Sunday, March 18, 2012

The Art of Speculation Series 1 - Know when to Sell

As they said, speculation is as ‘old as the hills’. However, there is a difference between speculation and investment. Speculation is an adventure ‘without calculation’ whereas investment is an adventure ‘with calculation’.  

A good example of speculation will be a speculative trade in a mining company. Say if ABC mining company announces that it had started prospecting gold in an area where it believed to hold a massive reserve. Without any further information released by the company, people who buy shares in the company upon hearing the news in hope that it will strike gold are called speculators. This is because the chances of it striking gold is very slim and such an adventure is purely betting because it involves high risk.  

As for an investor, his approach to investing is different. He will look for a company with stable earnings, dividend payout and also a good business model. He would probably be looking for a large multinational with a good track record and hence provides a low risk and steady return.   

The problem with both investors and speculators are they do not know when to sell because buying is easier than selling. Knowing what to buy and not knowing when to sell is akin to a manager who knows how to sell but don’t know how to collect. There are basically two problems arising when you don’t know when to sell.

One, trading profits are still what they call ‘paper profits’ when it is not liquidated. It will be an extremely bitter experience to watch your stock to go up in a straight line and then see it drop dramatically back to your purchase price and worst still below it. I am sure most of us have experience this in our stock market trading. How we wish that we had liquidated the stock before its price head south.

Two, we tend to be greedy when the stock price is going up steadily. Even though it had surpassed our price target, we will not sell because we will always hope it will go higher. However, the inevitable will happen when the stock price corrects, bringing it back to the ground and hence the profit disappears. Even though investors have set a predetermined price to sell, they will ignore it because they doesn’t want to sacrifice any part of their future profits.

So, how do we tackle such a situation? Professionals use a method known as ‘Stop Loss Order’. How does this work?  Say, if an investor buys 10 lots of ABC shares at $1 each, what he will do is put a stop loss at $0.95. If the share price goes down to $0.95 or below then the order will be executed. However if the share price goes up to $1.10 then he will adjust his stop loss price to $1.05. If it keep going up then he will need to re-adjust his stop loss upwards. So whenever the stock price corrects to the stop loss level, the stop loss will be executed and thus the profits will be protected.

Another way to protect your profits and loss is to follow an old adage from Wall Street and that is ‘sell till you feel comfortable’. Say if you bought 100 lots of ABC shares and if it has been giving you sleepless nights then the remedy will be to sell down the stocks until any movements up or down will not affect you emotionally. Hence, you will not have any more sleepless nights.

When come to investing we will need to differentiate between hope and reality. When market turns against us, we need to either take profits or cut losses. As we have said earlier it is easier to buy than sell and taking profits will not make you broke.

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