Big trends, in fact, often give you several opportunities to make money.

So even if you missed the “original” Internet bubble back in 1995, from roughly 1996 to 2000, you could have owned anything remotely tech-related and made money. From software to peripherals, communications equipment to semiconductors — all of them had their day. More recently, we’ve seen how the bull market in energy prices has benefited the entire field of related companies, from master limited partnerships to utilities.

The point is that, in order to make money, you needn’t catch every bottom or sell every top — it’s the middle 60% of a trend where the real money is made. By focusing on dominant trends in major bull markets, you can put the probability of success squarely on your side.

It’s a major falsehood that the more you invest, the more you make. In reality, it often makes perfect sense to be less than fully committed. Like an actor between movies, sometimes there’s simply nothing for a trader to do but wait. When you feel yourself stretching for investment ideas, the best step is to sit on your hands.

Of course, it’s easy to get distracted. And with an overload of stock market information, many traders, like caged parakeets, are drawn to make instinctual “buy, sell or hold” calls for almost any stock under the sun. From Freddie Mac (FRE) to Freeport McMoran (MCX), Citigroup (C) to China Yuchai (CYD), they have an opinion and comment on every investment on the board.

I don’t have opinions — I have positions. Because traders can’t have bets on everything, they must focus attention on only what they believe to be the highest-probability trades available. At any given time, I have a small list of perhaps three to six ideas that I’m observing or carrying out. Excess cash stays in cash.

As I wrote last year, cash, like gold, seems to inspire all-or-nothing thinking. People are either leveraged to the hilt in the Energy Select SPDR (XLE) or completely in cash with nary a stock in sight. Worse off, they begin making sell decisions based solely on whether they’ve got an appealing new trade. So they buy XYZ at 30 and it falls to 25, but they hesitate in getting out. Why? Because they don’t have any clue where they’d put the proceeds from their sale.

Finally, when it comes making money, you’re best served not by trying to target big returns but by limiting large losses. The most unfashionable secret on Wall Street is how substantial profit can be achieved not from one great trade or stock pick, but from consistent compound interest — what Benjamin Franklin called the “eighth wonder of the world.”

It’s a fact that money, when allowed to compound over time, will grow exponentially even at moderate levels of return. The trick is to keep the losses small, because drawdowns not only sap your capital, but also waste the irreplaceable time over which your money is able to multiply.

To that end, one has to cringe on behalf of investors in mutual funds whose long-term track records offer astonishingly dismal returns. Take, for example, the USAA Growth Fund (USAAX), a $933 million portfolio often recommend by financial advisers as a core holding. The fund’s 4.7% return year-to-date soundly beats major indexes. But shareholders aiming to compound their money over time have achieved less success. Over the past 10 years, the fund’s annualized return shrinks to 32%.

It’s a similar story for the Phoenix Capital Growth Fund (PHGRX), a $623 million fund whose inception dates back to the late 1960s. Year-to-date, the fund has nearly broken even, but large losses over the years have made substantial compounding practically impossible. And while its web site cautions that an investment is “appropriate for long-term investors who seek capital appreciation and can accept the higher risk associated with investing in the stock market,” one can’t help but note that the unmanaged Dow Jones Industrials are up roughly 130% over the past 10 years, yet Phoenix Capital Growth’s annual average return over the same period doesn’t even break 15%.

So don’t focus on targeting an upside return — limit the potential for catastrophic, double-digit loss. Lose 10% of your portfolio, and you’ll need only an 11% gain to recover. But a 25% or 30% drawdown of your entire portfolio’s value creates a mathematical abyss from which it’s exceedingly difficult to recover. A 35% loss, for example, would require an almost 54% return to get back to even. Given the uncertainty of capital markets, that’s a mountain investors big and small should avoid being compelled to climb.

– Originally on Aug 16, 2005 by Jonathan Hoenig

Emotions are not tools of cognition. So in managing a portfolio, you can’t act solely on what you feel; rather, you have to act based on what you think about what you observe. Save the tears and anger for a therapy session after the market closes.

As a young clerk at the Chicago Mercantile Exchange, I was always impressed with how, no matter what his profits and losses looked like for the day, the “local” I worked for was able to maintain the same, dispassionate demeanor in the pit. Regardless if he was up 50 ticks or severely in the hole, his disposition never changed. Beyond his market sense, an integral part of his professional skill was being able to ride the emotional highs and lows. This guy would make $30,000 in an hour and not even crack a smile, or be down more than double that and barely break a sweat.

Off the floor, many large trading firms now employ automated, or so-called black box, investing systems. Strategists input parameters for buying and selling into a computer and turn the microprocessors loose on the market. While I don’t use such an approach myself, I am cognizant that we as individual traders must be equally disciplined, emotionally cold and unwavering in both good and bad times.

Sometimes it seems as if we have the golden touch. From small caps to large caps, mutual funds to bonds, everything on the board starts moving our way. Profits are generous, and the high is intense. And when the money is flying in, it’s our emotion that dupes us into believing the good times will never end. (Note to self: They always do.) Through the fantasy haze of a convertible Mercedes or new plasma TV bought with a stock-market score, we often miss the forest for the trees.

And when a big idea comes along and really pays off, we too often end up falling in love. Regardless if it’s gold, bonds or even utilities, we become emotionally attached to what are, in reality, slips of paper we’ll never even see.

So don’t personify stocks; objectify them. A stock shouldn’t be your spouse, your buddy or your friend. You’re in a business and investments are your merchandise. Keep them on the shelves as long as they sell, but once the product stops moving, mark it down and get it out the door. As I’ve written before, I keep a pile of worthless stock certificates on my desk to remind myself that no investment is too sacred not to one day be kicked to the curb.

One way to avoid getting emotionally involved with winning trades is to focus on ticker symbols and prices only — end of story. I know far too many investors who wouldn’t dream of selling Apple Computer (AAPL) simply because they have an emotional connection to their iPods. Intellectually, we all know that a stock and a company are two different things. I also try to avoid annual-report conference calls with management, or anything else that might emotionally tie me into one particular name.

Of course, we mustn’t only learn to manage our emotions during profitable periods, but during those all too often times when the losses far outweigh the gains.

As I’ve written before, there’s no pain like the pain of losing money in the market. The inescapable pangs of sadness, self-loathing and rage are among the rawest emotions you’ll ever feel. But in the market, emotions are a liability. And when you’re losing money, they can become very costly.

Shortly put, you have to keep your cool. Emotional outbursts obscure the fact that losses are a normal and regular part of any trader’s routine. No one likes them, yet we must learn to deal with them. Getting emotional only makes a tough problem worse.

I’ve seen it before. Getting emotional when you lose is often accompanied by self-destructiveness, with traders punishing themselves through reckless trading, alcoholism, drug abuse and even violence. Indeed, the market doesn’t hang us. We do it to ourselves when we get so emotionally vested in any one stock or trade.

If a loss is such a psychologically devastating and unholy occurrence as to require a temper tantrum, then how rationally do you suppose we approach it in our portfolio? Indeed, emotions make your trading discipline disappear. So when you buy XYZ at 50 and it falls to 42, instead of walking away it’s our emotions that persuade us to double down, sell options or start day-trading the Nasdaq-100 Trust (QQQQ). We can’t stand the pain of being wrong, so we insist on being right. And nobody is right all of the time.

Alternatively, the self-loathing that comes with having made a bad decision in the market prompts many people to avoid taking a loss. So they bought XYZ at 50 and it falls to 42, but instead of walking away they hold on, stubbornly ready to go down with the ship. Even if you bought Pets.com, Exodus, Enron, WorldCom and Adelphia at their all-time peaks, provided you had a sell discipline you wouldn’t have ended up riding them all the way into the toilet. Emotions remove that self-control and sacrifice that constraint.

So start by consciously separating the emotion from the cognition. The fact we feel strongly about a stock, having researched the fundamentals, listened to the conference call and read the annual report, doesn’t determine how the trade plays out at all. Duke Energy (DUK) isn’t going to be affected one bit by how many staplers I chuck or garbage cans I kick.

What should guide our approach to XYZ isn’t how we feel about it, but how it’s acting. So once the trade is made, I don’t inquire as to every analyst’s opinion or even closely follow the company’s news. I’m in the position, my risk is defined, and the rest is up to the market and out of my control. To get angry and emotional just because a stock didn’t go my way is a complete waste of time and energy. I must add that it’s also rather uncouth.

Emotions, in both good times and bad, can wreak havoc on a portfolio. Emotions don’t shape your judgment, they distort it. Experienced traders, therefore, are skilled at not only observing investments, but distancing themselves from caring too deeply about them. And by smoothing out the emotional highs and lows, you’re more easily able to keep a portfolio on course in both calm and choppy waters.

– Originally on Aug 01, 2005 by Jonathan Hoenig

And although I’ve bought my share of sour stocks, once in a while I’m fortunate enough to come up with a few winners as well. While I’d love every investment to show a profit, you only need a handful of smart ideas each year to put together a respectable return.

So far this year, one of my best-performing trades has been in utilities, a sector that’s shown exceptional strength since I started pounding the table last fall. As regular readers, along with those who watch me on Fox News Channel’s “Cashin’ In”, can attest, this has long been a favored sector, one in which I’ve been able to experience the best kind of success — that which you can spend.

And while finding winners is difficult enough, managing them is oftentimes even more challenging. Once you’re fortunate to have one, you’re immediately faced with the conundrum of just what to do with it. In my case, I’m confronted with the winner’s curse: Should I pull the plug on my beloved utilities, or take a risk by holding on to them with the hope of even more electrifying returns?

Probably the hardest element of managing a winning trade is simply having the gumption to stay in it. Grabbing a profit, especially a generous one, achieved over a relatively brief period of time is extremely tempting. But as I’ve often pointed out, it’s the losers, not the winners, that should be routinely cut from a portfolio. It takes time, effort and money to establish a winning position. Once you’ve got one, don’t be foolish enough to quickly trade it away.

To that end, I believe the worst strategy in dealing with winning trades is to sell them too soon. Yet I often hear from investors who make it a point to dump investments simply because they’ve hit targets 30% above the purchase price. To me, that’s downright asinine. Just think of all the traders who sold Microsoft (MSFT) or Sun Microsystems (SUNW) in 1996 for no other reason than because they’d booked a good profit. How many thousands of basis points were left on the table just because investors were overanxious to hear the cash register ring?

Even more common is the downright bizarre practice of “portfolio rebalancing,” in which losing allocations are methodically bought and winning trades are sold. This approach, popular with many financial planners, is a recipe for underperformance because it systematically replaces strong allocations with weak ones — all in the name of diversification. Considering the market doesn’t “know” where you got in, why trade away big positions in stocks that have the wind at their backs? That’s precisely where the gravy is made.

So the most notable way to deal with a winning trade is to do your darndest to stay with it, riding the gains for as much of the move as possible. And when a big bet does pan out, you’ll find that small trades grow to become a dominating influence on your overall portfolio. For me, that’s occurred in big-cap utilities like Duke Energy (DUK), Allegheny Energy (AYE), Exelon (EXC), Southern (SO) and California Water Services Group (CWT). Trades that started as 2% to 3% of my fund have appreciated, in some cases, to encompass 6% or more. It’s a problem most of us would be happy to have.

Instead of dumping winning trades just because they’ve grown, I’ll instead start to diversify the portfolio’s risk by deliberately fishing in other pastures besides utilities. Existing trades aren’t abandoned, but assigned specific stop-loss levels. New money can be directed toward different types of investments.

For example, with all the bad news surrounding hedge funds that trade convertible bonds, I’ve begun looking for value in this volatile and relatively underowned asset class. For individual investors, I believe funds remain the best way to achieve exposure. Closed-end choices such as TCW Convertible Securities fund (CVT), Advent Claymore Convertible Securities & Income fund (AVK), Nuveen Preferred and Convertible Income fund (JPC) and Ellsworth Convertible Growth and Income fund (ECF) all boast attractive dividend yields and trade at a discount to their underlying net asset values. This is an appealing new area for me in which I’m just beginning to put money to work.

Also, amid all of the anxiety last week surrounding terrorist bombings in London and damage from Hurricane Dennis, it’s worth noting that smaller-capitalization stocks continued their outperformance, with the Russell 2000 index notching a new all-time high. So if you were heavy into large-cap utilities, diverting new money toward smaller-cap names in other sectors would keep your skin in the game while spreading the risk.

As I’ve written before, it makes sense not only to follow the market but also the slow-moving herd, whose arrival almost always heralds a trade’s imminent unraveling. If you’re making money, then it’s never too long before the crowd shows up wanting to hop on for the ride. Once that process has begun, it’s usually an ideal time to begin to move on from the trade.

While we can graph price action and economic fundamentals down to the decimal point, evaluating public perception (a.k.a., the herd) is a much more difficult and subtle process. Amid the strong performance for utilities, I wait each week for the Barron’s cover story or the BusinessWeek feature article touting the red-hot gains. When that finally happens, it will likely serve as an excellent point to begin paring back positions. Case in point was a recent Newsweek cover story on the falling dollar, which ironically turned out to be a great moment to go long the greenback.

At the moment, however, it appears the public is still more indifferent than indulgent when it comes to investing in most utilities. Right now, the group appears to inhabit an investment no-man’s land: too expensive for the value investors, yet not flashy enough for growth players. I don’t see the trend in utilities reversing just yet, and with winning positions already established, I’m content to hold on for the ride.

In the market, when you’re on a roll you sure as heck better sop up the gains while you can, because the good times never last. Unless you learn to exploit winners fully, there’s really no sense in unearthing them in the first place.

– Originally on Jul 11, 2005 by Jonathan Hoenig

Consider that both planter and money manager need to periodically prune away dead wood. Beautiful gardens aren’t simply grown, they’re continuously clipped and shaped. To raise a healthy garden, experienced horticulturists will rotate crops, clip old foliage and manage the sun. It’s not just about planting the seeds, but tending to the crop along the way.

Same goes for the market, where investment success doesn’t end with simply picking a stock. Ever wonder why most analysts are lousy traders? It turns out there’s a big difference between evaluating an investment and profitably guiding a portfolio. Call me crazy, but in my world there’s more to it than just buy, sell or hold.

We all have losing trades. Professional investors, however, get quite adapt at not dragging them around for years on end. Dead wood won’t sink a portfolio, but will make it significantly less efficient and, over time, less profitable as well.

When clipping my holdings, I always start by looking at the big losers, those positions in which I’m severely underwater by 20% or more. More often than not, these trades tend to be underbrush you’d be well served to simply chop away. As I’ve pointed out over the years, waiting for a huge loser to “come back” tends to be the wrong move. Mathematically, the odds just aren’t in your court. For a 30% loser to get back to even, it must gain more than 42%. Possible? Perhaps. But most likely it’s less probable than taking the loss and moving on to a new, more promising trade. If you’re dragging around old remnants of trades gone bad, either get out now or at least set some stops to get out. That way you can redirect resources toward more timely trades.

Another possibility to prune comes in managing what I call “worthless” positions, the insignificantly sized trades that make up less than 1% of an overall portfolio. The problem with such tiny investments is that, rise or fall, they won’t have any major effect on the bottom line. Yet in every $100,000 portfolio, I always see those $700 positions in Sirius Satellite Radio (SIRI) or Taser International (TASR). Just consider that an investment that size could double, yet it wouldn’t even amount to a 1% increase in your portfolio value. The capital such tiny trades waste isn’t worth the minimum amount of amusement they provide.

So make it a point to regularly review your holdings, paying close attention to the smallest allocations. Positions that amount to less than 1% of overall assets should either be tossed or, if you still favor the trade, bulked up. As I’ve often pointed out, dumping several worthless positions often allows you to cobble together a sizable trade that might actually benefit your bottom line.

Even beginning farmers know there’s a finite period in which any particular crop can be successfully raised. And while I love green beans and think zucchini is one heck of a vegetable, I also know that neither will grow when there’s snow on the ground. So while you would never think to plant tomatoes in November, most people insist on buying stocks at what I believe to be the exact wrong time. Despite all the analysis and hard work, the odds for profitability are stacked against them from the start, simply because they were buying stocks out of season.

As regular readers know, it’s my belief that markets — just like the weather — aren’t chaotic, but rather move in trends that tend to persist over time. Because raising a garden depends on planting seeds at the right time, investors are well served by determining if potential purchases are in season before they buy.

With crude oil hitting new all-time highs, one can’t help but take note of the bull market in energy stocks over the past few years. At a time in which many investors have complained of a lackluster market, the truth is that you could’ve owned almost anything energy-related since 2002 and made money. From pipelines and energy trusts to utilities and even Big Oil plays, a rising tide of crude prices has indeed lifted all boats. This has been energy’s “season,” and investors have had an odds-rich environment in which to participate.

A similar period occurred from 1996 to 2000, when almost any technology stock would’ve earned you money. For several years while tech was in season, the active investor had more than a few chances to make a buck.

And because the best indicator of the market is the market, you’ll be well served by waiting until your favorite stock finds some bids before you take a position. Experienced traders know they don’t have to buy the bottom or sell the top, just be nimble enough to grab a portion of the 60% move in the middle. For my money, it’s always best to wait until an investment shows some element of strength before plunging in with both feet.

Upon finding success in growing carrots, the enterprising farmer might try his skill at onions as well. By closely observing his crop and being responsive to how it behaves, he’s better able to help it thrive. Winning plants should get the water, or at least your attention. If your fern likes being sung to or you find a deep soaking does wonders for your rutabagas, well, hey, whatever it takes.

The point is that in the markets, we learn from observation. Most of our time managing money isn’t spent placing trades but watching how the market changes, acts and responds. I find the most successful traders aren’t those reading annual reports or listening to conference calls, but monitoring what actually counts: their positions in the market itself.

By doing so, I’m often lead back to trades in which I’ve already found early success. For example, recent profits in utilities and real estate have led me to a closed-end fund that focuses solely on those two sectors. Cohen & Steers REIT and Utility Income fund (RTU) sports a 7.28% dividend yield, trades at a 15% discount to its net-asset value, and holds increasingly valuable large caps like Equity Office Properties (EOP), Southern (SO) and Consolidated Edison (ED).

Or upon collecting profits in energy trusts like San Juan Basin Royalty Trust (SJT) or BP Prudhoe Bay Royalty Trust (BPT), the opportunistic trader might focus his bet while diversifying his holdings through one of the recently launched funds that owns the sector. Kayne Anderson MLP (KYN) is a closed-end fund that holds positions in several master limited partnerships, or MLPs, such as Plains All American Pipeline (PAA), Ferrellgas Partners (FGP) and Inergy LP (NRGY). (MLPs are actively managed, publicly traded partnerships that are especially prevalent in the energy sector.) The Kayne Anderson MLP fund trades at a slight premium to its net-asset value, and at current prices it pays a quarterly dividend of around 6.30%. Fiduciary/Claymore MLP Opportunity fund (FMO) holds a similar basket of names, but trades at a slight discount to its net-asset value.

The point is to take your cues from observations made in the market, not in a classroom or line item in a company’s 10-K. And to harvest the best crop, it never hurts to start by watering the plants you already have.

– Originally on Jun 20, 2005 by Jonathan Hoenig

At the heart of this hysteria is a complete ignorance of what hedge funds really are, both among the regulators who oversee them and the financial media that have, in recent weeks, whipped up a panic about how hedge funds threaten to disrupt financial markets world-wide. So let’s start by simply defining the term: A hedge fund is a pool of money pledged by “accredited” (read: rich) investors and managed by a general partner. While most people assume that hedge funds trade frequently and make big bets on financial esoterica, the truth is a hedge fund is a legal structure, not an investment technique.

So while the media routinely characterize hedge funds as “risky” or “highly leveraged,” the reality is hedge fund strategies, just like mutual fund strategies, run the gamut from the ultra-conservative to the highly volatile. Some funds use high levels of leverage, others sit in cash for months at a time. Some employ complex spread trades, while others simply buy and sell stocks. Just knowing someone runs a hedge fund tells you absolutely nothing about how it’s run. What matters are the strategies, positions and discipline that the manager uses to maximize the money.

Yet that reality hasn’t stopped one of the more ignorant perspectives regarding hedge funds from spreading like wildfire. Thanks to the negative media coverage, there now exists the notion that hedge funds are ticking time bombs, recklessly leveraged and dangerously allocated portfolios just teetering on the verge of throwing international markets into a near meltdown.

It’s a perspective that’s fueled by a new breed of sloppy journalism that makes Newsweek magazine’s Koran desecration story look like the Oxford English Dictionary. Business reporters now attribute just about any financial occurrence to those pesky and uncontrolled hedge funds. Oil prices high? Must be the hedge funds cornering crude. Tech stocks falling? Must be the hedge funds selling them short. They’ve become a convenient media scapegoat for every market move.

Most recently, it was the carnage in General Motors (GM) that was falsely attributed to hedge funds’ influence. And while many funds certainly lost money trading GM’s equity and debt, so did thousands of other investors, ranging from institutional pension accounts hedged with derivatives to Midwestern Ma and Pa Kettle’s 100 shares of common stock. And despite the fact that the size of assets controlled by hedge funds is still dwarfed by those controlled by mutual funds and other investors, the press has become quite comfortable with attributing every market maelstrom to this woefully misrepresented group. Because hedge funds are required under Securities and Exchange Commission regulation to keep a low profile (more on that in a moment), they are never able to clearly respond and silence the rumor, innuendo and gossip that now passes for legitimate reporting.

Another major point the fear mongers have focused on in recent weeks is the notion that hedge funds are somehow unregulated. While this is untrue, the inaccurate perception nevertheless fuels conspiracy theorists who claim that a secret cabal of investors is always behind the scenes pulling the markets’ strings. The fact is that hedge funds are exceedingly regulated. SEC rules limit those who may invest to wealthy investors. And while mutual funds and brokers spend billions of dollars a year on advertising, hedge funds aren’t allowed to promote or publicly solicit business in any fashion. Can you think of any other industry that is subject to such Orwellian constraints?

Naturally, because hedge funds aren’t permitted to promote themselves, the only time one ends up hearing about them is on the infrequent occasion when something goes wrong. While the vast majority of the thousands of hedge funds out there are run by hard-working, honest and ethical people, the press only reports on the few bad apples.

The truth is that the real loss of capital over the past few years hasn’t come from hedge funds, which have outperformed the market, but from SEC-regulated investments. On the corporate side, you’ll remember that Enron, WorldCom and Adelphia were all highly regulated firms. And among investors, just consider how many trillions of dollars were squandered thanks to the recommendations, trading and money-management skills of SEC-regulated mutual funds and investment advisers.

Try to keep in mind that hedge funds aren’t run by lawless bandits who, if not for federal regulators, would screw every investor out of their last dime. They are governed, as every one of us is, by the rule of law that prohibits violating individual rights. When cheating, fraud or financial impropriety exists, the law protects investors and offers legal recourse.

What the market needs isn’t more hedge fund regulation, but more openness. By lifting the public solicitation restrictions that keep hedge funds in the shadows, the investing public would be better informed of how the industry’s risks and opportunities compare with other investment options.

No doubt the cynical media will continue to suggest that hedge funds’ activities hurt investors large and small. Participants in hedge funds, so the argument goes, are being taken by the industry’s supposedly unreasonably high fees. Non-participants are hurt by their reckless and market-moving trading. Both suggestions are patently incorrect.

Despite all the hissing about hedge funds’ high costs, the truth is that they’ve been worth it, outperforming almost every other asset class. Since December 1993, for example, the CSFB/Tremont Hedge Fund Index has bested the S&P 500, the Russell 2000 and the MSCI World Dollar index.

More recently, hedge funds actually made money in May, according to both Standard & Poor’s and Hennessee Group, a research and consulting firm that tracks hedge fund performance. So despite all the negative smear pieces in the press, all the concerned lawmakers who’ve whipped up fear regarding the danger of hedge funds and all the calls for increased regulation, the truth of the matter is that hedge funds are, once again, outperforming the rest of the pack. As of June 1, Hennessee pegs year-to-date hedge fund performance at -0.27%, while S&P estimates a loss of -0.42%. That’s better than the 1.98% loss for the Dow Jones Industrials, the 0.98% decline for the S&P 500 and the 4.66% drop in the Nasdaq Composite.

It turns out hedge funds aren’t conniving fraudsters or market manipulators, but hardworking, opportunistic investors simply trying to make a buck. Look beyond the hysteria and you’ll see that while not every fund has made money they’ve generally provided investors with superior risk-adjusted results. And even beyond benefiting their investors, hedge fund activities have behooved the general public by adding liquidity to the marketplace, helping to ensure that investors of every size can assume or lay off risk at will. Far from disruptive, their influence is steadying, taking risks and entering markets that less adventurous investors would likely avoid. That’s the real story the mainstream press has yet to tell.

– Originally on Jun 13, 2005 by Jonathan Hoenig

For most active traders, margin is the best first choice for stretching their dollars. But as I wrote last summer, debt should be limited to high-probability trades, and not to try and pull a half point out of the Nasdaq-100 Trust (QQQQ) or take a flier on some bulletin-board tout. I’m apt to only use margin to add to a position of strength; that is, to support a winning trade in a dominant market trend.

Let’s say, for example, that I’m holding a profitable position in Equity Office Properties (EOP). With real-estate investment trusts continuing higher in today’s market environment, I’d readily use margin to buy a unit of Simon Property Group (SPG), which would diversify the winning exposure but keep capital focused on a major, timely trend.

But even using margin, you’ll inevitably hit a point where you’re looking to make an investment your capital just won’t support. So when it’s time to start making trades, do yourself a favor and get rid of the losers first. Even in a generally profitable portfolio, if you comb through the basement you’ll likely find a name or two that’s bleeding and below water. That’s the trash to be pitched first.

Human instinct will lead you to “shave” a few shares off your big winners and let the losers ride. It’s a tempting approach, but unequivocally the wrong move. Nobody knows the future, but it’s my belief that over time losing trades tend to stay losing trades. And because I believe buying El Paso Electric (EE) puts me in a much stronger position that continuing to hold a 25% loss in Evergreen Solar (ESLR), I won’t hesitate to reallocate that capital.

If you worry about the losers, the winners take care of themselves. And although it hurts to take a loss, you’re essentially buying the benefit of a tax deduction, usually a more valuable asset than an unprofitable open trade. So start with the losers, selling first those positions with the biggest percentage declines, then the smallest positions, and finally the least liquid stocks. Shaving off a portfolio’s dead wood will often generate enough fresh capital to move toward even more profitable heights.

Now let’s say you’ve sold all your losers, but you still need fresh capital. Before I dump a real winner, I’ll often use a conservative option technique and sell covered calls on a portion of existing profitable trades. For example, rather than cash in the gains on my positions in large-cap utilities like Duke Energy (DUK), Southern (SO) and Exelon (EXC), I’d sell slightly out-of-the-money call options on a portion of each name. In exchange for agreeing to sell those shares at a higher price, I’m able to generate enough premium to fund a few entirely new positions. Should the sector’s strength continue, I’d look to buy back the calls or roll them into higher strike prices and future expiration months. Cumbersome? A bit. But it’s still a preferable way of raising capital than simply dumping a winning trade.

If options just aren’t your style, or for other reasons you’re pressed to sell a winning position, my suggestion would be to sell the weakest first. If I have a 10%-15% winner that, over the course of the past few months has shrunk down to a 4%-6% winner, that’s where I’d start. Shave off some of those shares to generate fresh capital.

Also, when choosing between open winning trades, my preference would be to sell the most liquid instruments first. As I often point out, a trader makes money by providing liquidity to a speculative situation. If you’re in the enviable position of holding a winning trade in a comparatively illiquid name, then let it be. The better move would be to dump a winning trade in Microsoft (MSFT), SBC Communications (SBC) or some other actively traded name. Not only can you get back in much more easily and cheaply, but your market sales are less likely to push the price lower, a common occurrence with less-liquid names.

– Originally on Jun 06, 2005 by Jonathan Hoenig

And while I’m never totally confident in my market outlook, I’m usually quite comfortable with my position in the market. Unlike the Nasdaq or S&P 500, which will rise and fall regardless of what I do, I actually have control over how my money is dispersed. So instead of focusing on making predictions, a smart trader should first concentrate on managing his portfolio. The market’s inherent uncertainty can be mitigated by a prudent, disciplined approach.

In the biggest sense, position refers to the financial foundation on which an investment portfolio is built. That’s why portfolio planning needs to start before the first buy order is ever placed. You can’t make wise bets on the market if you’re being distracted by unemployment, debt, an unsustainable lifestyle or other serious financial setbacks.

Take credit cards. I’m always mystified by people who put money into investments while they’re still revolving a hefty balance to Visa or American Express. Who can be comfortable hoping to make 10% in stocks — and that’s on a pretax basis — while carrying credit-card debt at 18% interest? It doesn’t make sense.

And regardless of how savvy of a stock picker you might be, putting money into even “conservative” investments when your financial house is in disarray will end up a losing trade. As I’ve said many times over the years, traders must be able to take small losses as part of the regular routine of disciplined investing. If you’re overextended and playing with anything other than risk capital, then you’re much more likely to make irrational and emotionally driven decisions; namely, holding on to weak and low-probability trades. The strongest and most confident traders are those who know that almost any market malady, from a few bad months to a 9/11-style plummet, won’t have a material impact on their standards of living.

Of course, just as a financial foundation can be made more comfortable, so can a portfolio itself. I’m always anxious over what the next move for stocks might be. However, I sleep better knowing that at any given moment I’m only putting new money to work in what I believe to be the highest probability trades.

While it seems painfully obvious, you’d be surprised at how many people shoot themselves in the foot by wasting precious capital on impulsive, “fun” trades that serve as nothing more than expensive amusements. Amid a few winning ideas, they’re burning capital playing penny stocks or trying to grab a point out of General Motors (GM), Delta Air Lines (DAL) or whatever other news story happens to be above the fold in The Wall Street Journal.

As I like to point out, trading is about making decisions. Because you can’t bet on everything, limiting new purchases to ideas that meet your strict criteria, be it technical or fundamental, gives you the confidence to know that every drop of capital is being most efficiently deployed. I feel comfortable knowing that at any given time, my fund’s assets are pledged only to my best ideas — even if they don’t always work out.

The market will always be uncertain. Through our portfolios, however, we’re able to tweak positions as events unfold to tip the odds in our favor. What makes me feel comfortable in my holdings is the knowledge that every investment I buy has a specific level at which I’d bite the bullet and take a nominal loss.

Most any discipline works as long as you’re able to stick with it. So even if you’re resigned to sell any investment at, say, 20% below the purchase price, you suddenly make the most volatile foreign utility no more “risky” than a government bond. Putting that sell discipline in place right from the start makes dealing with the uncertainty of markets a much more comfortable affair. I’m able to place my bets and, in effect, let the market decide which trades are worth keeping and which should be kicked to the curb.

In this game, there’s no sure thing. We can’t control the market, only the size and nature of our exposure to it. And while I’m never terribly confident in predicting the market, I do feel comfortable as long as I keep my portfolio on a prudent and disciplined path. And if you use risk capital to make smart, focused bets with predefined risk parameters already in place, then you’ll undoubtedly find yourself not only a more comfortable trader but a more profitable one as well.

– Originally on May 23, 2005 by Jonathan Hoenig

Why? Well, as longtime readers know it’s my belief that markets aren’t chaotic, but rather they move in trends that tend to persist over time. So while I can’t precisely predict the future, I can observe the present and make calculated guesses about how securities are likely to respond.

Weak stocks tend to stay weak, or at least weaker than stronger alternatives. After a sharp decline, XYZ might indeed enjoy a dead-cat bounce, but all too often that’s the signal the trade’s gravy has already been mopped up. In my experience, very rarely does an investment break 20% lower because it’s intent on marching right back to previous highs.

So when XYZ cracks, smart traders should move to the side, preserve capital and reassess the forecast on market conditions. This is especially true when a decline in XYZ prompts a position to reverse from being held as a win to a loss. That alone is enough reason to get out of the trade.

One of the more memorable breakdowns occurred in good ol’ Microsoft (MSFT), which, like most tech stocks in March 2000, began deteriorating from all-time highs. Shares gapped from the mid-50s to the mid-40s overnight — a painful move for those long the stock. The real carnage, however, has occurred in the following years. The stock has continued a slow but steady unraveling that has made it dead money at best.

For a more recent example, there’s eBay (EBAY), the ubiquitous online auctioneer whose stock enjoyed a hearty renaissance over the past few years. In mid-January, however, that momentum was abruptly cut short when shares broke from the mid-50s to the mid-40s overnight. That was the smoke, the weakness in the stock indicating the company was no longer the equity leader it had been. And as is often the case in such scenarios, the stock’s initial weakness was the indicator to jump ship. Shares meandered in the mid-40s before sinking to the low 30s just a few weeks later.

Or take IBM (IBM), whose shares dropped from almost 100 to near 85 over the first few months of 2005. After the stock gapped from the mid- to low 80s in mid-April, it proceeded not to quickly recover to the early 2005 highs but to tread water and, eventually, drop another 10%. Even if you’d gotten out after the gap downward, it would’ve been better than hoping for a bounce back to higher prices.

Why run for the hills when an investment suffers a large break? Because while many often think rabid selling is what prompts a stock to suffer a precipitous drop, all too often it’s the lack of buying interest that’s really to blame. As I first wrote back in 2002, the law of supply and demand is also that of demand and supply. While most commentators are quick to interpret a market trend as the result of some action of investors, it’s often their inaction that’s ultimately responsible for the move.

So when XYZ drops 20%, it’s not the presence of sellers but the absence of buyers that causes such a sharp move. Considering that nobody has yet dumped the stock, why not be among the first in line to get out? This is why stop orders, even when triggered below a specified price, are a good idea. When the break does come, at least you’re at the top of the list to get your shares sold.

Of course, as with most elements of trading, that’s usually easier said than done. All too often, our egos prevent sound trading technique. After all, we bought XYZ because we thought it was going higher. To sell it after a loss, especially such a quick one, is both hurtful and humiliating. Just remember that taking a loss is the same as stopping it. Don’t make the mistake of thinking a paper loss isn’t a loss just because you haven’t seen fit to realize it yet.

The other main obstacle that usually prevents investors from exiting a position is the natural but misguided need to understand the fundamental reason behind the move. When a stock breaks downward, instead of running to the exits many often hold off until they know exactly what caused the drop. And as the price plummets, time is wasted combing the message boards, company press releases and SEC filings seeking what amounts to trivia.

It doesn’t matter why a stock moves, only how it moves. A good trader’s responsibility isn’t to explain a market drop but to be able to react to it in a calm and disciplined fashion. So when the air-raid siren sounds, don’t hesitate to run for cover. More often than not, a stock’s first big plummet signals the time to move on.

– Originally on May 16, 2005 by Jonathan Hoenig

Investors can use the idea of ballast to their benefit. Portfolios large and small should be grounded by conservative asset allocation and governed by a prudent approach, not to increase the speed of returns but to smooth the ride. When done well, adding ballast can help you boost your returns and keep you from getting seasick along the way.

Most people’s biggest investment is their home, which makes an ideal foundation for investment stability. You have to live somewhere, after all, and in most cases, buying a home you can afford is preferable to renting, regardless of where real estate prices are.

Did you catch the caveat? A home you can afford. Because while you might consider your home an asset, chances are it’s actually a liability — a rather large one. And while nobody knows for sure whether there’s a bubble in property prices right now, I can say with no uncertainty that there’s an abundance of exceptionally foolish investors taking risks in real estate they’ll no doubt live to regret.

In real estate, as with all investments, size kills. Owning a home you can afford is a smart investment and terrific portfolio ballast. The “no money down” crowd, however — those who’ve leveraged themselves to the hilt with interest-only loans on highly speculative situations — are begging for trouble. Ballast like that won’t steady your finances — it’ll sink them to a watery grave.

If you have an extra $10,000 burning a hole in your pocket, I’d advise using it to pay down your mortgage rather than to speculate in stocks. The market will always be a crapshoot, but paying down a mortgage is a guaranteed return that, even at today’s historically low rates, is virtually impossible to beat.

Cash, or more specifically savings, is another integral element of adding ballast to a portfolio. People don’t do much saving anymore. But in a simpler time, before 401(k) plans and hair-trigger trading, surplus funds weren’t put at risk, but rather into the bank. For most folks, especially those now used to a wallet full of credit cards and payday loans, this would be a great habit to develop.

Before you yelp for a stock tip, why not start with an “emergency fund” — at least six months of livings expenses tucked into a savings account or government-insured CD? It’s amazing how few individuals have accomplished this goal.

If you’re used to having your mood and self-worth dictated by the Dow Jones Industrial Average, you’ll undoubtedly find, as I have, that savings provides your portfolio will both ballast and piece of mind. The psychological benefit of having money far eclipses anything material you could buy with it. And while it’s a terribly unexciting goal when compared with writing options or short-selling stocks, the security that comes with salting away a few months of living expenses can’t be quantified. Life is better when you pull yourself back from the edge.

A final idea for adding ballast to your portfolio is to go for the gold. I’m the first to admit that precious metals, in which I have been previously heavily involved over the years, have recently lost their sparkle entirely. Years ago, these were major market leaders. Now they’ve become the weakest things on the board.

Yet I still believe that precious metals play an important role in a diversified portfolio. Gold is nobody’s debt, promise or obligation. Long before Sirius Satellite Radio (SIRI) and Petrokazakhstan (PKZ) ruled the herd’s portfolios, gold was money. Gold and silver are the only investments I know of that are mentioned in the Bible, and I’m certain they’ll have value thousands of years from now. That’s one long-term bet I’m willing to make.

Whenever I have a bad day in the market and no paper investments go my way, I find deep satisfaction in holding a gold coin in my hand and knowing, regardless of the market’s zigs and zags, that I own a hard asset that will store value over time. Hold an ounce of gold in your hand and you’ll quickly see what I mean. Think of it as pacifier for stock junkies.

One challenge an investor could shoot for would be to accumulate one ounce of gold for every year of their age. A 35-year-old investor, therefore, would need to have accumulated 35 ounces of gold — worth a cool $15,000 at today’s prices — solely for the purpose of long-term savings. While I prefer buying physical bullion, the newly launched Street Tracks Gold Trust (GLD: 56.14, 0.00, 0.0%) exchange-traded fund also makes an excellent choice for accomplishing this allocation.

Adding ballast can present significant challenges for people. But I believe it’s a smart endeavor for sophisticated investors looking to anchor their portfolios amid a turbulent market sea.

– Originally on May 09, 2005 by Jonathan Hoenig

So although Bill Miller is still heralded as one of the best portfolio managers around, he too was pummeled by the brutal bear market. An investment in his Legg Mason Value Trust (LMVTX) dropped some 40% from 2000 through early 2003.

Or take legendary portfolio manager Stanley Druckenmiller. In early 2000 he left George Soros’ Quantum Fund after bad technology bets erased almost $3 billion — more than 20% of the hedge fund’s assets.

Even Warren Buffett, the Oracle of Omaha who is lionized as the world’s greatest investor, has stumbled from time to time. From the summer of 1998 through early 2000, an investment in his beloved Berkshire Hathaway (BRK.A) fell by almost 50%.

Because it’s not a matter of if you’ll experience a losing streak but rather when, what really counts is the way you handle it. All traders stumble now and again. The trick is knowing how to pick yourself back up off the mat.

To say that losing money hurts is an understatement. In fact, it’s often difficult for those who don’t trade to fully comprehend the anguish and despair that come along with a drawdown in your account. The inescapable pangs of sadness, the uncontrollable inner rage and personal pain are among the rawest emotions you’ll ever feel.

And while we’ve all experienced disappointment and sadness before, unique to the pain of investment losses is the immense self-loathing that comes along in knowing that it was our own actions that precipitated the pain. Nobody forces us to take a position or make a trade. When we lose, we do it to ourselves and have no one else to blame.

It’s that reality that leads us to antagonizing self-examination in the hours and days following a market loss. Even after years as a professional trader, I can’t tell you how many times I’ve buried my face in my hands, thinking that had I only sold XYZ earlier or bought less of ABC I would’ve avoided my market misfortune.

But while the market might trip us, it’s usually our own loss of discipline that slits our throats. And after a series of losses, one of the most common and financially dangerous reactions is to quickly try and reverse the damage. Because the pain of accepting a loss is so great, many traders will resort to reckless technique in an attempt to make up the difference. Simply put, they get completely out of control.

Like the compulsive gambler who can’t help but bet the farm, a trader in the midst of utter desperation tends to throw out proper technique altogether. If he usually trades 100 shares at a clip, then he’ll start betting 1,000. If he’d always held investments for a big move, then he’ll start playing for the two-point pops. While he’d previously held a diversified portfolio, he’ll begin betting the ranch on just one or two sectors.

Problems are magnified if despondent traders turn to substance abuse. It’s a phenomenon I first observed as a clerk on the floor of a major Chicago commodities exchange. Consider that if alcohol lowers inhibitions in a bar, just think of the damage it can do to you while trading. You’re down 10%, slightly tipsy and desperate to make it up. So why sell short 50 shares when you’ve got the margin for 5,000? Or why bother waiting for some puny dividend-paying stock to move when there’s a penny stock on the pink sheets that’s bound to rise or fall double-digits before lunchtime. My advice: Just say no.

Rationally, we know that losses are part of the game, and that all investors, from time to time, experience disappointing declines. But the trader mentality is a competitive one that wants to win. Because our profit/loss statement is what we use to keep score, the best traders get used to separating their net worth from their self-worth.

As painful as it might be to lose money, you must be able to maintain composure and confidence even in the midst of a bad run. In the market, money will always come and go. Lose your discipline, however, and you’ll never see another dime. When losses come, you must think of them as part of the trading game, not a personality flaw.

One of the best ways to ensure you don’t fall off the wagon, even during a rash of heartbreaking losses, is to only take chances with risk capital. The market is stressful enough, and as I wrote a few years back, the best way to maintain discipline is knowing that it’s risk capital — not a mortgage check or tuition payment — that’s on the line. The only smart risks are those you can afford to take, and you’ll never be able to make rational decisions when your pride and paycheck are both on the line.

During a drawdown, I’ve also found it useful to reduce my risk and re-evaluate the market with a fresh perspective not influenced by my previous positions. So instead of berating yourself about why you didn’t dump XYZ in time, take the loss, take a break and come back to your portfolio with a youthful and unbiased view. Losses will always be part of trading. How we cope with them is what sets the professional trader apart from the pack.

– Originally on Mar 28, 2005 by Jonathan Hoenig

Yet market fantasies can ruin a portfolio when allowed to overwhelm a trader’s rational faculties. Following a script can be dangerous. What’s important is to have a general belief of how a market might move, not a detailed description of XYZ Inc.’s every tick.

For example, oftentimes people are intent on earning a profit in a specific stock. They’re not merely interested in XYZ — they’re downright married to it. They construct detailed industry analysis and earnings forecasts. They read countless research reports and newsletter recommendations. They draw trendlines, set price targets and take up shop as resident know-it-alls on the Internet message boards. XYZ is their world, till death do they part.

Of course, somewhere in the middle of the glowing research reports, they forget that the point of investing is to make money, not necessarily to make money in XYZ Inc. And even though the market might not be confirming their forecast, they stubbornly hold on because their ego is on the line and they want their fantasy to come true.

Take, for instance, the big pharmaceutical companies like Pfizer (PFE) or Merck (MRK), which for many years investors dogmatically believed were can’t-miss stocks. With more baby boomers needing health care, the fundamental case appeared strong. Blockbuster drugs like Viagra only reinforced the companies’ appeal. Yet because investors had built up such a detailed fantasy of what those stocks were supposed to do, many failed to see just what they were doing — trending downward week after week.

One of the quickest ways investors can distort their rational perspective is to read annual reports, one step I rarely recommend investors undertake. Page through the SEC filings, read the quarterly updates if you like, but make no mistake — the annual report is a sales tool. Flashy ones too easily cloud investors’ judgment of whether to buy, sell or hold.

It’s downright amazing how even the most dismal companies can find ways to show an encouraging-looking chart in the first few pages of their annual report. Keep flipping and you’ll see images of happy multicultural employees and customers, plus lots of pretty pie graphs on heavy glossy paper. Investors fall in love. Their fantasy about the company’s prospects quickly overwhelms the reality of how the stock might be performing. So when the market is melting — the stock is down 20% and falling — they can’t conjure the strength to actually pull the trigger and take the loss.

This is the problem with market fantasy: It prompts you to make emotional decisions from your gut, not rational ones from your head. Even when you have the deepest conviction that XYZ is a terrific company, you must be humble enough to know that sometimes — at least for the short term — the stock just might have to get kicked to the curb.

Rather than spending hours conjuring up a full economic forecast of what will happen, you should try to conjure up an idea of what might happen without writing the whole scenario.

For example, when I was buying gold stocks in 2001, I had a belief that the precious metal would rise, but not a precise notion of by how much. My hypothesis wasn’t contingent on a detailed economic or political scenario, but simply an observation that gold was a strong asset class not yet found by the herd. In short, I had the plot but let the script write itself.

While I certainly applaud those who carefully research their investments, the truth is that once you’ve put money into a stock, all the due diligence in the world isn’t going to affect how it trades. By continually researching and reviewing, investors are prone to becoming too personally attached to particular companies. Dumb decisions are sure to follow.

Ultimately, when analyzing the market, the primary influence should always be the market itself. If the fundamentals happen to look good or the annual report is slick… well, that’s just icing on the cake.

While it’s tempting to have a fantasy about how an investment should work, successful investors will always trade based on what’s happening in the market — not in their heads.

– Originally on Mar 14, 2005 by Jonathan Hoenig