The Stock Picking Recipe

If you’re a self-proclaimed home chef like me (with little to no actual training in culinary arts), you know how useful a recipe can be.  Similarly, there are recipes for picking stocks and, in fact, each style of investment philosophy uses a similar recipe. The ingredients used within the recipe – in our case, financial metrics – to value a company and to estimate its future prospects, account for most of the difference between philosophies.

All logical investment philosophies attempt to determine two things:  First, if the investment in a particular stock will preserve the capital that is invested and, second, if the invested capital will earn what the investor requires or expects from it.

To evaluate whether an investment will preserve capital or not, an investor needs to look for signs of how stable a company is. Metrics that give us an indication of the stability of a company are as follows:

Current Ratio: Generally, the higher the better. At a value of 1, there is not a lot of flexibility in the company’s finances; the company’s short-term assets are just enough to cover the short-term liabilities. Many companies maintain a current ratio of 1.5 or higher.

Debt/Equity: Debt like other things is fine when used in moderation – too much can be bad. This metric measures how the company finances its operations. If a company takes on a lot of debt in proportion to equity, it may be an early warning sign of trouble ahead. At a minimum, anything above 50% should be understood further.

Short % of Float: This metric is generally an ‘either or’ metric. It is either immaterial (around a couple to a few percent) or it is substantial. This metric indicates the markets view of the stock. The higher the ratio the more cause for concern, because it means the market is betting the stock price will fall.

Operating Cash Flow: If a company is not generating cash, it will likely take on debt in order to continue operating. Companies which need to do this continuously just to make ends meet will be serious trouble in a matter of time. If Operating Cash Flow is declining or negative, an investor should understand what is causing this.

These metrics serve as a basis for determining how well an investment will preserve the capital invested in them. In determining whether a company is stable, a thorough analysis should be completed; however, this gives us a starting point to determine whether or not a company is of investment quality and should be examined further.

In part 2 of this 2 part article on how to pick stocks, we will explore how to determine whether the invested capital is likely to earn what the investor requires or expects from the investment.

Bonds fall into the category of “fixed income” securities. They are classified as such because, as opposed to stocks, which, generally, rely on capital appreciation (increase in stock price) to provide return to investors, bonds (generally) provide a fixed payment every six months. This payment is similar to the interest payment that you pay on your mortgage and is equal to the coupon times the principal. The coupon is the interest rate on the bond (different from the yield) and the principal is the face value of the bond. Most corporate and municipal bonds are issued in denominations of $5,000, so a bond with a 4% coupon would provide payments of $200 per year in the form of $100 payments every six months. Then, upon maturity, the bond issuer (corporation, municipality etc.) must repay the principal in a single installment. If you were to purchase a 2 year corporate bond at face value with a 4% coupon, you would receive four semi-annual payments of $100 and one payment, two years from now, of $5,000, for a total return of 108% or 8 percent gain over two years.

Risks associated with bonds
Bonds are frequently viewed as safer investments that carry less risk. This is generally true, which makes bonds a great investment for individuals with lower risk tolerance. However, the risks of bonds are many and complex, and should neither be ignored nor understated. The primary risk for an income investor who intends to hold bonds to maturity is credit risk, or the risk of default. For highly rated debt, this risk is pretty small, and for any given corporation, the risk of default is certainly smaller than the risk of loss of stock price or cancelling of dividends (unlike dividends, coupon installments are not discretionary). Other risks – to be discussed in a later article – are particularly relevant for the investor who does not intend to hold the security to maturity and intends to make money off of both the coupon payments and the change in price of the bond, selling it to another investor before maturity. These risks include price (rate, market) risk, prepayment risk, reinvestment risk, inflation risk, liquidity risk, and many more.

Price vs. Yield
You may have heard that a bond’s price moves in the opposite direction as its yield; that is to say, that yield and price have an inverse relationship. This concept can be confusing for the new investor, so it’s best to think about the relationship in one of two ways:

The most important thing to note when considering the relationship is that yield is not coupon. Yield includes the coupon (interest rate) that an investor receives but that is not the only component of yield. Yield (in this case yield to maturity) is the total annualized gain that an investor receives upon maturity. Most investors do not buy bonds at the face value, they purchase them, generally, at some price above or below the face value (the amount they receive upon maturity). If they purchase the bond below face value, it is said to be purchased at a discount, and if they purchase it above face value, it is said to be at a premium. Keeping this in mind, if an investor purchases a one year bond at $4,500 with a 5% coupon, the yield to maturity is greater than 5% because the investor will receive a total of 5% coupon payments (that’s 5% of $5,000, not $4,500), and the investor will receive the face value of $5,000 at maturity. As such, the investor pays $4,500 and after one year will have received $250 in coupon payments and $5,000 in principal. So, total yield to maturity (ignoring discounting and reinvestment for simplification purposes) for this purchase would be 16.67% ($5,250/$4,500 – 1) .

So, the basic formula for calculating yield to maturity for a one year bond is: (coupon * face value + face value) / (price).

From this formula, yield can be seen as inversely related to price, because price is the basis (denominator) for determining yield. The more you pay for a bond, the lower your return (yield) will be. Another way to think about the relationship of price and yield is to think of how the market responds to changes in interest rates (coupons). Coupons are a large portion of yield, and are equivalent to yield if the bond is trading at face value. So, if you hold a bond with a coupon of 4% and the coupon for a similar bond rises to 5%, you will be receiving a lower compensation for the same level of risk than the investor who buys the 5% bond. Thus, if you decide to sell your bond after rates have risen to 5%, you will have to sell it at a discount (loss) to compensate the buyer for the lower coupon. To be exact, you will have to sell your bond at a price of roughly 99% of face value ($4,950) so that the yield to maturity for the buyer is equal to the yield to maturity of the other issue. In other words, as interest rates (and thus yields) rise, the prices investors are willing to pay for prior issues falls, because the bonds with lower coupons are less attractive and the buyers must be compensated for taking the lower interest rate.

Duration
The final topic that this article will address is bond duration. Duration, simply put, is the average length of time of the cash flows of the bond. Because an interest bearing bond pays coupon payments as well as a final payment of principal, an investor does not have to wait until the bond matures to collect some of the money. Duration measures the weighted average length of time of cash flows. With the exception of zero coupon bonds, duration will always be less than time to maturity, because some of the money you receive will come before maturity. Duration is important in the bond investment world, because it is a measure of price sensitivity. The longer the duration, the more a bond’s price will be affected by a given change in yield. This is because the uncertainty associated with a longer time horizon causes an investor to require a higher return on investment (more risk = higher return). This same principal is why bonds that mature in ten years tend to have higher coupons than similar bonds maturing in one year. So, as a total return (not just hold to maturity) bond investor sets up his portfolio, he must be aware of duration of the securities he purchases. If he believes that yields will rise, he will want to have a shorter duration so that the increase in rates affects the prices of his securities less; alternatively, if he thinks yields will drop, he will want to have a longer duration so that the decrease in rates yields a larger increase in prices of his securities. Further, a bond investor who is risk averse will want a portfolio with a short average duration; if he has a higher appetite for risk, he may want a portfolio with a longer duration so as to yield higher return.

Let’s dive into the compelling arena of mortgage finance.  Specifically, we are going to take an inside look at the big GSEs (Fannie, Freddie, the like).

Recently, NPR (your premier source for listening to people with interesting names say things softly during your morning commute) and ProPublica (which is a liberal fan ‘zine who are probably known for something – didn’t they win a Pulitzer or whatever?) released a spectacularly mis-informed piece on Freddie Mac.  It has been making quite the splash around the econo-blogosphere, with sides being drawn and spittle flying in all directions.

So, we at RV decided this could make a perfect topic to expand upon our already long running (ok, maybe just one volume) “Banking for Dummies” series.  Let’s get started, shall we?

The story begins with the  aforementioned NPR/ProPublica  piece, in which we discover that good ol’ Freddie has been accumulating exotic mortgage securities known as “Interest Only Reverse Floaters” on it’s books.  These pay handsomely, as long as the mortgages (homeowners) which underlay the security do not refinance (thus lowering the payments on their underwater homes) when rates get nice and low (like now, for instance).  This seems a bit removed from the GSE’s stated purpose of helping out the little guy buy that McMansion they could never afford always wanted.  The following “everymen” are interviewed for the story:

The Silversteins have a 30-year fixed mortgage with an interest rate of 6.875 percent, much higher than the going rate of less than 4 percent.  They have borrowed from family members and are living paycheck to paycheck. If they could refinance, they would save about $500 a month. He says the extra money would help them pay back some of their family members and visit their grandchildren more often.

The Silversteins used to live in a larger house 15 minutes from their current place, in a more upscale development. They had always planned to downsize as they approached retirement. In 2005, they made the mistake of buying their new house before selling the larger one. As the housing market plummeted, they couldn’t sell their old house, so they carried two mortgages for 2½ years, wiping out their savings and 401(k). “It just drained us,” Jay Silverstein says.

Finally, they were advised to try a short sale, in which the house is sold for less than the value of the underlying mortgage. They stopped making payments on the big house for it to go through. The sale was finally completed in 2009.

The NPR/ProPublica team characterize these positions as “bets” (the guy running the book on these must be making a huge Vig on this action) against these poor folks (who, by they way, seemed to have defaulted on their prior loan).  They continued to then get offended/outraged on Freddie’s ass and declare that this a huge conflict of interest and that Freddie Mac is a disgustingly greedy, baby killing monster. This may have been a bit of overstatement on their part.

However, a more evenhanded look at this whole situation reveals that, perhaps, there is nothing really that sinister going on.  To fully understand this, lets take a look at how these GSE’s operate:

Step 1.  Issue debt to raise money

Step 2.  Buy up conforming mortgages from originators (like banks and home loan companies)

Step 3. Securitize these loans into mortgage backed fixed income instruments (CMOs) and sell ‘em

They come in two flavors (both of which, by the way, are guaranteed by the GSE, thus removing all credit risk from the investors who buy this stuff).  One is a Principle Only (or PO), which is funded by the principle paid back through the loan.  The other type is Interest Only (or IO), which is funded only by the interest payments made on the loan.  The PO bits are nice and safe, with just some interest rate risk left for the investor to manage (as the credit risk was so-nicely taken by the GSE, and the prepayment risk – from the prepayment option embedded in most North American fixed rate mortgages – is held within the IO bits) and are thus easy to sell to investors.

The IO bits are a bit more complex.  These securities are funded by only the interest payments made on the loan, and are thus exposed to both interest rate risk as well as the pre-payment risk (i.e. the volatility) embedded in the original mortgages (if the mortgages gets pre-payed, there will be no more interest cash-flows to fund the IO). These usually have a negative effective duration – which is important, remember that for later.

Now.

Not only are these IO bits exposed to more risk, but they can then decomposed even further, into an IO floater and IO reverse floater pair. This makes the market for the IO bits more liquid, as the IO floater portion pays a coupon of usually LIBOR + spread (nationalized off of a larger portion of the original IO tranche), and is thus easier to manage in terms of interest rate risk.  The reverse floater (notionalized off of a smaller portion of the original IO tranche) is paid the difference of the original coupon rate on the IO and the IO floater LIBOR+Spread.  Because the reverse floater is notionalized off of a smaller portion of the original IO tranche, the coupon of the IO Reverse is then multiplied by whatever multiple the notional on the IO floater is larger than the IO reverse.

Whew.

What you end up with, after all of this witchcraft financial engineering, are three bits – a PO bit, which is simple and safe(ish), an IO floater that does have some interest rate risk and pre-payment risk (but has a linear sensitivity to rate moves), and an IO floater that is complex and more difficult to manage (and is usually only sold to sophisticated investors).  If you look at the formula for the coupon for the IO reverse floater ( [Original IO Coupon - Spread - LIBOR] * IO Floater Notional/IO Reverse Notional), you see that it pays off big in a low rate environment when no one pre-pays.  Just as NPR/ProPublica reported…

HOWEVER. We must then move on to Step 4 of being a GSE.

Step 4. Manage your asset / liability mis-match.

This is a vital step to understand, because we believe it is this which is driving the GSE’s to take the actions they have, um, taken.

Remember Step 1? Where you issues some debt so you could start buying up mortgages?  Well that left you with a lump of liabilities with some average duration.  Now remember your assets?  All those mortgages and PO / IO CMO bits? They have a different duration.  And for the IOs, some level of volatility.  So you have to wade into the swap market and normalize the duration mis-match between your assets an liabilities. OR. You could hold onto some more of those IO reverse floaters (which, by the way, not a lot of people are particularly asking for these day anyways, but, you as a GSE who makes the damn things should understand pretty well and model with some level of confidence) with their negative duration and use them to help ease the asset/liability duration mis-match.  And make a bit of profit on the volatility side as well (if vol is, say, under priced at the time).  Presto! Mr. Director at the GSE’s treasury department earns his bonus this year.

Other bloggers have noted that the Freddie is probably just holding onto the scraps of the deals it can’t sell rather than actually buying up these instruments (as NPR/ProPublica contend).  But even if they were buying these things up, who cares?  It is likely a hedging strategy given the insight the politically connected GSEs naturally have into these instruments and the prevailing political environment (the headwinds facing new re-fi rules)

So there you go. Class Dismissed.

So what do smart investors do differently than the rest?

Investors who consistently outperform the market are actively engaged in the management of their portfolios. It is not enough to build a portfolio and walk away from it; rather, it requires constant review and fine tuning. The reason lies in the flow of new information.

The Basics

First, let’s understand some basics about the flow of information. The market is a pricing tool, which takes into account all available information every second of every business day. As new information is received, the market digests the information and makes a decision as to how much each company is worth, given the newfound knowledge. As the market goes through cycles, each time reassessing what companies are worth, prices adjust to the appropriate level. This constant fine-tuning by the market allows it to allocate more capital to the companies that will give investors the highest returns, and less to those companies that are expected to underperform. These instantaneous cycles that shift funds between companies, make the market both diversified and efficient, and enables it to get a healthy return.

How can you beat that?

Sure, the market sounds intimidating – and it is – but there is one fact that gives investors a fighting chance. The market holds all invested money, which is more money than could possibly be allocated to just those companies that are doing well. Some of the money will inevitably remain with the companies which will underperform, and because of this, the gains will be offset by losses either partially or completely. If this wasn’t the case, it would be next to impossible to beat the market.

Investors who consistently outperform the market recognize the relationship between the flow of information and price, and constantly review their portfolios to make sure they are allocating capital to the stocks with the highest potential return on investment. Further, they are able to concentrate their investments into the securities that will outperform the market, whereas the market must allocate capital to all companies – the good ones and the bad ones.

To beat the market, investors need to be able to identify those stocks that will provide the best returns. However, any analysis is bound to be wrong for the simple fact that it is an estimate of things to come, and most of us are not in the business of predicting the future. Using this analysis, the investor will make a decision as to whether to invest in a company, and if so, how much. When an analysis is wrong, it may often be the difference between outperforming the market and falling short.

To beat the market, it is not enough for us to analyze companies. Incorporate these three simple rules into your investment strategy to give your portfolio an edge.

The Steps

Keeping a comfortable Margin of Safety is crucial to wise investing.

The First rule is to maintain a Margin of Safety. The concept is simple with an example: If the analysis estimates XYZ stock is worth $10 and you decide to maintain a 10% Margin of Safety, then you should invest in the XYZ stock at a price no higher than 90% (100% – Margin of Safety) of the price determined in the analysis. In the example I gave, this means 90% of $10, or $9. By applying a Margin of Safety to our analysis, we are allowing for error in the analysis. If an analysis has more uncertainty, a higher Margin of Safety should be used.

The Second rule is to Dollar Cost Average. This sounds complicated, but is not. In fact, if you have a 401k or an IRA, you are probably already applying the technique and didn’t know it. Dollar Cost Averaging is a concept based on a simple fact that successfully timing the market is almost impossible to do. One study showed that in order to produce successful returns, an investor would have to time the market right approximately 80% of the time. Dollar Cost Averaging allows us to invest our money at a fair price by contributing a fixed amount of money over time instead of trying to time the market. Learn more about Dollar Cost Averaging here.

The Third and final rule is to keep those commission costs low. The more times you make trades, the more fees you have to pay. For example, to invest $100, you may be required to pay a $7 commission on the trade. This fee is what a company will charge you to cover their costs and to execute the trade. For an investor to recover this cost, the stock would have to gain over 7%, and that’s just to break even. To breakeven and beat the market, this position might have to earn 15% or more! So, how can we lower our commissions? It’s simple, invest larger amounts, and invest less frequently. If you are scratching your head right now, don’t worry.  If you think that this rule is somewhat contradicting to our Dollar Cost Averaging rule above, you are correct. What we can take away from this observation is that it is important to strike a balance between the two rules where you are comfortable.

Investors who consistently outperform the market are not doing anything secret, they are simply investing their money in smart ways – they are “Intelligent Investors.” By applying these three simple rules to your investment strategy, you should be able to give your portfolio an edge.

Not Bonds…Not Mutual Funds…Not Real Estate…Not Gold…Not Artwork or paintings…Not Wine, (yes, I said wine)…Not Sports memoribila…Stocks.

So why buy stocks first??

Stocks provide one of many ways to invest your hard earned dollar and still diversify. The main reason is that stocks provide the highest potential return over the long term, compared to any other investment…. Period. Certainly while all listed above are great ways to diversify and provide a mixed portfolio, stocks at the end of the day continue to outperform over the long term investing approach.

It’s been said, and many articles provide that stocks average about 10% return per year, bonds 5-8%, real estate 3-6% (after expenses) and down the ladder.

When you buy stock, you indirectly share ownership of that company, thus becoming a shareholder. When the values of that company’s shares go up and down, it gives you the ability to sell and make a profit. Some companies periodically, pay a dividend where they will pay you in additional shares instead of cash payout. You can also exercise Dividend Re-Investment Plans (DRIP) with their dividend reinvestment programs that are available.

Tagsales, Yep they are still here. With dollar cost averaging and buying fixed dollar amounts of stocks at fixed intervals, you are able to average out and buy more shares of stocks when the price is lower and less shares when the price is higher. Using DCA you can continuously find stocks at “tagsales”. Although its been said you cannot time the market, DCA can bail you out even if you think it’s a “sure thing”.

Representing the United States Market, this is how the Dow Jones Industrial Average has performed in the last 107 years (1900 – 2006, Monthly):

Here’s another look at the DJIA in the last 105 years (1900 – 2005):

So…what do you know about DCA?

Dollar Cost Averaging, as opposed to Lump Sum Investing, is one of many tried and true investment strategies. Its purpose is to invest equal monetary amounts regularly over specific periods of time (say $100 monthly) with your portfolio. When successful, more shares are purchased when prices are low, and fewer shares are purchased when the price is high. DCA’s goal is to lower the average cost per share of the investment, giving the investor a lower total cost for the shares purchased over that period of time, and helping them make more money.

As an example, let’s say you decide to purchase $100 worth of ABC LLC each month for three months. In July, ABC is worth $33, so you buy three shares. In August, ABC LLC is worth $25, so you buy four additional shares this time. Finally, in September, ABC LLC is worth $20, so you buy five shares. In total you’ve purchased 12 shares for an average price of roughly $25 each.

It’s been said that DCA has a psychological appeal, when the market dips you get a better deal on pricing, and when the market goes up, people are happy regardless. What do you think?

Keep your chin up high, and always stay true to your investment techniques. Good techniques can be the difference between making money, and breaking even. Which side are you on??

Great article explaining options. It seems like if you did want to enter into one of these hedging strategies using both calls and puts that you would need a pretty big upswing or downswing to realize any profit. This is probably more effective in a volatile market like we are seeing today but under more stable conditions would you still recommend this strategy? – Jeff

That’s a great question, and we can examine the question in a few parts.

This is a probability curve (also known as a Standard Distribution curve). Think about this as 10 coin flips: The probability is highest (Y-axis) that you get 5 heads and 5 tails. The probability of anything else happening drops accordingly.

First, to answer the question regarding the volatility required for this strategy, we would need to think back to the days of school when you learned about standard distribution curves.

A standard distribution curve is the graphical representation of probabilities. Probabilities are easy to understand if you think of a coin flip.

If you flip a coin 10 times, the coin is likely to land on heads 5 times out of 10. If we expect to see the coin land on heads 5 times out of 10, we can say it has a 5/10 or 50% probability of landing heads. These 10 flips of the coin represent 1 outcome (landing heads 5 times).

The standard distribution curve represents all possible outcomes. In the coin example, it is not very likely that the coin will land heads 0/10 or 10/10 times. These outcomes are very unusual. The most likely outcome is 5/10 times. With a typical standard distribution curve, the majority of outcomes (~70%) will fall within a central area, which statisticians call 1 standard deviation. So when you graph the data, the graph looks like a hill (with most of the outcomes stacked up in the middle), with a tail to the left (0/10) and a tail to the right (10/10). The tails represent outcomes that happen the least amount of times.

So keeping this in mind, let’s apply this concept to stock prices. With stock prices, just as with other “random” things like coin flips, we will expect a stock’s price to fall within the area on the graph that represents 70% of all outcomes.

In the article, I mentioned briefly that options gave the right to purchase stock at a set price.  We will discuss the details of how option contracts are priced at a later date, but it is important to know that the cost of an option does account for volatility. When the market is more volatile, options cost more. They cost more because the chances of a big upswing or downswing increase, and if that occurs, you profit.

With the coin example, volatility could be thought of as putting a weight on one side of the coin. If you put a weight on one side of the coin, it will change the way the coin falls, and it will change the outcome of your flips so that it is more likely that it will land heads 0/10 or 10/10 times.

To answer your question, profiting from this strategy is hard to do even in a volatile market, because you would need to buy the options when volatility is lower. As market volatility increases, a big upswing or downswing is more likely, and so the cost of the options goes up. When options cost more, we have to pay more to buy these options, and it becomes harder for us to profit from this strategy.

The “Triangle Pattern” I presented in the article is unique, because volatility is typically lower than usual in this instance. This would be the perfect opportunity to buy options, because they will cost less than usual, and give you the best chance of making money.

For a stable market there is a different strategy which is relatively riskless, and is a great way to earn an extra return (2-3%) on your portfolio. We will cover that strategy in a later article.

This brings us to Options.  If we can understand Options, we can position ourselves to capitalize on large changes in the market.

So, what, exactly, is an option? At its very basic level, an option is a contract. It allows you the right, but not obligation, to purchase shares by a certain date at a locked-in price.

As a rudimentary example, let’s say you are interested in purchasing 100 shares of IBM at (for the sake of this example) $50 a share because you believe it might quickly gain value.  You could spend $5,000 and hope your intuition was right, or you could limit your risk by purchasing an option.  This will allow you to lock in the price, called the strike price, until a mutually agreed upon date. No matter how the market moves, your price stays fixed.

In this case, let’s say you decide to purchase an option at $3 per share ($300 total for 100 shares), allowing you to lock-in the original price of $50/share until the end of the month.  Even if the shares rise to $60/share by the end of the month, you have the option to purchase 100 shares at the original price of $50/share.  From there, you can sell it off at the current price of $60/share, gaining a profit of $10/share. At 100 shares, that’s a $1,000 profit.  Easy money, right?

Now, what if, instead of the stock rising, it drops to $40/share by the end of the month? You don’t have to buy it (since an option gives you the right, not obligation, to purchase it), so you’re losing only the $300 you spent on purchasing the option.  You’re, essentially, limiting your risk.

This is the most basic type of option, called a Call option.  A Call option gives you the opportunity to buy stocks at a pre-determined price, regardless of the market.  The opposite concept, is a called a Put option.  In a Put option, you purchase the opportunity to sell your stock at a pre-determined price.  If you own 100 shares of IBM at $50/share and want to sell it, you lock that in as the selling price. If the stock drops at the end of the month, the buyer has to buy it at the strike price ($50/share), allowing you to profit off of the devaluation of your stocks.

With Options, the most you stand to lose is the value of the option itself ($300, or $3 x 100 shares, in our example), and the opportunity for a strong profit ($1,000, or $10 x 100 shares, in our example.)

By purchasing both Calls and Puts on a security, you aim to limit risk by locking in the price before it makes any change, high or low.  If the change is small, the Call’s profit will (approximately) offset by the Put’s Loss (or vice versa), cancelling each other out.

So now we have the tools necessary to profit in a large upswing and a large downswing, while averting the risk associated with it.  This is a pretty good spot to be at, and it brings us back to the Triangle Pattern we discussed in part 1, which often ends with a large shift (either upward or downward).

You can make some big profits with these types of large changes, since the gains on Puts and Calls are exponential.  The larger the market shifts, in either direction, the larger your profit. The losses, on the other hand, can only be a maximum amount of what you paid for the option itself.

Using these concepts, we have, essentially, limited our risk while positioning ourselves to make a nice profit.  By packaging different options together in different ways, you are able to carve out the areas on a standard distribution curve where you will profit.

The question that many try to answer: How can we limit risk? Is there a way to profit no matter which way the market went? In this two part article, we will examine the strategies necessary to do this.  If you have already read this section, skip to part 2 here.

So how do we begin limiting our risk? The answer lies partially in a concept called technical analysis.  In technical analysis, charts (based on stock prices and the volume of trades) help us evaluate recent trading activity. Often times, traders will set upper and lower price points, creating a trading band that shows the range that they are comfortable buying/selling stock. These price points often show up on charts as resistance (upper) and support (lower) for trades.

Studying these charts for certain patterns will allow us to draw conclusions and determine how the trader feels about the future of a stock. One pattern is called a “Triangle Pattern.” It’s named this because it literally looks like a triangle.

To see this pattern, draw a line from one upper point to another high point, and similarly draw a line from one low point to another low point. Over the course of the period you are observing, a triangle pattern emerges if the lines begin to converge.

This pattern represents a bit of hesitation by traders, as they are seeking direction. Traders, by nature, are looking to take prices higher or lower, they are not interested in sitting still.

When you see a triangle pattern, it’s usually the calm before the storm.  Investors are waiting for an indication as to whether they should be buying or selling stock. Indeed, it’s when the stock breaks out of the Triangle Pattern that is most interesting, as it typically involves a huge uptick or downtick.

Notice how the pattern breaks out with a large swing?  With this in mind, we could build a straddle position with options to capture that large swing, and profit regardless of how it turns out.

So, how can we position ourselves to make money no matter which way the stock goes?  The answer lies in part 2.  Click here to continue reading.

Enter CNBC’s Million Dollar Portfolio Challenge.  By following a few tips you could have better than a 1 in 6,000 chance of winning (and have a ton of fun while you’re at it). Those odds are far better than winning the Powerball (1 in 200,000,000), or being struck by lightning (1 in 1,000,0000). Not too shabby, huh?

Below, we explore some tips and tricks to the challenge that will significantly help increase your chances of winning. After reading this, you should be able to compete with the best players in the competition.

The Competition

The competition involves constructing up to 5 portfolios with the use of one million dollars of imaginary money in each. There are some basic rules to trading, such as only being allowed to take long positions, and being limited to holding no more than 20% of a portfolio in any single security. Along with these constraints, there is a limited list of companies approximately 2,700 securities long.

The winner of the competition – the person holding the portfolio with the highest value after 10 weeks – walks away with a cool one million dollars, while the runner-up walks away with a Maserati. CNBC even gives away exotic vacation packages on a weekly basis to the portfolio which has gained the most on a percentage basis in any given week.

With nothing to lose, and some big prizes up for grabs, (whether you are a beginner or a professional trader) you should be playing.

Approximately 670,000 portfolios were competing for this past year’s prize.  Seem intimidating? If you are new to trading, you may be asking yourself whether competing in this competition is even worth your time. The answer: A resounding Yes. The competition was designed in such a way that it limits the possible strategies that can be employed.  By following a few key guidelines, you’ll be able to compete in next year’s competition with the best of them.

The Strategy

The first thing to keep in mind is that you are using imaginary money, so throw out anything you may have learned about investing, because it doesn’t apply here. The object of the competition is to get the highest return possible in a matter of 10 weeks. For this competition – and only this competition – I am recommending that you take on as much risk as possible.  You know the saying “High Risk / High Reward”? You will not win this contest by investing in a basket of safe securities; you will need to create a portfolio with as much risk as possible.

Maximizing risk in this competition comes down to several simple things:

First, I will advise that you only invest in 5-6 stocks in any given portfolio. You are allowed to hold up to 20% of a security in any given portfolio, so for me, I chose to invest in only 5 stocks. The idea here is to concentrate your pool of money into the riskiest securities that CNBC allows you to trade. In this instance, risk can be viewed as volatility or standard deviation of the stock price. We are concerned with how each securities price will change when there is a catalyst.

Next, and most importantly, you will want to identify 5-10 securities that will give you the highest probability of making 3-5% in any given day. The competitors who consistently ranked in the top 20 earned an average of 5% per day for the first half of the challenge, and 3% during the second half.

There are about 2,700 to choose from.  By the time you are done analyzing each one, the competition would be over.  So how can you avoid that?  Easy…I did it for you.

Looking over the closing prices for the last 30 days of each company, I was able to calculate the ones with the highest probability of earning 3% to 5% in a given day.

The investments that registered the highest on my list included a few Exchange Traded Funds (ETFs) — namely FAS, FAZ, TNA, QID, SDS, VXX – and companies in the Energy and Financial sectors – CWEI, ING, STP.

The next part of the strategy involves the use of leverage.

The stocks with the most leverage are usually the ones that also have the highest probability of earning 3-5% in a given day, but this is not always the case. Building a portfolio of stocks that have both of these qualities (high probability and high leverage) will ensure that when the market takes off, you leave your competition in the dust.

Holding all things constant, the company with the most leverage is the riskiest, and for this competition, risk is a good thing. A few of the ETFs I mentioned above are in-fact leveraged ETFs – some are as high as 3X.

FAS (a 3X Financial Bull ETF that tracks the performance of a basket of financial companies) will earn approximately 3 times the amount the underlying companies earn. If those companies earn 2%, FAS will earn approximately 6% in that same day.

The final part of the strategy gets around one of the basic rules of the competition.

The competition does not allow a player to take a short position in a stock, so with the exception of a handful of the 2,700 stocks on the list, all of them will increase in value only when the market increases in value – they are positively correlated. Unfortunately, the market does not go up everyday, which means you would lose money on the days that the market was down. Luckily, I was able to find the ones that increase in value when the market goes down: SH, SBM, SGP, QID, SDS, VXX, and FAZ to name a few.

A portfolio of these types of securities will help you get ahead in the competition.  As with anything, there are other strategies and a certain amount of luck involved, but knowing this knowledge will let you compete with the big boys.

Find more info here: http://milliondollar.cnbc.com/