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The Buy Side

How to make money from mass hysteria Add to ...

Some years ago a former partner of mine – an investor who I had thought was always guided strictly by a company’s long-term fundamentals – called me up from the golf course. “Yesterday I took a flyer on a stock,” he said.

I was shocked. “Which stock?,” I asked.

“Disney,” he said. “The Bass brothers, who owned a big chunk of it, put it up as collateral for another investment, which just went sour. So their banker sold their Disney on a margin call. When a banker sells in a panic, do you think he cares about price? He just drives it down to sell it. That’s my chance to buy it cheap.”

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And when do you sell?, I asked.

“I already sold it,” he said. “So now I can go back to golf.”

I tell this story to demonstrate that even a fundamental investor can occasionally profit from a short-term trade. It all depends upon your willingness to take advantage of forced selling and public panics.

As another former partner of mine used to say, a smart trader always goes against the public, since the public is always wrong – by definition. (Because if it were right, it would be rich, and then it wouldn’t be the public.)

If you do want to take a flyer on a stock, wait for a public panic in something likely to survive, such as a blue-chip stock, or the world as a whole. Risk only a very small amount of your capital (1 or 2 per cent, maximum) and put a stop-loss order below the purchase price to limit your losses. Finally, set a target above the purchase price – and a time limit.

These two elements – price and time – are as important for a successful speculation as the right panic. Here’s why:

Price

For most investors, the maximum loss that your stop-loss order should allow should be 5 to 8 per cent, and the target price should be at least double this amount. (If you’re buying a $10 stock, and your stop-loss order kicks in at $9.50, your target should be $11 or so.)

What this means is that if your purchase continues to sink, your loss is limited, but if the price rises, your gain will be limited too.

The iron rule here is: If either of these two prices are reached, you’re out. No debate.

Over time, a 2:1 gain-to-loss ratio will make you money even if your calls are correct less than half the time.

Of course, you can only take advantage of panics in this way if the stock you’ve targeted is widely traded, with continuous, liquid markets. Also, it only works if the underlying stock is of a real company, not a scam. And don’t do this too often, as trading costs will otherwise eat your capital. Choose your spots.

Time

Unlike fundamental investors who wait patiently for a depressed stock to return to its appropriate value, professional traders set a time limit. If the position they’ve taken in a stock does nothing for a certain period, they’re out.

If you’re betting on a one-day panic, for instance, you may not wish to stay more than a week or 10 days. If the stock continues to drift, take your capital and go elsewhere.

Let me demonstrate how this works in practice.

Last year BP saw its share price halved after the company messed up in the Gulf of Mexico. A smart money manager I know bought shares close to the bottom, with a stop-loss order, was closed out, then went in again with a “widened” (higher percentage) stop, and made money at the new target. He of course has missed the huge rise since, but that was okay. It was a disciplined trade, not an investment.

A more recent example is News Corp. . When the hacking scandal broke, the stock began to drift. But once Rupert Murdoch closed The News of the World, the stock sank. This was – perhaps still is – the time to take a smart flyer on the stock. Remember to use a stop-loss order, with a target gain equal to twice the potential loss. If the stock reaches either of these points, sell it. If it does neither for a week, sell it.

Why News Corp.? Because the company will survive, and now that the beleaguered Murdoch clan has given up purchasing the rest of BSkyB, the stock is already rising.

Keep in mind that betting on mass hysteria should not be a one-time gamble but part of a long-term strategy that resembles good poker playing. You play good hands and fold bad ones. You never risk too much on any hand. Over time a disciplined approach pays off – but only if you stay disciplined.

Follow us on Twitter: @GlobeInvestor

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