Did I hear you say you want to invest with no risk? You can do so. But don’t expect a reward. Many people invest in so-called low risk fixed return instruments such as CD’s, Money Market accounts and government bonds. But bankers don’t get rich giving away money. Try doing a correlation study of bank CD rates and inflation rates. You will find (as many researchers have) that those wily bankers set their CD rates at the inflation rate. So if you have a $100,000 Jumbo CD at 4% (a rate we haven’t seen in a long time), a year from now your account statement will show $104,000. But you will only be able to buy $99,000 worth of today’s goods and services with that money. How can that be? After you pay your taxes and adjust for the erosive effects of inflation on your money, your real purchasing power will have dropped 1%, even though you were told you would make 4%.

What about high reward investments like futures (commodities trading) or Forex (currency trading).  If you have a very high risk tolerance, lots of time, and unlimited capital that you are willing to lose during the learning process, you might become one of the very few people who learn to successfully trade these high risk instruments. But even experienced leverage traders often lose huge amounts of money. (These are called leveraged instruments because you can control between $300,000 and $4,000,000 in commodities or currencies for every $100,000 you invest. Leverage like that works fine when you bet the right direction. But if you are wrong, the results can be devastating!)

The truths about fixed return instruments and leveraged instruments articulated above have given rise to what I call “The Big Lie.” The Big Lie has been repeated so often that even financial professionals (who should know better) sometimes repeat it. Like most propaganda, if people hear something often enough, it begins to sound true, even if it is illogical.

And The Big Lie is totally illogical. The examples above (and many others I could provide to you) seem to prove its veracity. But remember that all lies must have an element of truth in order to make them sound plausible. It is true that you can lose value in your account with so-called “no risk” investments.  And you can certainly lose all your life savings in the high risk investments that claim they will make you rich overnight.  And of course, even if you make a little money in these unwise ways, there is still the principle of “Opportunity Loss.” This is profit that you could have made with the money you invested in the instruments described above. But you lost the opportunity to make those profits because your money was tied up in unprofitable or marginally profitable instruments.

So what’s an investor to do? First of all, recognize that the Big Lie is…well, a lie! The good news? There is a middle ground. There are investments that have good returns and low risk. How do I know this? Because millions of men and women make their livings from the stock market, and some of them make very good livings, indeed. These are by and large very smart people (although I will grant that some of them might just be lucky!). Intelligent people invest their dollars where they get the best return. Stock market investors keep their money in the market because they have found the proper balance between risk and reward that proves that the Big Lie is…a lie.

Balancing risk and reward comes down to discovering High Probability investments, and implementing your investment program with a well conceived risk management system. iDayo, Inc. (www.iDayo.com provides a very High Probability stock selection system that also allows its Members to trade options on its selections. (Options investors like high probability, too.) In High Probability investing the great majority of the investments make profits, and the percentage made on the profitable trades far exceeds the percentage lost on the unprofitable trades. Both a great system of stock or option selection and a great risk management system are necessary to consistent profitability. But today we are going to concentrate on Risk Management.

And we are not even going to discuss one half of the iDayo Comprehensive Risk Management System™ designed by Tom Barrett, iDayo’s CEO. (The other half is the system of diversification which has made Mr. Barrett and iDayo™ famous. This is discussed in two other articles you will find invaluable: “Investing with Low Risk” and “How iDayo™ Made Profits During the Bear Market.”

Let’s focus our attention on the most important Risk Management Tool an investor has at his or her disposal: the use of stops. Stops are often called “Stop Loss Orders” by the uninformed (including many stock brokers!). In fact, the SEC outlawed the use of that term several decades ago because the so-called Stop Loss did not stop losses. Brokers liked the term because it implied that their customers would not lose money, when in fact in most cases when a stop is used a loss is guaranteed.

There are different ways to use Stop Orders (as they are properly termed). The most common use is to limit losses, not to eliminate them. It’s all about risk and reward. The Lord is the only One who gives rewards without any risk or cost on our part. In investing there is no such thing as reward without risk. The idea is not to eliminate risk, but rather to limit risk to a manageable level consistent with making good profits. Thus the name of the article.

We will discuss several different stop techniques that have been proven to work well with the High Probability Stocks that the iDayo™ system publishes. But first we need to understand how Beta affects the level at which you should place your Protective Stop. You should no more invest in stocks (or options) without using stops than you would swing on a circus trapeze without a safety net to catch you. But imagine what would happen if the safety net was too close to you; you would get caught in it as you swung by. And if it was too far away and you fell, by the time you hit the net your speed could be so great that you would still be hurt.

Which brings us to the discussion of Beta. Beta is the relationship of a stock to the market in terms of movement. A Beta of 1.0 would mean that you should expect the stock to move pretty much with the market. A 2.0 Beta would mean that the stocks will likely move twice as much as the market. So a 5% up move in the market should translate into a 10% jump in your stock. The problem is that Beta is a two-edged sword. With that same 2.0 Beta in a market down 5%, your stock would go down 10%.

So we see that a high Beta is good with High Probability stocks. But if you are like the vast majority of Americans, and only 50% of your stock picks make money, you definitely do not want high Beta stocks.

Here’s how Beta affects your decision as to where to place your stop. I had classical Wall Street training and experience when I was in the brokerage business. I was taught to use 10% stops on all trades. That made sense because the stocks recommended by our national firm’s analysts very seldom made large moves. If the reward was not likely to be great, the risk should be minimized accordingly.

When I first became a Member of iDayo™ I had to adjust my thinking. iDayo’s High Probability stocks are by necessity high Beta stocks. A stock with a Beta of 1.0 will never make a 200% move in four months (as many iDayo™ stocks have done) because the market will never move 200% in that frame. That would be like the Dow Jones Industrial Average making a move from 12,000 to 36,000 in four months.

For high Beta stocks a 10% stop is too restricting. They need room to “breathe.” I discovered that the hard way when I first started buying iDayo stocks. There were times they would initially drop 10% or more and I would be stopped out. Then they would run up to impressive gains, and I would be sitting on the sidelines. Needless to say, I quickly learned to trust the system, including its recommended stop levels.

In the past iDayo™ Members have used only a 20% Fixed Stop. That means that once a stock is bought and the stop set 20% below the buy price, it does not change. iDayo’s ten year track record is based on that type of stop.

But for the last four years many of iDayo’s most sophisticated investors have met with me weekly, first via conference calls and then by Webinars. Together we tested variations on the stop methodology. We came to the conclusion that raising the stop level in reaction to upward price movements would capture more profits and reduce the likelihood of being stopped out at a loss.

This can be done manually by monitoring the stock’s price movements and periodically raising the stop level. But an automated “Trailing Stop” is more efficient because it doesn’t depend on the investor to remember to check the stock frequently. Some have asked me why iDayo™ did not employ Trailing Stops back in 1998 when we began publishing stock selections. The simple answer is that automated Trailing Stops were not widely available then.

Automated Trailing Stops work like manually determined and entered Trailing Stops, except that the broker’s computer moves the stop level up for you in increments you determine at the time you place the order. As the stock moves up in price, the stop level goes up as well. But if the stock drops, the stop stays at its last level. The result is that the Trailing Stop captures profits that would melt away with a Fixed Stop.

We found that the best method was to use a 20% Trailing Stop until the price appreciates 50%. At that point it makes sense to tighten the trail to 10%. Once the stock is up 100% we tighten again to 5%. A tighter stop is prudent when stocks make very large gains, because stocks tend to come down much faster than they go up. A conservative investor does not want to lose his or her gains, and an automated Trailing Stop is the best way to capture gains.

A discussion of stops would not be complete without addressing options. While many of our Members only invest in stocks, there are growing numbers of options traders who understand that the best stocks on which to play options are the High Probability selections that iDayo™ publishes. This allows them to take advantage of both the leverage of options and the reduced risk afford by high quality stocks.

The main principle is that the stops on options should not be set according to the price one pays for the option. A trader can pay widely varying prices for an option depending on the time frame and the strike price. Since the option’s value is dependent on the underlying stock’s price movement, it is logical to tie the stop on the option to the price of the stock.

Most brokers offer a “contingent” stop order. With this type of order you are basically saying to your broker, “If the stock drops 20%, please sell my option immediately.” This allows investors to follow the iDayo™ system using options, because they exit the option at the same level at which the stock would be stopped.

We cannot invest without risk. We can manage our risk in order to preserve our capital and maximize our profits. It is my hope that this discussion will help you recognize the wonderful tools that are available to help you realize your investment goals.

Tom Barrett, CEO
iDayo, Inc.
www.iDayo.com
561-753-5998 or
888-LOW RISK