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you risk the possibility of losing 50% or more of your portfolio value?

Referring to Figure 3.1, you can see that an investor who bought the Value Line at the lows in December 1984 and held until August 25,1987 (my indicators gave sell signals on August 25) was up 67.9% before dividends. If the same investor held through October 5, when again there were signs of a top, then he was still up 65.9%. But if he continued to hold, then by October 19 he had lost all of his accumulated return-he was back down to a 0% return before dividends-two years and ten months worth of profits down the tubes in just 14 days! Clearly, the risVreward wasnt there. You might say that "hindsight is always 20-20," but I was almost completely flat-most of my money was in T-Bills-from August through October, and I was short through the crash. As the book progresses, yo uU see why this wasnt luck.

Another case where I consider the risk too great to participate is to invest heavily in takeover stocks and junk bonds in the latter part of bull markets. Some people will tell you, "There is always a good deal out there, no matter what the condition of the stock market." Well, maybe so. But I have lived through and seen what bear markets are like. Stock prices drop day after day with no end in sight. Previously strong businesses are forced to liquidate assets to service their debt, and many weak and/or highly leveraged businesses go bankrupt. Leveraged buyouts (LBOs) are just that-leveraged-and the speculative bubble that made them popular in the eighties was bound to burst, as was indicated by the United Airlines fiasco in October 1989.

Value Line Monthly Bar Chart





2. &7 \ 299.&0

10/2/S7 2&3.:7

\2J&A Low


10 /&7 Low 173.&0

1982 1983 1984 1985 198b 1987 1988 1989

TQ 20/20 CC 1991 CQG Inc. Figure 3.1 Value Line monthly bar chart. An investor who bought the Value Line at the December 1984 low and held it until the August 1987 high was up 67.9% before dividends. If the investor continued to hold until October 2,1987, he or she was still up 65.9%. But a mere two weeks later, at the close of

October 19, all the gains were wiped out.

By my philosophy, the only reasonable way to be involved in an LBU near market tops is to get involved early, buy calls with a risVreward ratio of 1:10 or better, and participate in a small way. Then before the stock price reaches the target takeover values ... take your profit and run!

On the other hand, the ideal time to get involved in a takeover is at bear market bottoms or in the early stages of a bull market. This is where the real value is. As Robert Rhea put it, the last stage of a bear market "is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets." The market player who avoids being invested near the top of bull markets-where he can really get hurt in a panic crash-and plays the short side in bear markets can be in the position to take advantage of such distress selling. You might miss the last 10 or even 20% of the gains to be made near bull market tops (while making T-bill yields), but youll definitely still have your capital when the time comes to buy value with tremendous upside potential and almost no downside risk. In my view, the way to build wealth is to preserve capital, make consistent profits, and wait patiently for the right opportunity to make extraordinary gains.


Obviously, the markets arent always at or near tops or bottoms. Generally speaking, a good speculator or investor should be able to capture between 60 and 80% of the long-term price trend (whether up or down) between bull market tops and bear market bottoms in any market. This is the period when the focus should be on making consistent profits with low risk.

Consistent profitability is a corollary of the preservation of capital. Now what do I mean by a corollary? A corollary is an idea or a principle which is a direct consequence of another more fundamental principle. In this case, consistent profitability is a corollary of the preservation of capital because capital isnt a static quantity-it is either gained or lost. To gain capital, you have to be consistently profitable; but to be consistently profitable, you have to preserve gains and minimize losses. Therefore, you must constantly balance the risks and rewards of each decision, scaling your risk according to accumulated profits or losses, thereby increasing the odds of consistent success.

Suppose, for example, that you operate on a quarterly accounting basis. When entering a new quarter, any new positions should be small relative to the risk capital available because there are no profits accumulated for the period. In addition, predefined exit points should be established at which you admit being wrong, close out your position, and take the loss. If your first positions go against you, the size of any new position should be scaled back in proportion to your loss. That way, you never end a quarter losing all of your risk capital-you always have some left to build with. Conversely, if you make profits, you should apply a portion of the profits to your new positions while banking the balance, thus increasing your upside potential while preserving a portion of gains.

If I were a young speculator with $50,000 to trade in the commodities futures markets, I would take an initial position of no more than 10% of the total-$5000 set exit points to limit potential losses to 10 to 20% of that-a $500 to $1000 loss. In other words, I would set it up so that my losses were n more than 1 to 2% of the total risk capital. Upon losing $1000 in the first trade. I would scale back my next opening position to $4000 and limit my losses to somewhere in the $400 to $800 range. And so forth.

On the upside, if I made $2000 on my first trade, I would bank $1000 and increase the opening size of my next position to $6000, in effect reducing my initial capital at risk ($5000) by 20%, while increasing my actual risk capital by the same amount. That way, even if I lost on my next trade, I would still be up money for the period. Assuming that I was right in my market calls 50% of

the time, I would make a lot of money by employing this strategy. And I would make a respectable living being right on only one out of three trades, provided I maintained a risVeward ratio of, at most, 1:3. In other words, if you pick opportunities so that the probable reward is at least three times greater than the objectively measurable potential loss, you will make profits onsistently over time.

Anyone who enters the financial markets expecting to be right on most of their trades is in for a rude awakening. If you think about it, its a lot like hitting a baseball-the best players only get hits 30 to 40% of the time. But a good player knows that the hits usually help a lot more than the strikeouts hurt. The reward is greater than the risk.

This concept of constantly balancing risVeward to keep the odds in your favor applies no matter what trend you are involved in. For example, when I day trade the S&P futures, the smallest movement I am interested in is one where I can select spots to limit losses (usually by setting stops when I place the order) to between three and five ticks (a tick is equal to $25 per contract), while the nearest resistance or support levels on the profitable side are a minimum of 15 to 20 ticks away. If I were

looking for an intermediate movement, I would apply the same principles but with different dimensions, such as one to three points of risk versus three to ten or more points of profit.

For example, although I took my short position with options to increase my leverage in October 1989,1 considered shorting the S&P Index futures as well. Basing my decision on reasons described earlier, I would have gone short (refer to Figure 3.2) the S&P Index on Thursday, October 12 when prices failed through the August 5 high of 359.85; and I would have been looking for a sell-off of several days to at least 346.50-the previous minor sell-off low. The market would prove me wrong if it went above 364.50-the high set on October 10. What was my objective risk? It was 4.65 points or $2325 per contract. What was my probable reward? It was 13 points or $6500 per contract-for a risVreward ratio of 1:2.8. Although this doesnt strictly meet my criterion, my other risk assessment factors would have overridden the small discrepancy.

Once the market moved through the probable reward point (point 2), 1 would have lowered my exit points to ensure a profit. I would have watched further minor support points (points 3, 5, and 6) to see how the market reacted to them, while lowering my stops on the way down. There is a trading rule that says, "Let your profits run, and cut your losses short." My interpretation of this rule is, "Neve r give back more than 50% of any gain." In this case, once prices broke 346.85 (point 2), I would have set my stop at 347.10, then moved it down when they broke through points 6 and 7. The most likely result is that I would have been stopped out at 342.15 (four ticks above point 7), for a profit of 17.7 points, or $8850 per contract. Because of all the factors pointing to a correction, I would have considered this a low -risk trade; but I was so confident that the market was going to tum down that I bought out of the money puts to maximize leverage instead of playing it this way.

S&P December Futures Daily Bar t h.irl

34000 -

32000 -

30000 -

TQ 20/20 t 1991 CQG Inc.

Figure 3.2 Trading the S&P Futures through the October 13,1989 crash. Important trading levels.

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