My trading philosophy & a basic overview of my strategies

Wall Street likes to label things. Large cap vs small cap, value vs growth, investors vs speculators, fundamental vs technical...the list goes on and on, and it always seems so cut and dry.  In reality, the stocks and people these terms describe cannot be organized into such neat little boxes.  A small cap stock according to one person can easily be a mid or even large cap stock to another.  A person may describe himself as an investor, while others may define him as a speculator.  A fast growing company selling at an undervalued price is coveted by both growth and value investors...so which is it? It's frankly ignorant to believe that such dynamic and subjective things can be split up into exclusive groups.  Of course, Warren Buffet will always be considered an fundamentals investor, and no one will ever consider a safe, dividend paying Johnson & Johnson (JNJ) to be a growth stock.  However, there are always the grayer areas, so any good investor/trader/speculator should never make definitive boundaries between these groups.

Some stereotypes hold...but most don't

I bring up the whole issue of stock market stereotypes because I do feel like I personally fall into one of those gray areas in terms of my investment philosophy.  I essentially want to put my money into stocks of companies that exhibit strong growth potential ("growth"), have proven themselves as of late ("momentum"), are undervalued in terms of the price they should be trading at ("value"), and I want to ride the resulting trends, or lack of trends, both up and down for profits ("trend-following").  I find stocks by analyzing their earnings reports and balance sheets ("fundamentals"), and make my entry/exit based off of their stock charts ("technicals").  If I truly believe a stock has room to grow and will appreciate in time, I will hold on to it for months ("investor"). However, I also make carefully calculated bets to enhance my gains ("speculator").  In general, I destroy every possible chance of being stereotyped as really anything.  I simply aim to profit from the stock market as effectively and efficiently as I can, maximizing gains while minimizing risk. Isn't that the eventual goal of every one of these stereotypes?

My stock market strategy is really a three pronged approach. My portfolio consists of five to six slots, of which I split among three main strategies.  Three of the six are devoted to my core strategy of finding fundamentally strong stocks with high growth potential, who are close to or have broken out of sound technical bases.  Much of this strategy mimics the methods of William J. O'Neil's CAN SLIM system, but also includes elements influenced by Peter Lynch and Jim Cramer, to name a couple.  The fourth slot in my portfolio is reserved for a stock that I feel is severely undervalued, but fundamentally strong, shows great growth potential, and will appreciate in time. I'll enter that position with less emphasis on the technicals and more on the fundamental growth outlook, and typically aim to hold onto this stock longer than usual. My fifth spot is bit smaller than the others (the first four each make up 18-22% of my total portfolio, while this one is 10-16%), and is for pure speculative plays, including options use.  Of course, every trade I make has solid reasoning behind it, so these speculative plays are made as calculated bets. I might be trying to profit off of a one time event, execute a swing trade, or make a directional bet on the market, but in any case, I can justify why.  My final portfolio slot only exists if resources are left over (if every other slot used it's minimum allocation).  With up to 12% of my portfolio, I use these residual funds for further speculation as well.  In terms of stock selection, I first examine the overall market and economy to see which way they are headed, then zero in on the strongest/weakest (depending on the market) industries. I pick out some of the leaders/laggards, then put the rest of the market through a number of screens to fill out my watchlists. I narrow down the lists into manageable sizes, analyze both the fundmentals and technicals behind each stock, and determine a proper entry/exit scenario for each.  If a technical event triggers a buy/sell signal, I will give a final evaluation and enter the position if my portfolio has room.

I will probably detail each of the three strategies I employ in later posts, but I also want to talk a little bit about my core philosophical beliefs about investing.
-First off, I don't see speculation as many people do. To them, speculation is seen as reckless, lazy, and prone to losses. To me, however, I see it as a calculated bet. It is commonly used to refer to high risk, high reward investments, and if the risk is managed properly, it can be very profitable. For that reason, I use the terms speculator and investor interchangeably.  An example of smart speculation would be analyzing a company that has come out with a hot product that's taken the nation by storm in recent months. After noticing multiple quarters of earnings growth, along with signs that this company may only be a short term one hit wonder, the investor might decide to speculate on this very volatile stock ahead of its next earnings report, betting that it will beat estimates. She runs the risk of a potentially catastrophic loss if the report doesn't go her way, but is enticed by what would surely be monstrous gains if it does. One way of managing this risk is to buy 100 shares of this stock, while also buying a put option of the same stock at a strike price equal to the current stock price.  If the earnings report does come out positive, she earns a fortune and can sell the stock at a much higher price, while letting the put option expire worthless. Her only loss is the cost of the option premium, which will almost certainly be offset by her gains.  If the earnings report is worse than expected, however, her put option essentially insures the loss and allows her to buy 100 shares at the original price, which would exactly offset the loss incurred by the stock she already owns, less the premium.  This basic strategy allowed this investor to speculate on a single event with a downside risk limited to the cost of a single option contract's premium, and with a virtually limitless upside reward.
-This lengthy example of why I believe speculation is safer than most people think leads me to my second major philosophical belief, that options are NOT risky unless you want them to be.  As my previous example showed, options can be used as a relatively safe form of insurance on existing stock in a portfolio.  Options and other derivatives get a bad rap from the media and other sources as being far too risky for the average investor. I firmly believe that if used and understood properly, options can be a valuable tool for maximizing gains while minimizing risks.
-Third, I strongly believe in the power of mathematics and other quantitative methods as important tools for any successful investor. Mathematically based reasoning is usually objective, leaving subjective human emotions out of the process. Subjectivity harms speculators more than they realize.  Going with an emotional judgement over one that is based on actual facts increases the probability of the unexpected happening.  Of course, it is possible to overuse quantitative methods to essentially see patterns in the data that don't actually mean anything.  However, math, statistics, probability, econometrics, etc. can provide an investor with an invaluable set of analytical tools.
-Fourth, I never lose sight of the very basic mechanics of the stock market--the economic concepts of supply and demand.  The plethora of formulas, theories, and strategies often reduce investors to "analysis paralysis," and cause them to forget what really makes stock prices go up and down.  If demand is high and a lot of people want a stock, but there isn't enough supply/shares to satisfy all the demand, the price will go up as the first group bids higher and higher for a slice of the pie until the demand is gone.  Likewise, stock prices go down if there is plenty of stock in the hands of those trying to sell.  They will offer it for sale at lower and lower prices until sufficient demand buys.  If not enough demand exists at a given price, the price will be lowered until demand does exist, at which point the supply/demand equilibrium is met.  On a macroeconomic scale, it is factors like interest rates, corporate earnings, and economic news that drives these levels of supply and demand. On a microeconomic scale, industry and company earnings/news drive the supply and demand. Taking it further, an investor must realize that a large input of this supply/demand comes from large institutional investors.  It ultimately doesn't matter what you or your neighbor think about a stock's prospects. If the institutions come to a stock with huge demand for a relatively small number of shares float, that stock price will shoot through the roof until that demand is diminished. Likewise, if many institutions own virtually all of a stock's shares, and news of a lawsuit against the company has the institutional owners running for the exits, the  excess supply relative to demand will drive the stock price down in a hurry.
-Finally, I do not believe that the stock market is random.  It may be very close to random in the short run, but I absolutely do not think it is possible for it to be random over time.  As my supply/demand explanation implied, stock prices are determined by the collective perspective of the stock.  Humans, while complicated, tend to cluster into similarly thinking groups.  A strong argument in favor of technical analysis is the psychological reasoning for why support and resistance lines, for example, exist.  When virtually the same information is available to everyone, there will certainly be a large number of people who come to the same conclusion that a stock, for example, is undervalued when it gets to a certain price level, especially when it is a round, clean number like $50.00.  If this is demonstrated over and over again, with a stock chart showing clear "bounces" off an invisible line when the price nears $50.00, could it really be completely "random"?  Stocks form discernible trends because people tend to bandwagon and herd together in the same direction, increasing the demand for a stock until there is no demand left, at which the trend reverses downward in search of demand to stem the bleeding of supply.  Again, on a day to day basis, stock price movement may seem close to random, but over time, trends and ranges do form. History does repeat itself.

Only time will tell whether these principles will allow me to succeed in the stock market, but until I can be proven otherwise, I will firmly stick to them.  Of course, I am always open to new ideas, so if anyone would like to offer constructive criticism or fresh ideas, please do.

the Zaggmate..turns an IPad into essentially a laptop

As for today's market activity, I had a mildly positive day, with my portfolio increasing by $250.  I continued to pare down my holdings in anticipation of the market correction I predicted in my last post. The S&P 500 did finish down today on higher volume, as did the NASDAQ, but the Dow Jones Industrial Average was up (mainly on Disney's (DIS) price boost from its earnings report).  Could this correction I've been expecting be starting? Perhaps. However, my analysis of the current uptrend does indicate that a correction is imminent, and for that reason I sold off my 200 shares of Gulfport Energy Corporation (GPOR), and bought 10 February put options for the S&P 500-mimicking ETF SPY. My last trade for the day had seemingly crazy origins, but with logical intentions. I had a dream last night that a stock I recently sold, ZAGG, shot up in price  while i helplessly watched, continuing higher than I had ever imagined.  Of course, a silly dream didn't form a basis for buying this stock, but I opened up my research on the company to give it a long term look.  I have always liked ZAGG, mainly because of its strong growth potential.  As a producer of protective coverings for a wide range of electronics, especially Apple (AAPL) products, the company has become wildly successful over the past year.  With innovative accessories to complement its covers, helped along by riding Apple's (AAPL) successful run, ZAGG does not show signs of slowing earnings growth. It was even showcased on Oprah's tv program.  With Apple (AAPL) already preparing it's second version of the IPad, along with more and more tablet competitors, ZAGG should have no problems selling their very practical accessories over at least the next few months.  For that reason, I see no reason for ZAGG to slow down any time soon, despite being stuck in a slowly uptrending consolidation at the moment.  Based upon this outlook, I bought 5 May call options on ZAGG, at a strike price of $10.00 (ZAGG is currently trading at $9.05, but has been above $10.00 multiple times).

Wednesday, February 9th, 2011

Daily Change: Up $250.31 (1.25%)

Current Porfolio Value ($20000 on January 24th, 2011): $21831.01  (Up 9.1%)

February Performance: Up $2905.12 

Market Outlook: Bullish but have been anticipating a correction since Friday, and today's S&P 500 & NASDAQ distribution day may be a sign that a correction is imminent. I believe that the DJIA's up day was skewed by Disney's (DIS) price change.

Holdings:

APKT - 100 shares - $70.84/share

LULU - 100 shares - $81.50/share

SPY Feb 19 $130.00 Put - 10 contracts - $0.57

ZAGG May 21 $10.00 Call - 5 contracts - $1.45

Trades: Wednesday, February 9th, 2011

-Sold GPOR (200 shares) - Broke even on a plummeting stock, ahead of what I anticipate will be a correction

-Bought February 19 $130.00 SPY Put Option (10 contracts) - Reasoning outlined in blog post

-Bought May 21 $10.00 ZAGG Call Option (5 contracts) - Reasoning outlined in blog post