This column was originally published on RealMoney on March 30 at 11 a.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
One of the most important components of a trading plan is the risk/reward profile. Isn't it common sense that the amount of risk you take dramatically affects your ability to make money? We all want a positive alpha in our portfolio; in other words, we want performance that's better than we'd get if we just bought an index fund.
The problem for many traders is that they don't think in terms of alpha, only beta. In simple terms, beta refers to the degree of volatility in a particular stock, index or even your portfolio.
Interestingly, when I chat with professional money managers, they all talk in terms of alpha. But when I talk with private, retail traders and investors, they only talk about beta. Their idea is that you have to be wrapped up in volatility if you want to make money.
That approach to trading assumes that the more risk you take on, the more reward you're entitled to. However, an alternative outcome of taking on a lot of risk is disaster, and many traders learn this the hard way. In a volatile market, fortunes can change very quickly. It sounds great to say, "Buy low, sell high." But the problem is that emotional reactions to high volatility can jumble up that saying, and you end up with "Buy high, sell low." That happens when all you look for is beta.
So how can you create an alpha component in your portfolio without getting out all the theoretical models and supercomputers? You get back to basics and define your risk according to your anticipated reward. You don't put on a trade where you risk $6 for the possibility of making $1. If your reward is just a couple of points, then your stop had better be tighter than a buck. Otherwise, the trade just doesn't make sense.
If you have a bunch of those types of trades in your portfolio, you don't have alpha; you have agony. Instead, focus on finding long positions where you're buying very close to a key support zone and where resistance is at a high enough level to entice you to weigh the risk of getting stopped out on a decline below support against the potential reward of the stock moving in the anticipated direction.
If that's not a bet that you'd make purely on the basis of the numbers (e.g., risk $1 to make $3; risk $2.50 to make $6, risk $5 to make $15, etc.), then you shouldn't even be looking at the trade. That's because you're not going to outperform the market taking those dinky little trades unless you are right on every single one of them. And that never happens.
Here's what I'm saying in a nutshell: You can go broke taking a profit if all you ever think about is the profit.
Let's look at some reader requests.
This weekly chart of
is pretty ominous. After getting cut in half during the first six months of 2006, the stock has since been working on building a base. But it's standing on shaky ground now, dipping below $17 for the first time since October. If you're trading this bounce, you may be in the wrong stock at the wrong time. Even if Marvell does bounce off support, too many folks are sitting in losing positions over the next $3. I'd sell now.
looks a lot like a ski ramp, moving lower and lower until finally turning up. I don't think the semiconductor sector is where you want to be right now, but if you're long Micron, you might want to consider putting a stop just below the breakout level.
looks a bit like Micron because it recently broke above resistance. But this is a weekly chart, so the breakout is a bit more established.
So far, this week's volume is well above average, and we've still got one more day of trading to go. When I see heavy volume at the top of an advance, my interpretation is that there are eager sellers who are happy to supply all comers for the stock. That's a different dynamic than we'll see in light-volume conditions, when the lower-volume decline might be due to nothing more than passive profit-taking. I'd keep a stop below $25.
looks a bit like a cup-and-handle pattern, popularized by William O'Neill. It's not picture-perfect, but the dynamic is similar: a strong advance from July until January, followed by some backing and filling on light volume. That's a recipe for a breakout, which we've seen over the past couple of weeks. A relative strength index, or RSI, that stays above the midline on pullbacks is a bullish sign, so if you're long, why not just let it ride? But I'd consider putting a stop back down between $17 and $18. If the stock falls that far, it has more work to do, and there's no reason to stick around while the work is being done.
is making a series of higher highs, while falling back to $26 on each pullback. That makes it increasingly difficult for the bulls to maintain a series of higher highs. At some point, buying pressure will dry up before the stock surpasses the previous high. When that happens, we could see more aggressive selling. But for now, I'd wait to see whether buyers step up at $25 again. And if I were long, I'd sure keep a tight stop.
Be careful out there.
At the time of publication, Fitzpatrick had no positions in any of the stocks mentioned, though positions may change at any time.
Dan Fitzpatrick is the publisher of
, an advisory newsletter and educational forum dedicated to teaching effective risk management and trading methodologies to aspiring traders and investors. He is a former hedge fund manager and a member of the Market Technicians Association, and he now trades from his home in San Diego, Calif. While Fitzpatrick holds various securities licenses, he does not give recommendations to buy or sell stocks. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback;
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