Capital Management

Capital Management has always been part of the syllabus in academics but i think it has moved up the ranking level in terms of importance due to its relevancy to apply them to the real life markets. Of course, not forgetting the financial crisis that has wiped out billions of dollars from the markets, also contributed in making Capital Management one on the most important subject in schools. Let me just touch some of the topics that falls under this broad category and share some possible solutions to the problems.

Cutting Losses (Capital Preservation)

Money management in its most basic form, is to know when to take calculated risk and when to cut loss for $$ losing trades. Assuming that most readers are familiar with the 3 phases of a stock cycle (accumulation, consolidation, distribution) – a lot of the retail investors who got “stuck” at the distribution stage will tend to be overly hopeful and are less willing to accept the fact that they are actually catching the falling knifes from the Institutional Boys. In fact, those people who get stuck in this kind of situation will usually find themselves sinking into deeper shi* since institutional selling will usually last longer than a few days. The difficulties in cutting losses for the losing trades will increase over time and these investors will then have no choice but to convert themselves into long term investors. Cutting losses is never easy as it is an act of admitting that you are WRONG. Trust me, no1 in this world wants to be wrong…

What should you do?

  1. Before entering into a trade, list down the reasons that prompted you to click on the “BUY” button. (If possible, look out for reasons NOT to buy this stock – this will complete an investment decision)
  2. Decide on an entry level and set a stop loss limit BEFORE entering the trade.
  3. After being caught in the above situation, this stop loss limit will be your life jacket as your mental strength weakens and you find yourself sinking deeper and deeper into the ocean of despair. This happens when the stock goes against you the moment you entered the market. Just when you thought all is lost and you are going to be consumed by the darkpool in the ocean, your life jacket get inflated and poof! You are alive! Merely losing your life jacket (10% of invested capital?) in the battle of the mind.
  4. Take a break and review the pros/cons for this counter. Are the points that prompted you to buy still valid? If they are, you might want to gather yourself together and find another entry level after the sell down. Else, move on! You might have lost 10% of your initial capital, but you managed to free up the remaining 90% and prevented any loss of opportunities going forward. A worthwhile bargain afterall.

Leverage

A powerful tool that can potentially reap profit of multiple times when used correctly or a self-destructive tool that can potentially magnified your losses when utilise by a newbie. A double-edged sword like leverage, is only suitable for savvy investors who fully understood the working mechanism behind. Any investors who only focus on the potential benefits without a thorough knowledge of how it works, is courting their own doom. Leveraged products available in the markets includes the commonly seen FX trading, CFD (contract of difference), margin/share financing trading..etc. I shall not elaborate on the details of each product as that will probably take up a few pages of my post. Kindly approach your brokers for more information. Once you are familiar with them and are ready to tackle leverage, here’s some tips that might be helpful:

What should you do?

  1. Keep your free equity/maintenance margin/initial margin in check! Make sure you are very sure about the amount of leverage given to you, be it cash or shares financing. Track the amount of free equity very closely, as this is the amount that you will have left as a safety margin (mark to market) after taking any positions. Should the market goes against you, this amount will be reduced by the mark to market losses and a margin call will be triggered once this number hits 0! Afterwhich, you have 1-3 days to top up the account b4 they liquidate your position.
  2. It is a good practice to leave around 50% buffer as your safety margin so as to ride through the market movements without having to worry about getting margin called. eg.) Assumption: 10k cash in margin account, Leverage 10x, maximum position possible: 100k (Try to utilize only 50%, ie to say, take a maximum position of 50k only with 5k and leave the 5k as a safety buffer since this amount will fluctuate as your P/L goes up and down).
  3. Check your FX/CFD account daily and note the difference between these account holdings Vs your CDP holdings. These holdings are basically virtual and no shares will be going through CDP (for the case of CFD). Since these holdings are not “picked up”, they requires your attention everyday as the P/L will be updated on a daily basis.
  4. As an advocate of safe investing, i always stress that you will only take positions that are within your risk tolerance level. For eg.) Same assumptions as of above, if 1000 shares of DBS cost $15,000 in normal shares, 1000 shares of DBS will cost you $1500 in a CFD account. Although you can buy a maximum of 6000+ shares in the CFD account, you will be overleveraging yourself if you do so since you cant even pick up 1000 shares in the real market!!! Hence, a safer way to take on leverage is to buy maybe 1-3000 shares in DBS and take advantage of the big movements in big cap stocks. (Use leverage to your advantage and it is best ultilized in taking positions in big cap stocks since you will be unable to do so previously in the cash market).

Averaging down/Pyramiding up (Buying)

If you are using the staggered buying strategy, thumbs up for you! In this manner, you would have reduce the chances of getting yourself stuck at a price significantly and this will leave you with more ammo should the price correct/run up in the future. This is important as this strategy will prolong your survival in the trading game and ensure that you have sufficient ammo to last through the investment cycle. Here are some tips for thoughts:

What should you do?

  1. If you have used up only 30% of your ammo to buy a stock @ $1 (example), you will have the option to average down when it drops to say $0.80. Personally, i feel that a stock is worth averaging down only after a significant drop, say 20%. When the share price plunged to $0.80 cents, check out the news flow/technical aspect of stock (gaps will usually get covered, just a matter of time). If the outlook seems fine and the fundamental of the company doesn’t change, you can consider adding more positions at this level. This will take up another 30-50% of your capital depending on your risk appetite.
  2. Averaging down using another stock – another strategy that is often forgotten. Assuming that stock XYZ and ABC are companies in the same industry of a similar size and market share, both intrinsic value is at $1. If you have spent 30% of your capital in stock XYZ at $1 just before a major correction and price of XYZ dipped to $0.80 after the correction, you have the option to average down in XYZ. However, if you notice that ABC has plunged to $0.50 after the same correction, you can actually switch over to buy into ABC over XYZ. In fact, assuming everything is identical after the recovery, you will be better off in ABC as the rate of return will be higher in ABC over XYZ!!
  3. Pyramid up – another very useful strategy if the plan is well executed. Basically, taking the same example from point 1 – if you buy into a stock at $1 (30% of total capital), when it rises to $1.10, the strategy is to pyramid up, and load up another 15% of total capital @ $1.10. When the stock rocketed up to say $1.30, load up another round of say 5-10% at $1.30. When the party finally ends at $1.30 and starts to reverse the trend to $1.170 (take profit level set @ 10% from peak), sell all your holdings @ $1.17. In this manner, you would have lost the last leg (small amount) and profitted heavily on the 1st 2 legs of run up (huge bottom).

Try them and see these strategies work!

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