Friday, February 19, 2010
I never saw any of the money.
Back in November 2008, I started buying Sequenom, a small biotech with an exciting technology for fetal testing. Shares were trading hands for less than $13. And I thought the stock could go as high as $100.
Over the next few months, the stock jumped to $25. I was sitting on a 100% profit. But I never collected...
In the brutal selloff of February 2009, the stock gave back all the gains. Worse still, in April, a scandal involving fake data dropped the stock below $4. My 100% gain turned into a 70% loss.
Of course, I'm not the first guy to see a profit turn into a crushing loss.
Think of the guys who rode the darlings of the tech bubble. In the late '90s, Nortel, Cisco, and JDS Uniphase were all multi-baggers... on paper. If you didn't sell, you ended up losing all of your profits and likely a chunk of your capital.
Or think of Warren Buffett, the world's greatest investor. Between 1994 and 1998, his investment in Coke jumped more than 300%. It peaked at 75 times its average annual free cash flow. But even as Coke started the inevitable decline, Buffett hung on. Over the next two years, his stake lost more than 50% of its value.
It's brutal and embarrassing – I know – to see profits vanish even faster than you piled them on. But there are a couple of extremely simple strategies to ensure you never have to suffer like I did.
One I'm sure you're familiar with is the stop or trailing stop. We wrote a short guide on them here. The basic idea is, you set a price where you'll sell your stock no matter what. No hemming or hawing or hoping it'll come back. It's "mechanical," so it takes emotion right out of it.
A stop will help prevent a catastrophic loss. And if you use a trailing stop, which "trails" the price of your stock higher, you can lock in profits as you go. If you use them right, you'll never take another "round trip."
The thing is, stops just don't work for some investments.
If you're like me, and you trade risky options, tiny biotech stocks, or volatile mining stocks, you might see your shares drop 50% overnight.
Take the Dendreon story as an example. In 2007, investors were betting on Dendreon's prostate cancer vaccine winning FDA approval. They snapped up shares at $4 prior to the FDA advisory panel meeting. The panel voted in favor of approval. Dendreon soared to more than $16 a share in days.
But a few weeks later, the FDA decided to ignore the panel's recommendation and reject the vaccine. The stock tanked 70% on the news. Investors saw their four-bagger evaporate in an instant.
In that scenario, there's not much even the tightest stops can do for you. So how do you protect profits?
Sell half your position at a double. Let me explain...
The goal of selling half of the position once you're up 100% is to preserve your capital. You can't lose money in the trade. Moreover, you can ride the second half of the position higher without worrying about every little decline. If you're comfortable hanging on through the bumps, you're more likely to get a multibagger out of your trade.
Now, for a steady, large-cap company generating solid cash flow, this isn't a great strategy. As a general rule, you want to let your winners run. So for those kinds of investments, a 25% trailing stop will serve you well.
But for the trades I'm talking about – in a landmine-filled sector like biotech or mineral exploration, where you risk seeing all your profit and half your capital vanish in a wink – take your original investment off the table if you can.
I was so excited about the potential gains in Sequenom, I didn't follow my own rules. Don't make the same mistake. When you're smart enough and lucky enough to see a double, grab your cash and finish the ride risk-free. When a stop just won't work, this is the absolute best way I know to avoid another Sequenom.
Oil & gas drillers surge... Anadarko, Penn West, and Atlas Energy reach fresh highs.
Big Defense stocks Raytheon, Northrop Grumman, and General Dynamics rally to new highs.
New highs for mega biotechs Celgene and Biogen Idec... fund XBI at a 16-month high.