Define the Risk Before You Buy

In scanning the headlines today it is amazing how many are focused on the broad markets testing lower, pulling back, correcting or just flat out falling fifty-percent. Each time the market has hit a new high over the last 12 month the doom-and-gloomers have come out of the woodwork to tell us how much danger there is putting money to work in the market at the current levels. No one really know where the right side of a chart of the market is going, but everyone has their suggestions or convictions. Thus, I don’t know that it is really worth the argument relative the future of what will, may, could, should happen? I find it similar to the articles on Wednesday on which stocks to buy because the republicans won control of the Senate. First, they have to be sworn into office, and then the Senate would have to meet, propose a bill, vote to approve it, send it to Congress, have them vote and then forward it to the President to sign off to make it law! Wow, I bet that happens next week! Speculation sells newspapers and moves markets short term if it is believable enough. The reality is it takes time for the market to react to events and develop them into either short or longer term trends. All that said, what do we do with the markets at new highs or near the old ones? Should we still be buying? Again, that would be speculation on my part. Buying now depends on your strategy, is it sustainability longer term and are we willing to accept the risk of the trade moving forward. In other words, define the risk of the position to your portfolio before you buy, not after, and in turn you will answer the question.

There is obviously elevated risk in buying SPY, SPDRs S&P 500 index ETF now versus four weeks ago. The higher the market climbs the greater the risk of the asset. However, that should not stop us from buying SPY if it make sense relative to the current market activity and belief the markets will continue to grow going forward. It is important to note that we have a belief about what the market will do based on our research, we don’t know, or our belief is our way of speculating what we deem will happen based on our strategy or research. The key is knowing what you will do if what you believe to be true… isn’t. What we believe to be true about the markets looking forward will either be validated by the markets activity or invalidated by the markets activity over time. The goal is to be willing to accept either answer and have a plan of what to do in either event. Defining the risk of the position prior to putting money at risk allows you to handle the action to be taken when it arises… good or bad.

We evaluate risk prior to buying a position, but we never stop that evaluation process as the market continues to evolve every day and it repaints the story or belief as more data unfolds and the next bar is posted to the chart. Thus, we will continue to measure the risk of each position daily relative to the current market conditions. Risk management is an ongoing process as long as we have money invested in the market.

For illustrative purposes below is a chart of the S&P 500 Index. As you can see the resistance from the ‘V’ bottom pattern was 2012 and break above that level would be a breakout and continuation of the previous uptrend. Thus, if we use the 2015 level as an entry point for investing. (please note you cannot buy the index) We would use a break below 1985 as our stop or exit point should the breakout fail as an entry point (the market invalidates our belief). 30 points would be the risk or 1.5%. Our target based on the projections looking forward are 2155 or a possible gain of 140 points or 7% (market validates our belief). We can thus define our risk if the trade doesn’t work and as the trade moves forward we have a way of measuring our risk daily relative to what takes place in the markets. Defining your risk before you buy is the key to managing risk while you own the position. The goal is to keep the process both manageable and profitable or worst case controlling the size of our loss.

SP500