There are three questions that every investor needs to answer about any potential investment before investing;

  1. Is this a good time to get in?
  2. How much should I invest?
  3. When should I get out?

Not having an answer to even one of these three questions can turn a great opportunity into a missed opportunity. Unfortunately, many investors jump into their investments without good answers to even one of these critical questions.

Take a look, for example, at this 10 year percentage gain chart of Netflix:

NFLX1

Netflix has gained over 4,000% in the past 10 years. A $1,000 investment in Netflix 10 years ago would be worth over $40,000 today.

Great work if you can get it, right?

The question is, who got it? Reed Hastings, the CEO and co-founder of Netflix, presumably captured a big chunk of these capital gains. Other long-term employees of Netflix have also likely benefited from these gains via stock options. Early venture capitalists with big equity stakes and high conviction may still be holding shares of Netflix for such huge gains.

But how many individual investors who bought Netflix stock over the past 10 years are up 4,000%? Probably not many. In fact, I’d wager that the majority of individual investors in Netflix have probably lost money – even though Netflix is up 4,000% in ten years. In fact—I’d bet a lot of money on it.

Think of all the ways that an investment in Netflix could have been a total disaster.

From the high in July 2011 to the bottom in August 2012, Netflix fell over 85%. How many retail investors likely lived to tell the tale through that cycle? In 2014 alone Netflix has been down 32% and then up 35% and then down 35% again before finally rocketing up over 100% in the past six months. That’s tough volatility to navigate.

I’m not here to tell you that I’ve got all the answers on Netflix. My point is that even with enormously successful stocks like Netflix, there are still a ton of ways to screw things up – especially if we aren’t completely clear about what our plan is.

That’s why I’ve created all the tools that are now available in TradeStops and TradeStops Pro. Let’s take a look at how all these new tools can help us to answer the three questions that every investor needs answers to.

Question #1: Is this a good time to get in?

Answer: Yes, if the stock has triggered a Re-Entry Rule and hasn’t since been stopped out by its Smart Trailing Stop. Otherwise, no.

Combining the new TradeStops Re-Entry Rule and the Smart Trailing Stops 2.0 algorithm is a powerful way to make sure that market tailwinds are behind you and that you stay out of any big trouble. You hear it all the time in sports – championships are won by great defense. The same is true of investing. Don’t make any big mistakes. Stay in the game. Wear down your opponent (by staying in your winners). Create a few breakthrough opportunities.

That’s exactly what you get when you combine the Re-Entry Rule and Smart Trailing Stops.

The Re-Entry Rule makes sure that the best long-term trend is on your side and that the investment in question has made a strong move in your direction – a move that is greater than the normal expected volatility level of the stock (i.e., more than VQ%).

The Smart Trailing Stop 2.0 algorithm makes sure that – once the Re-Entry Rule has triggered – the investment continues to behave well and doesn’t have any corrections greater than VQ%.

I’m so excited about the synergies of the Re-Entry Rule and Smart Trailing Stops that I’ve taken to referring to them as Dr. Smith’s Indicator or the DSI. Don’t be surprised if you see this name pop-up in TradeStops soon. It’s my basic red light/green light indicator for TradeStops.

When is it a good time to get in?

  1. When the trend is with you and the investment has proven itself with a strong move in your direction (Re-Entry Rule); and
  2. The investment hasn’t since corrected more than VQ% from its recent high (Smart Trailing Stop 2.0).

Question #2: How much should I invest?

Answer #2: Take 1% of your investment capital and divide it by the current VQ% of the investment.

Let’s say that you have a $100,000 portfolio—then 1% of your portfolio is $1,000. The current VQ% on Netflix is 37.7%. If we divide $1,000 by 37.7% we get $2,652.52. That means that we can invest up to $2,652.52 in Netflix. At today’s price of $624.06 we can buy 4 shares. That would give us a position size of $2,496.24.

Pretty simple, huh?

There are, of course, possible variations on the above example. If Netflix is a high conviction investment idea for you then you might decide to risk 2% of your capital on this opportunity. But the basic idea is the same. Take a small percentage of your investable capital and divide it by the current VQ% to figure out how much money to put into the investment.

This approach ensures that you put more of your capital into less volatile investments, and less of your capital into more volatile investments. Lest you think that sounds a little boring—think again. Putting less of your capital into more exciting but volatile investments like Netflix is actually the best way to profit big from opportunities. Why? Because if you put too much of your hard earned capital into a stock like Netflix, you’re probably going to get sick to your stomach from the volatility and throw in the towel at exactly the wrong time.

Question #3: When should I get out?

Answer #3: When the Smart Trailing Stop is triggered.

The Smart Trailing Stop algorithm is based upon the normal expected volatility levels of the investment – the VQ. If an investment is behaving well then volatility should not be expanding; it should be contracting. As volatility contracts, the Smart Trailing Stop tightens. If volatility starts to expand, it means that new uncertainties have entered the marketplace. Something in the underlying investment thesis has changed. If you don’t have good answers as to why volatility is expanding beyond the VQ then it’s time to get out, take a breather, and let the dust settle.

That’s exactly what the Smart Trailing Stop algorithm was designed to do.

Summing up…

  1. It’s probably safe to get in if a Re-Entry Rule has triggered and it hasn’t yet been stopped out by the Smart Trailing Stop.
  2. Decide how much to invest by taking 1% to 2% of your investable capital and divide that amount by the current VQ of the investment.
  3. Exit when the Smart Trailing Stop is hit.

That’s it!

Taken together these three steps offer a very powerful portfolio and risk management system that will:

  • Help you avoid the devastating mistakes that undo most investors;
  • Allow you to profit more on both your conservative investments and your more speculative investments.
  • Dramatically increase the odds that you’ll experience a few wildly profitable winners—investments that go up ten-fold, twenty-fold… or more.

That’s a system for success.

Finally, since I’m sure you’re curious, how did this system do on Netflix?

NFLX reentries

Not too bad!

The beginning of each red stop loss line is where the Re-Entry Rule triggered and the end of the red line is where the Smart Trailing Stop exited.

Over the past 10 years this system would have produced the same amount of profit as a buy and hold strategy but done so with less risk.

It also would have provided you with crystal clear answers to the three questions every investor needs answered before investing.

Peace of mind? Priceless.

To the growth of your wealth,

richard's signature

Richard M. Smith, PhD
Founder, TradeStops.com
CEO, TradeSmith