Today’s Sunday Edition discusses the biggest reason why your investments might be underperforming, and why the Rebel Income system isn’t subject to this one fatal flaw, which might explain the nearly 30% annual returns over the last two years.
In a study conducted by Dalbar Inc.—the nation’s leading financial services market research firm—through 2014, the 20-year annualized S&P return was 9.85% while the 20-year annualized return for the average equity mutual fund investor was only 5.19%, a gap of 4.66%.
The biggest reason for the underperformance, according to their research, is psychology. The study also defined nine of the irrational investment behavior biases specifically, with the biggest culprit being:
Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.”
Investing in mutual funds is a little different than investing in individual stocks, however, I believe the fear of loss is heightened when dealing with individual stocks as opposed to mutual funds, since mutual funds have greater built in diversification.
However, 95% of individual stock risk can be mitigated simply by owing a basket of 8 to 10 quality and uncorrelated companies. But that discussion will be saved for another time.
Today’s focus is on “panic selling” and why the Rebel Income system is designed to help you avoid this fatal mistake, which can kill your overall returns.
The majority of the put sells Thomas recommends do expire worthless, and subscribers just keep the income. However, there are times when the stock price drops below the assigned price, and sometimes by quite a bit.
For example, Thomas sold a put on CSIQ with a strike price of 29 and the stock dropped to $19 before reversing and moving back above the strike price, allowing us to exit with a profit. Another example is ANF which was assigned at 27.50 and dropped down to $16 before moving higher resulting in a profitable trade.
On average Thomas is assigned a stock 25% to 30% of the time, meaning the stock drops below the put option strike price.
Of course he never succumbs to “panic selling,” which has even drawn criticism by a few subscribers because he chooses not to use stop loss order to protect capital. But it’s hard to argue with his track record.
In today’s reprint of Thomas’ Rebel Income newsletter (annual subscription $1,164), he discusses when he believes a stop loss order should be used, but why he chooses not to use them with the Rebel Income system, which has closed 98 winning trades with only 3 small losers and outperformed the stock market 10 to 1 since inception (last two years).
Stop Losses and Value-Oriented Income Generation
Occasionally I get emails from subscribers about my approach to stop losses on the stocks I hold in my portfolio. If you’ve followed Rebel Income for a while, I expect that you’ve noticed I never write about stop losses on stocks I am assigned from my put selling trades. This isn’t a simple case of omission, but instead a deliberate piece of the income generation system I use. I don’t use stop losses on any stock I am assigned on purpose.
This might sound a little foolhardy or possibly even irresponsible at first blush… especially if you are a new subscriber and are still trying to get used to the system I use and write about. I think that in order to understand why stop losses aren’t useful for my system, it is important to talk about where they are useful first and why in those cases you should never place a trade without them.
When it comes to the stock market, we are all conditioned to think in very directional terms. Buy a stock at a low price, hold onto it a while, and hopefully sell it sometime down the road at a higher price. For a lot of investors, that is the entire scope of their investing experience. If you’ve traded options, you’ve been able to expand your perspective quite a bit more, but again you are still generally encouraged to work with a directional bias: buy call options if you think a stock will increase in price, or buy put options if you think a stock will decrease in price. This directional bias is what drives most of the investing activities of the general public; in this context, stop losses are absolutely critical and should never be ignored.
Most directional trading strategies are designed with a very short-term timeframe in mind. Most focus on trying to take advantage of short-term swings along a trend line or a breakdown of a stock’s current trend, which usually marks the beginning of a new opposite trend. The problem with strategies that are designed around trying to predict what direction a stock is going to follow in the near term is that they have a very low probability of success; a 25 – 30% success rate is considered normal even for the most experienced and skilled technicians and traders. Speaking for myself, in more than 15 years of options trading, I have never been able to achieve a success rate higher than 30% with any of these types of strategies.
To be clear, it IS possible to make money with these kinds of methods, even with such a high degree of failure. It requires a high level of discipline and patience, however, since a low probability of a winning trade also means a high probability not only of one losing trade, but of several in a row. In the short term, losing streaks often seem to mount the losses to the point that the few profitable trades you will see can’t possibly make up the difference. The only way they can is to keep a long-term view and make sure that you apply a hard stop loss on every trade you make. Where the stop loss is set will vary depending on the system you’re using, and I’m not going to take space in this post to elaborate on that detail. The point is that the stop loss is designed to limit the loss per trade enough so that even if you do see a major losing streak, the sum of your losses will be limited enough to keep you in the game for the winning trades.
I write a lot in Rebel Income about how I use put selling as a gateway to value-oriented stock ownership. If you look around the web, you’ll see that even a lot of long-term, value-focused investors use stop losses as well. In fact, if your sole purpose of holding a stock for the long-term is to be able to ride a long-term upward trend, you should absolutely be using a stop loss. I think that in this case, not using a stop loss is irresponsible and foolhardy, because you are still thinking in directional terms.
The stop loss should be wider than it would be a with a short-term trading strategy, because you have to be willing to give the stock enough room to fluctuate in price quite a bit as it rides along its trend line. I think that in these cases, setting a 25% hard stop below your initial purchase price is smart. If the stock moves above your purchase price, recalculate your stop loss; do it each day the stock makes a new high above your purchase price, but once it is raised, it is never adjusted lower. If the stock experiences a short-term swing downward, leave your stop loss at its last adjustment (which should be 25% below the highest price in the last peak). If you get stopped out, so be it; if the trend holds, the stock should swing back upward and eventually move above that last peak, so you can adjust the stop loss higher again. The nice thing about this approach is that you don’t have to worry about “how long do I let the stock go up before I get out”; you just wait until you get stopped out of the trade.
Understand, the method I’ve just outlined requires just as much discipline as any short-term trading strategy. The good thing is that if the stock does form a long-term upward trend, you may see it increase in price by two or three times, or possibly even more. Even waiting for a 25% drawdown from the trend’s highest point means being able to capture a big chunk of the trend. The caveat is that not all stocks will form the kind of long-term trend you need, or move high enough before you are stopped out to make the trade profitable. The probabilities for this system are a little higher than for the shorter-term strategies I mentioned, but generally not by more than 10%, which means that you should still expect to see more losing trades than winning ones. Again, this is why the stop loss is so important; in those trades, you’ll need to make sure your loss is limited enough that your winning trades will be able to make up the difference in the long-term.
I’ve just spent several paragraphs talking about why stop losses are so important and critical to directional systems. Now I’m about to tell you to forget all of that information… at least for the trades you make following my system. I’m not doing this to imply that I know better than people who have been using directional trading strategies; I have made a lot of friends over my years in the market who have been very successful following those systems and continue to make a lot of money with them. I know those methods work. However, I also believe that most investors will not make money following those systems because of the difficulty—emotional and financial—that is associated with the losing side of those systems.
Think about it, if you are the middle of a prolonged losing streak, and watching your account get smaller and smaller with every trade you make, do you think it will be easier or harder to keep the big picture in view and stay the course? Most investors have a limited amount of capital to work with, and watching our hard-earned capital disappear into thin air again and again just isn’t something most of us are equipped to deal with. This isn’t a criticism of human nature, but simply an acknowledgement of reality. It is a fact that only a small percentage of investors have the emotional makeup required to endure the kind of prolonged losses that are normally associated with directional investing and trading. While I’ve used directional strategies in the past and am very familiar with them, the truth is that I put myself in the larger percentage of investors – those that generally shouldn’t be dealing with directional investing. I know how to be successful with directional trading, but it is very hard for me to maintain the discipline it requires. I have to fight my emotions on a regular basis, which only adds stress to my life. I don’t believe investing should create more stress than life brings every day all by itself. That is why my system is built the way it is.
I differentiate between my system and traditional, directionally based value investing by the fact that my approach looks first to generate income by selling puts, and factors stock ownership into the equation second. By selling puts against a fundamentally solid stock trading with a great value proposition, my goal is use the directional bias of most investors in my favor. If that bias keeps that stock above my put option’s strike price through the duration of the trade, the option expires worthless, my first purpose (income generation) has already been achieved and I move to the next trade.
If the stock is below my put option’s strike price at expiration, that doesn’t mean that the market’s natural directional bias isn’t working for me, but it does mean that the second piece of approach—stock ownership—comes into play. This is where the other major difference between what I do and what even most value-oriented, long-term investors do, because I don’t work with a stop loss. Why wouldn’t I work with a 25% hard stop loss, when this number actually sounds pretty reasonable?
My first answer goes back to my first objective: income generation. I emphasize dividend-paying stocks exclusively in my system, which means that when I am assigned, I become a shareholder of record in the stock, which means I receive dividend distributions as they are paid. Some of the stocks I’ve been working with, like BBY, JOY, and others are currently paying dividends in excess of 3% per year – which is better than what you’ll get by putting your money into a CD or money market account at the bank right now.
The other part of the income argument is the second major piece of my system: covered calls. One of the first things I look for an opportunity to do when I am assigned a stock is to sell a covered call and keep the income generation machine churning. Subscribers to Rebel Income have seen me write about several covered call trades that have helped me generate a significant amount of immediate income on stocks I’m currently holding in my portfolio. Unless you’re approved for margin trading and have adequate reserves to cover the trade, most brokers don’t allow you to set a stop loss on a stock you’ve written a covered call against, no matter how far away from the current price it is. This is because if you get stopped out of the stock, the calls you’ve sold are now naked, leaving you exposed to an unlimited amount of risk for the duration of those contracts.
There is a third part of my reasoning for not using stop losses, too. Those who have followed along with my trades for the last year or so know that there are a number of stocks that have seen long, protracted declines in price after I was assigned their shares from a put sale. JOY, SLCA, ANF, CBI, and HAL are just a few examples of stocks I’ve watched drop far more than 25% below my initial purchase price. I’m still holding shares in several of those companies today, not because I’m stubbornly unwilling to admit I was wrong, but because my fundamental analysis of those stocks continues to lead me to believe their long-term value is much higher than even the price I was assigned at. The only circumstance that will ever lead me to finally throw my hands in the air and close the position at a loss is if I see signs of a significant deterioration in the strength of their actual business operations. As long as the fundamentals remain strong and point to a higher intrinsic value than my entry price, I am willing to continue holding these stocks. In fact, readers will have noticed that I’ve used some of those protracted drawdowns as opportunities to sell more put options, since being assigned again would mean that I can average my price even lower than my initial purchase price. Using this third element on JOY, for example, enabled me to average my actual cost in the stock significantly below the $40 per share my initial assignment occurred at. Being able to average my cost down made the position easier to manage and a lot less stressful than it might have been otherwise. When JOY recently announced it had agreed to a buyout at $28.50 per share from Komatsu Ltd. (a new event that clearly changes the value proposition for the stock), the fact I had been able to average my price below the stock’s current price made it possible to close my position with a modest net gain.
This is a pretty long explanation of why I don’t use stop losses, I know; but I think it is important to make sure that you have all of the facts associated with the Rebel Income system as possible. The fact is that even though I don’t use stop losses, I do think about risk management every day. It’s why I’ve built the system the way I’ve outlined, and it’s why you’ll see me continue to provide as many details about the different pieces of the system as I can.
If you are like most investors, the emotions involved in directional trading are simply too powerful to control on a consistent basis.
Why not follow a system that mitigates the emotions that cause “panic selling” and allows you to sleep well at night?
Not to mention generates returns that far outpace buy and hold investing, yet keep the bulk of your money sitting safely in cash the majority of the time?
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