Upside versus Downside

Stocks that appear to be on sale may not be worth it. I usually won't buy a stock unless I believe I can make around 100% or more for my money. The downside risk needs to be negligible also. The fundamentals of the stock and the macro view of the world need to be examined before buying a stock regardless of whether the chart looks good or not. It is not worth it to gamble on buying a stock with a possible 20-30% upside versus a downside risk of that same amount.

A recent example of this is GMCR, Green Mountain Coffee Roasters. They sell the Keurig single cup coffee makers, and I love the one that I own. I also enjoy the single cup serving K-cups of coffee that GMCR sells. I believe the company has great products, and they will continue to grow.

However, when it comes to investing, GMCR may not be the best choice. In November of 2011, the stock price had dropped to the mid 60s from a high of over $100 per share. The chart made it appear that GMCR had formed a bottom in the mid 60s, but "the devil was in the details." It still had considerable short interest against it, and when it missed its earnings for the quarter narrowly, the stock sold off in an avalanche and dropped 38% to $42 per share. This was a costly loss of capital for anyone who had just bought the stock in hoping that it would go back to $100 per share. At $42 per share, the stock's PE was still high at 32, and it was a lot higher at $67. At its high around $108, GMCR had a PE of around 80.

So, GMCR had about as much downside risk in the mid 60s as it had upside potential. No one can deny the company's growth, but investing must be done carefully to avoid large losses. Bad things can happen as much or more than good events. Unless the downside risk of a stock of almost nothing, and the upside is fairly certain to be around 100%, it is not worth investing your money.

Fixed Asset Allocation

In today's turbulent market, it is necessary for an investor to have a good plan to prevent a possible large financial loss in stocks. One way to do this is to allocate one third of your portfolio to shorting stocks, one third for long stocks, and one third for dividend stocks or bond ETFs. For example, if you have $9,000 to invest, $3,000 would be allocated to each group.

It will also be important to keep the gains or losses inside each respective group in your portfolio. For example, if you own TVIX, the double volatility index ETF, as a stock for essentially shorting the market, and the initial $3,000 investment gains another $3,000, the $6,000 stays in the shorting group. When TVIX is high, you could sell it and buy it back again whenever it hits a low point. In this way, you could eventually make a million dollars in the shorting group, and it would not matter then if your long stocks and dividend stocks all went to zero.

This plan will protect you from losing all of your money because the stock market cannot destroy a person in all three of these directions if you are buying and selling at reasonable levels. For example, I know a man at work who bought TVIX in the first half of 2011 for somewhere in the $20 range. Then, when the stock market fell apart in August and September of 2011 due to Congress failing on budget issues and due to European financial problems, TVIX went as high as $100 per share. My friend sold TVIX at $68 after his initial money tripled since the price increased over three times. He made around $20,000 profit in just a few months with a modest investment of around $10,000, and he closed his position with $30,000.

This situation will also be highly predictable for years to come. The world will be wrestling with financial problems until the end of time, and money can be made in the stock market simply by being in the right stocks at the right time. For example, if you are patient with TVIX, you can probably make 200% profit per year just like my friend did. The market volatility will only subside intermittently because the world's problems are too great. When TVIX is low, you can buy it with your allotment of shorting funds and sell it when you are up 50% or more. Every few months, this pattern can be repeated.

For example, if you make 200% on your initial investment of $3,000 on TVIX during the first year, you will have $9,000 in this part of your portfolio. In the second year, the $9,000 can be turned into $27,000 on the short side of the market while it does not matter what the rest of your portfolio is doing. You must maintain a separation of your assets because if one group fails, another one will succeed. Then, in the third year of trading TVIX, your $27,000 could make 200% more, and you will have $81,000. When this money is doubled twice in the fourth year, then you will leave the year with $243,000 in your account all made on the short side of the stock market.

So, the way to survive in a dangerous investing world is to divide up your assets and keep them separated from each other. There will always be a temptation to put all of your money on the long side or all short or all on dividends. Just do all three, and you will most likely have overall big gains in the stock market rather than painful losses.

Insider Buying

One of the most certain signs that a particular stock or the stock market will rise is the amount of insider buying. Hundreds of insiders have been buying stock in their companies during the past few weeks. I know we still have negatives with Greece and other European countries as well as our own Congress, but it looks like we may still have a year-end rally for stocks.

One of the best places on the internet to look for insider buying is Filing4.com. They have daily listings of insider buying as well as records going back two weeks. In addition to great information, it is free. They will also send you a daily email Monday through Friday showing the insider buys of each day. You may also discover new worthwhile companies that are not yet on Wall Street's radar. So, Filing4.com is a great place for staying in touch with possible future movement of a particular stock or the stock market in general.

Volume and Bollinger Bands

The way to make money in the stock market is in knowing when to buy a stock before it takes off. This situation can be understood by three factors: (1) knowing which stocks are really strong and news driven, (2) narrow Bollinger bands, and (3) low volume.

Low volume means there is not much current interest in a stock, and this is really the best time to buy it as long as you are buying a strong news sensitive stock. The volume will eventually pick up with a strong stock whereas volume may always be low on a poor stock.

Narrow Bollinger bands mean a stock will soon break out either in the up direction or down. Again, if you are looking at a strong stock, that is the time to buy it for whatever direction you anticipate it will go.

For example, TVIX, the double VIX volatility ETF, was selling for around $20 per share in the first part of June 2011. It also had narrow Bollinger bands at the time along with low volume. It was the perfect setup for a strong stock. It took almost two months before TVIX really started rising significantly, but it began making a moon shot around the first part of August when Congress was so indecisive about raising the debt ceiling. This was a very powerful volatile news driven situation. TVIX made it all the way to $100 per share by the first trading day of October.

Since it is difficult to pick an exact top, the best thing to do is to take profits when you have made three or four times your money and while the stock price is still high. TVIX spent several days in the $80 and $90 range. That would have been a great time to sell. You would have made 400% on your money in four months. A lot of people won't make 400% on their money in a lifetime. It is well worth the patience to wait for the right time to buy and then sell while you still have a great profit. If you can make 200% or more for your money in just a few months out of each year, you could sit on your hands the rest of the time and enjoy life!

Never Go All In

Most people agree that you should never put all your eggs in one basket on just one stock. Diversification is not enough, though. If you own five stocks, and you want to buy one more with $10,000 in cash, you should not buy the new stock all at once with the whole 10K. You should buy it in three or four segments. One thing that I have seen happen many times is your new stock immediately drops in price as soon as you buy it. This could be for a number of reasons.

First, you might not have done your homework. It might be a bad stock. If you only spent $2,500 on your first buy instead of the whole 10K, your losses will probably be minimal.

Secondly, the whole stock market could be going down, and it is taking your stock with it even when it is okay. One example of this is ERX, the 3X energy ETF comprised of major oil companies and other stocks. It looked like it had formed a bottom around $40 per share during August of 2011 and the first half of September. Then, suddenly, it dropped to the low 30s and even below 30 during the last part of September and the first trading day of October. If you had just spent $2,500 on your first purchase of ERX, you could have bought the rest of your position after it went down 25%. Then, you would have made a lot more money with ERX when it came back along with the rest of the stock market in the next month.

Stock Market Instability

The world is waiting to see how the Europeans will handle their financial issues during the week of October 24. It is my guess that we will see more promises rather than definite action. The EU is about as divided as the U.S. Congress. It is difficult to get anything done this way.

I am not planning to buy any additional stocks for the long term until there is more visibility on which way Europe is headed. The same thing could be said about the U.S. also. We have seen some good reports in October, but one month does not make a trend. I am long on the leveraged ETFs ERX and UDOW, but I would rate them as a hold rather than a buy at this level with the Dow at 11,800.

If anything goes wrong with the EU plans, the stock market could fall below 11,000 again. If the market rises on good news, that may be a good time to buy a volatility ETF because the good times will probably not last. If TVIX, the double VIX volatility ETF falls to 40, I will be a buyer. Sooner or later, bad news will reign again in the stock market. If you buy a few thousand dollars of TVIX at a low level, you could quickly double your money when extreme volatility sends TVIX past $80 per share again.

Low Volume Tops

The volume level is one of the best indicators for knowing when to sell a stock. For example, a three month chart of ERX, the 3X energy bull ETF, showed a relatively low volume of 2M shares in the middle of July 2011. ERX was selling for more than $80 per share then. When the August 2011 Congressional impasse began over the debt ceiling, ERX started dropping dramatically on much higher volume until it finally bottomed on the first trading day of October.

ERX was trading at around $30 per share when it had a buying volume surge of more than 8M shares on the second trading day of October 2011. As of October 14, the volume has dropped down to 4M shares. ERX may never reach its former high anytime soon. However, when the volume drops to 2M shares again, that may be the intermediate top for ERX. It so happens that the stock market in general is following the pattern of ERX, too. One reason for that is that ERX is an ETF stock which comprises some of the world's biggest oil companies. So, as oil goes, the market seems to follow, or vice versa. Anyway, it may be time to go short again whenever ERX falls to a low volume level of 2M shares of trading per day.