GO AHEAD AND SPEND
hours analyzing the Fed or counting cars in the
Home DepotI have positions.>
And this allows me to focus on the best use of capital, especially important considering that we live in a world of scarce resources. The desire to buy an investment, yet lacking the available capital to execute the trade, is an altogether familiar occurrence to the active investor.
I grew up a bit the day that I began to think in terms of trading positions rather than stocks. It's an important distinction, even more important if cash is in short supply. That's when the tough choices are made. It's crucial to maintain even the slightest advantage that puts the odds in your favor.
The best position to be in, without a doubt, is to have an open winning trade. That's the strongest hand. As I mentioned just last week, profits come from winning trades. These are the lifelines of a portfolio, so winners must be the absolute last option to consider when looking to raise cash. I know it's fun to take a profit, but it's almost always better to maintain a winning position rather than liquidate it for the sake of buying something new.
Howard Stern got you psyched for Sirius Satellite Radio? Are you pining to get into Plum Creek? It shouldn't matter. Regardless of how promising a new trade might be, I've never had success in arbitrarily dumping one stock in order to jump on another. Right off the bat, it stops profits instead of letting them run. Even worse, it breeds the emotional, gut-driven approach that churns many traders to shreds. The only person who gets rich in this scenario is the stock broker.
A much smarter way to raise cash is to analyze overall use of capital. I can't tell you how much gunpowder is wasted in tiny, useless positions that many traders carry around like old luggage: a hundred shares of Lucent Technologies in a $100,000 portfolio, or small stakes in mutual funds from three 401(k)s ago. Why do I call these positions useless? Think about it. A stock or fund that makes up one-tenth of 1% of a portfolio could double without having any discernible effect on the bottom line. So when you're looking to raise cash for a new pick, weeding out some tiny old ones is a great place to start. It becomes a matter of swapping weak positions for a considerably stronger one. If you don't like an investment enough to have at least a 1% portfolio stake, then I question whether it's even worth owning at all.
After culling useless positions, it's time to turn to losing ones. Losing positions are a fact of life. For the experienced trader, they are simply part of the game. And because taking losses is the best way to escape losers, capital for new ideas can be raised by pulling the plug on them. While there are plenty of well-educated investors who believe a loss isn't real simply because they haven't yet seen fit to take it, they're wrong. Only fear of failure encourages investors to hold losers, waiting desperately for them to get back to even. Don't make the same mistake. Sitting on a losing investment is an inherently weak place to be. Not only is the market not validating expectations, but by holding on the loss can't be applied against other taxable gains already booked.
When I need to raise cash, I'll usually try and sell a uniform portion of each losing trade. So if I've got four open positions, each down 15%, I'll sell one-third of each and use the proceeds to fund a new idea. I've reduced my exposure to losing trades without eliminating their potential altogether. Also, I've taken a legitimate position in what I hope is a promising new idea. Overall, it's a position of much greater strength than simply rubbing a rabbit's foot and waiting for a rebound in XYZ.
Beyond useless stocks and losers, a third strategy is margin buying. Once I'm fully committed but still want to jump on a trade, I consider a shrewd use of margin to be an appropriate alternative to marshalling assets. I last wrote about using margin over the summer, suggesting that margin use should be opportunistic, not obligatory. And if there are no useless positions to dump or losing trades to sell, I'd use margin to establish a new trade that represents a smart and timely risk.
Stock trading is a business, and like most businesses, it oftentimes requires working capital to make it run. That's where margin borrowing comes in. When skillfully deployed, it can strengthen your hand by allowing you to take additional positions without disturbing profitable, existing ones. Think of it as a short-term bridge loan as you shuffle between trades, not an adrenaline fix from which you'll never come down.
Of course, using margin isn't free. You'll pay interest to a broker. But a winning trade a real winner will more than compensate for that expense. Profitable trades don't jump a mere 5%, but somewhere deep in the double-digits.
I can't stress enough that trading comes down to putting yourself in the strongest position. If there's an investment you believe is a smart buy, yet all your assets are tied up in profitable trades, I believe it's preferable to use margin rather than liquidate winners. Assuming you use stop-loss orders on all trades, you'll inevitably end up generating free cash once one of the investments weakens. That will reduce margin expense while keeping the strongest trades intact.
No matter if you're investing hundreds of millions or just a few thousand dollars, trading comes down to making choices. The thoughtful investor understands it's not so much individual stocks that are being chosen between, but positions in the marketplace. The trick is to always maintain the slight edge that a strong, advantageous position provides. So dump the useless, sell the losers and even consider buying on margin to generate the free cash necessary to establish what you consider the best positions for your portfolio.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.>