We’ve all been there…
You’re flying high one minute. A moment later, everything is crashing around you.
Nasty surprises are one of life’s most unwelcome events. When they happen, we’re often left wondering: What could I have done to avoid this?
The usual answer is: Not much.
You see, life has a certain randomness. It simply isn’t possible to control every variable — no matter how hard we try. The reality is that bad stuff can happen without warning.
Few places are more prone to surprises than the stock market. A stock can look good one day, and then be hit by a sharp downdraft the next. This is one of trading’s most unenjoyable experiences.
I’ll talk more about this in a minute. You’ll see why many traders get nowhere in the market. But first, I’ve got a story to tell. It’s about a nasty surprise I hope you never experience.
Trouble in paradise
The year was 1998. I was in Singapore visiting an old friend and his wife. My wife was joining us a few days later. The four of us were heading to the Thai holiday island of Ko Samui.
But there was a last minute hitch. Our beachfront bungalow wouldn’t be available on time. Rather than waiting a few extra days, the decision was made to switch destinations.
A couple of hours later we had a new itinerary. We were now off to the white-sandy beaches of Cebu — an exotic getaway in the southern Philippines.
Our arrival at Cebu airport was like any other. However, a nasty surprise was only minutes away.
The terminal was typical of many in the region. Heavily armed police and anti-drug messages set a serious tone. The harsh penalties for drug trafficking were abundantly clear.
But none of this was a concern to us. With any luck, we’d be swimming in turquoise water within an hour. All we had to do was collect our luggage and find the hotel shuttle bus.
The baggage carousel was the usual hustle and bustle. My bag was the last of all the passengers’ to appear. It was a large blue canvas duffle bag with a number of zip pockets.
But something was wrong…
Large white chalk ‘X’s were on every face of the bag. My body went cold as the bag slowly made its way towards me. Airport security had flagged my luggage for closer inspection.
This was the nastiest of surprises.
My instant fear was that someone had put drugs in the bag. The zipper pockets made it easily accessible. Was the unimaginable happening to me?
Three choices quickly came to mind:
- Leave the bag and walk away;
- Look inside and clean off the chalk;
- Pick it up and head to customs.
My bag was already attracting attention. I really only one choice — option three.
Sure enough, the customs officers were waiting. They told me to step to the side. Two of them then went through my bag, compartment by compartment.
Time stood still. My heart was racing. It was terrifying.
And then it was over. I had the all clear to move on.
The reason for all this is still a mystery — I didn’t get an explanation. But it’s still the most vivid of memories. This was by far the most unpleasant surprise of my life.
The airport baggage carousel isn’t your typical trouble spot. But that’s the nature of nasty surprises — they can happen anywhere, and at any time.
A more frequent source of surprises is the stock market. Chances are you already know this. The sting of a sudden setback is something many traders experience.
Let me show you what I mean…
Click to enlarge
This is the chart for biotech business Sirtex Medical [ASX:SRX]. It gave the market one the worst surprises of 2015. The stock was also in the Quant Trader portfolio.
SRX had been trading strongly right up until it fell. It was actually one of the best performing ASX stocks at the time — up 150% in the previous 12 months.
The selloff was due to a clinical trial not meeting expectations. More than $1 billion — or 61.5% of the company’s value — vaporised at market open. It was the nastiest of surprises.
But this didn’t have to be a disaster (and it wasn’t for Quant Trader’s portfolio).
You can limit the impact of an SRX with one simple strategy — spreading your risk.
Many traders make the critical mistake of placing a few big trades. This increases their portfolio’s vulnerability to the sudden collapse in a single stock.
I’m going to show you three scenarios from back-testing. I’ve set these up to simulate how many people trade. The strategy you’ll see takes profits early…and let losses run for way too long.
The swing factor is the number of stocks in the portfolio.
Here’s the first test…
This is the most dangerous strategy — the single stock portfolio.
Now, it’s possible to make a fortune with this method. But you need a lot of luck. It all hinges on buying the right stocks. You only need one SRX to bring it all undone.
This test (and the others you’ll see) starts on 1 September 2009 with $20,000. The system follows the first available entry signal whenever it has free capital. It then takes profits when a stock is up 30%, and holds losing trades until losses hit 75%. I see people trade like this all the time.
Despite the ineffective strategy, 80% of the exits were profitable. This can happen when you resist cutting losses and take profits early.
But the simulation still ends with a loss. A small number of big losses weigh it down.
Let’s move to the next test…
This test uses the same variables as before. The only difference is a wider spread of risk. This strategy allocates its capital across four stocks.
Overall, the result is still poor. The sequence of trades for this test didn’t produce a string of large wins. But the impact of any one loss is lower than the single stock portfolio.
OK, it’s time for the last test.
This time I’m going to increase the portfolio’s size to 20 stocks.
What do you think will happen?
Let’s have a look…
Spreading risk widely has made a big difference. Volatility is noticeably lower than the smaller portfolios. A nasty surprise in one stock has less overall impact.
Let me give you an example.
Say you put all your capital ($20,000) into SRX just before the collapse. The next day, the stock opens 61.5% lower. Your account would now be worth $7,692…it’s a disaster.
Now let’s suppose a different scenario.
This time you put a quarter of your funds into SRX. You still take a hit. But it’s not as bad as if you bet the house. Your account is now worth $16,923. You can bounce back from this.
Finally, there’s the 20-stock portfolio. Each trade represents 5% of your capital. Your loss on SRX is a mere $615…it’s a blip. Your portfolio is off just 3%.
There’s another important benefit to owning more stocks: It increases the odds of getting on some good trends. This also helps make the third scenario the most profitable.
Big bets can seem like a fast way to riches. But the consequences can be lethal.
Nasty surprises can and do happen. Limiting their potential for damage is vital. Quant Trader’s strategy for this is to spread risk. It’s about many small trades — not a few big ones.
Until next week,
Editor, Quant Trader
Editor’s note: Despite the recent market volatility, Quant Trader has recently cashed out several big winners. Last week, the system booked a 72.5% gain in Fisher & Paykel. The week before that, it was a 140% profit in Smartgroup. And two weeks earlier, Quant Trader closed out Auckland International Airport for a 65% gain. Imagine profits like these in your account. Get immediate access to Quant Trader’s signals — and claim a 30-day trial subscription — by clicking here.
PS: Quant Trader sources all images and charts above unless otherwise stated.