Investment Basics: Fish Oil and Donuts (HYG)

We at Normandy have an outstanding track record.  Our trades since inception some eight years back have produced thousands of percentage points in gains, despite the occasional loser or brief streak without a grand slam win.

 

That said, holding on to one’s gains is just as important as making them, and that brings us to a crucial aspect of trading that’s rarely discussed in the investment newsletter world – the matter of cash management.

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In a word, cash management is everything.  Anyone who emerged a winner in the stock trading game did so on the back of a very deep understanding of the principles of cash management, of which we hope to provide you an outline below.

 

Ask anyone who’s wealthy who acquired his fortune by way of trading, and if he’s honest he’ll tell you he was minding his cash all the while, be he a pompous hedge fund manager or just a streetwise bloke who kept his mouth shut, his eye on the screen and never traded too big for his britches.

 

A Thumbnail Summary of Cash Management Principles

 

The ultimate purpose of a cash management plan is to avoid taking a catastrophic loss.  That means never allocating more to a trade than you can afford to lose.  Catastrophic losses not only wipe out trading accounts, they can also lead to deep depressions that, in many cases, take years to recover from.  They can force folks into behaviors that are reckless and self-injurious, too, everything from alcohol and drugs to borrowing money to ‘make it all back’, to every manner of family related strife – and all because you went in too big on a ‘sure thing’ and didn’t have the wherewithal to step back and close the bugger out when it started moving against you.

 

We must avoid the catastrophic loss.

 

And that means limiting the size of our trades to a small percentage of our trading capital.  Notice we said ‘trading capital’, and not ‘net worth’ or ‘liquid assets’ or anything else.  Trading capital is not your house or your car or the loans you can secure with those assets, nor is it your retirement savings or your kid’s college fund.

 

Trading capital is money set aside after all those items have been accounted for and tended to.  It’s money whose purpose is exclusive and inalterable – it’s meant solely to create wealth.

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Just as the water and fertilizer and proper fencing and annual pruning is meant to make the oak on your front lawn thrive and develop into a mammoth and statuesque centerpiece for your home, so, too, is your trading account meant to assist in the development of that item so many long for – personal wealth.

 

The tree provides shade and comfort for you at leisure and a playground for your children, enhancing your life in a great many ways.

 

As does your wealth.

 

You would never knowingly do anything to detract from the growth of your tree.  So, too, you must never willingly allow your trading capital to diminish.

 

Trading Percentages and Stops

 

Every trade must be planned and strictly executed according to one’s cash management plan.  That means a hard limit must be adhered to regarding the amount allocated to each trade.  We generally recommend no more than three to five percent of your trading capital be allocated to any initiative that we recommend.

 

If your trading portfolio is $100,000 that means no more than $3000 to $5000 per bet.  If it’s $10,000, no more than $300 to $500.  No exceptions.  No crying.

 

That will also mean that if you’re trading our recommendations here at Normandy, you’ll occasionally trade a single option or pair of options, while at other times you may trade up to 30 pairs – all depending upon the opening price of the initiative, your maximum trading limit and any margin restrictions you’re obliged to uphold.

 

But you must never trade more than your limit.

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That said, there will be times when we recommend a trade as a core holding.  Often our deep-in-the-money options initiatives are categorized as such, and we’ll tell you explicitly in those instances that the trade is eligible for an enlarged five to ten percent of your trading book.  These trades generally carry far less risk than our normal course offerings.

 

Stop Loss Fever

 

Setting stops is another aspect of pre-trade planning.  Most of our trades are hedged in some fashion, so may not require stops.  We like going long/short or using spreads where the risk profile of the trade can be determined beforehand and maximum losses can be judged acceptable or too steep as the case may be.

 

Not all options trades are stop loss eligible, though, and much will depend on your or your broker’s online software.  If that’s the case, a mental stop, a point on the chart through which the underlying moves, must be selected before the trade and held to dogmatically.  The trade must be closed if that line is crossed – even if it’s just by a penny or two.  A red line is a red line.

 

After that occurs a cold reassessment can take place that determines whether an opportunity exists to reverse the trade or even reenter the initial trade a second time.  But that assessment must be made while there’s no skin in the game.  All money must be off the table.

 

We’ll leave it at that for now.  There’s much more to be said, but it’ll have to wait ‘til next week, at least.  It’s time for a trade.

 

Go get ‘em Huey!

 

We like what’s been happening in high yield lately.  In short, spreads were wider than they should have been for while (900 basis points) and have now began to tighten (600 bps), indicating a greater penchant for risk.  Even last week’s Brexit vote couldn’t shake the confidence of the junk market, one of the most sensitive quarters of the investment arena.

 

Have a look here –

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The iShares iBoxx High Yield Corporate Bond ETF (NYSE:HYG) has been trundling higher for months.  As early as December, RSI and MACD began diverging against price, indicating the long decline was wrapping up.  But recent strength was most manifest in a climb above another major moving average just a week ago.

 

Look now at the weekly –

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The weekly is significant in revealing that both RSI and MACD are now above their respective waterlines, the first time this has happened since the summer of 2014.  It also shows a massive change of ownership that began last fall, when new buyers emerged to scoop up shares from tired sellers’ hands.

 

It’s now time we did the same.

 

 

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With kind regards,

 

Hugh L. O’Haynew

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