We went long in the YBR portfolio yesterday with selections from the "Explosive GRT & EPS Stocks" Strategy. The VectorVest RealTime Derby made the decision to pick this strategy as simple as pie.

The "Explosive GRT & EPS Stocks" portfolio clearly had the highest performance rating of the strategies recommended in Wednesday night's Views. We calculate a portfolio's performance rating by multiplying the percent winners times the percent gain. Since the RealTime Derby calculates the percent winners and the percent gain on a tick by tick basis and delivers the results on a second per second basis, we were able to make our decision quickly and easily.

If you are not using VectorVest RealTime, you can obtain a close approximation of a portfolio's real-time performance by using our Portfolio Tracker, which is free. Another option would be to use Yahoo!Finance. In this case you'd have to manually build a WatchList of the stocks from each strategy and check them when the major indexes all gain more than 1%. This event happened yesterday at 10:09 AM, so we jumped in.

Now we are faced with the task of managing the portfolio. You may recall that the original exit strategy for a long YBR portfolio was to sell any stock that had achieved a 50% gain or a 30% loss. Stocks that were sold from the portfolio were not replaced. In real life, I found that I could not handle using a 30% Stop, so I began to use tighter Stops. I finally settled on using Stops that were 10% below the higher of the purchase price or the highest closing price attained thereafter. This seemed to work quite well, but I don't know if it gave the best results as far as risk vs. reward goes.

Even though I did some investigative work on this issue, I asked Mr. Glenn Tompkins to look into it more thoroughly. My ultimate goal is to get the maximum profit at the minimum risk. I'm sure that Mr. Tompkins will be able to help me find the sweet spot in Managing the Yellow Brick Road Portfolio.

Many years ago, I received a frantic call from a gentleman that had "bet the farm" on a speculative stock that was mentioned on CNBC. He was losing his shirt on the position and wanted to know what to do with it. Even though I felt very bad for him because he had been paralyzed in an auto accident and bet his entire injury award, $360,000 on the stock, I refused to offer him any advice. But I wondered, "How could he be so stupid?"

This incident led to my classic essay, dated 05/24/96, "Where's the Beef?" More recently, 05/11/07, I wrote about a guy who lost $500,000 on the quiz show, "Are You Smarter than a Fifth Grader? Two weeks later, I wrote another essay called, "The Risk of Ruin." It was about position sizing, actually.

Position sizing is a very important part of portfolio management and, in fact, it is the first thing one should consider when putting money at risk. Before making any investment, whether it be for the purchase of a car, house or stock, one must ask, "How much can I afford, or am I willing, to lose on this investment?"

The answer to this question has several parts, the first being that of asset allocation, i.e., "What percent of my net worth can I risk in this particular asset class?" Once this has been translated into dollars, you know how much money you have to work with. Let's suppose the amount is $10,000. The next question becomes one of, "How should I invest it?"

It is generally believed that one should not risk any more than two percent of their stake in any single stock position. Even that seemingly small amount is too much for me. I believe that one should not risk any more than one percent of their stake in any single stock position. (See my 02/06/09 essay on Risk Management). What? One percent of $10,000 is only $100. How can I make any serious money investing only $100 at a time?

Hold on, silly boy. There's a big difference between what you invest and what you risk. For example, you may invest $1,000 of your $10,000 stake in any single stock position and still limit your risk to $100 by using a 10% Stop-Loss order. Or you can invest $500 in any single position and use a 20% Stop-Loss order. In fact, there are an infinite variety of investment and Stop-Loss combinations you can use to limit your risk to one percent of your stake. My essay, "How to Set the Right Stop-Loss Percent," dated 02/20/09, explains exactly how investment decisions and Stop-Loss percentages are tied together in Position Sizing.

In regard to managing the Model Portfolio, we start with a stake of $100,000 at the beginning of the year and normally elect to have 10 positions with a 5% or 10% intraday Stop-Loss, depending on how we feel. At the end of each day we calculate new Stop-Loss Prices from the higher of our purchase price or the highest closing price since purchase. Our goal is to get the Stop Price above the purchase price as soon as possible.

In the current campaign, which started on Monday, June 22nd, we used 50% of our available funds to establish 10 positions. Therefore, we are effectively risking only 5% of our stake even though we're using a 10% Stop. Moreover, we have not been replenishing vacated positions since the downturn has appeared to fizzle-out.

One of the errors many investors make is they think that making money in the stock market is only about picking the right stocks. It could be if you're right all the time. But nobody is right all the time. So the secret to success is that of making money in spite of your losers. In fact, many of the most successful money managers say that of even greater importance than stock selection, is Position Sizing and Portfolio Management.

Our experience with the current C/Up Yellow Brick Road campaign is much better than the one we had starting on January 9, 2009. What was done differently?

First of all, we took steps to prepare you better for your entry into the market when we got the C/Up signal. For example, I wrote an essay on "Avoiding the Stampede" on March 13th, well before we actually got the C/Up signal on March 26th. Then I wrote another essay on March 20th, called "Off to See the Wizard." This essay explained that we would be suggesting several strategies for you to consider when going long on the C/Up signal because we knew that our subscribers would move-the-market if too many tried to pile into the same stocks at the same time. So we reiterated our guidance on avoiding the stampede and suggested five additional Strategies that were described in our "Strategy of the Week" presentation called, "The YBR Express Lane." Therefore, we suggested six Strategies on March 26th, when the C/Up signal arrived.

We also said, "Please do not buy any stocks tomorrow unless the market is moving higher and please use limit orders." I can't emphasize enough how important it is to buy rising stocks only when the market is rising. Well, the market did not rise the next day. In fact, it got hammered for the next two trading days and the Primary Wave went from Up to Dn. So we sat tight. Finally, on April 1st, the Primary Wave turned to Up again, and we alerted the "Yellow Brick Roaders" to prepare for entry. We went long with "Explosive GRT & EPS Stocks" on April 2nd.

Now, the fun began. It turns out that the suggested Exit criteria for the Yellow Brick Road Strategy was a 50% Gain or 30% Loss. I found that I liked the 50% Gain, but I became increasingly uncomfortable with the 30% Loss. Some of these stocks, such as ALTI, soared early on but came down sharply shortly thereafter. I didn't like that. Why should I be using a 30% Stop-Loss when the stock had soared nearly 36%? Normally, I would raise my Stop so that I could capture most of the gain. Moreover, I'd be a damn fool if I ended up losing 30% on the stock. So I tightened my exit criteria and I began using a Ratchet Stop when I thought the market was getting toppy.

The VectorVest Ratchet Stop is defined as, "the highest Stop-Price reached while the stock was in your portfolio." In the case of ALTI, this would have been $1.09, one cent below our purchase Price of $1.10 per share. The Model Portfolio shows that ALTI was sold at $1.10 per share on April 28th. Subsequently, I began using a 20% Ratchet Stop to exit positions. These Stops are usually higher than the VectorVest Ratchet Stops.

Nevertheless, I ran a back-test this morning just to see what the affect of using a Ratchet Stop instead of the 30% Stop-Loss would have been on this portfolio's performance. As of yesterday's close, the Ratchet Stop portfolio was up 35.71% and the 30% Stop-Loss portfolio was up 40.01%. Our actual gain since April 1st is 36.94%. Not bad in any case. Even though the 50/30 G/L portfolio had the best performance, I still prefer using a combination of 50% Gain and the VectorVest Ratchet Stop.

Recently, I received the following email: "Would it be possible for Dr. DiLiddo to do an essay on sell stops? I have been whipsawed out of so many good stocks lately due to stocks ranging from 20 to 30 percent below the price only to see the same stocks recover quite rapidly. I end up buying the stock at a higher price if I want to continue to stay with it. I have lost more money that way than if I had just stayed with the stock with very few exceptions.
I called my broker at Schwab and he said he never uses stops as the Wall Street traders have a window to see where the stops are on all stocks and control enough of the stock to sell it down to knock out the stop positions and turn around and buy them when they go back up. I am sure this is nothing new but it is costing all of us a tremendous amount of money. He suggested that I put alerts on stocks so that I could make my own decision if I want to sell or not. I know this only works well enough if you are there to deal with the alert, but it may have some merit.
Even if I try to guess the range the stock is in, it seems to take drastic dips if only for a few minutes and I am sure that is where Wall Street is knocking out the stop prices. It is very frustrating."

Best Regards,

Norm

Ah Norman, I feel your pain. We have experienced the same frustration of having stocks go exactly to our Stop Price, knocking us out and returning to their normal trading pattern. How are we addressing this problem?

Let's see what we have done in managing the Model Portfolio. First of all we have been favoring highly liquid stocks. For example, we decided to buy only the five highest AvgVol Contra ETFs when we went into the market last Tuesday. My belief is that it would be virtually impossible for any trader to manipulate the price action of these actively traded stocks. Next, we bought only five stocks instead of the usual 10 because these particular ETFs behave pretty much the same. Consequently, we would not have received much more diversification by adding additional positions. Of course, having five positions instead of 10 makes it easier to manage the portfolio, but it also increases the percent risk of loss on any single position.

To counteract the problem of higher risk, we chose to use only 50% of our available funds. This decision also allowed us to use a 10% Stop-Loss instead of the 5% we normally use. The wider Stop-Loss Percent helps accommodate the high volatility of these stocks and also makes it harder for traders to knock us out of our positions.

Do you remember the formula that I presented in my February 6, 2009 essay on Risk Management? Well, here it is again:

S = (100 * R * N) / C

Where
S = Stop-Loss Percent.
R = Percent Risk of Loss on any single position.
N = Number of positions, and
C = Percent of Capital employed.

Basically, we like to keep R, the percent risk of loss on any single position, equal to one percent. So with five positions and 50% of our capital invested, we should be using a 10% Stop-Loss. And that's what we have been using.

Now here's how to relieve your frustration, Norman, and make money in this market: First and foremost, you must "let the trend be your friend." I know it wasn't easy to do while we were in the grip of the Wicked Wedge, but you must remain patient and be prepared to take what the market gives you. Last week, we were prepared to go either long or short in our Model Portfolio depending upon what the market gave us. The market went down, so we played the market to the downside with Contra ETFs.

The next thing to do is trade only high volume stocks---say those with an AvgVol of 250,000 shares or more. Then you should use the widest Stop-Loss percent that you can. Let's say you want to keep R to one percent and trade a 10 stock portfolio. Now, if you invest no more than four percent of your available funds into any single position, i.e., employ a total of 40% of your available funds, S = (100 * 1 * 10)/40 = 25%.

That's How to Set the Right Stop-Loss Percent.