Chapter 9: Implementing the Reverse Scale Strategy: A Step-by-Step Approach
Contents
Now that you have a good grounding in the Reverse Scale Strategy, we are ready to review the steps needed for you to implement it. Obviously, going through these steps the first time will take more than five minutes, but after you are set up it should only take five minutes a day to maintain and execute the strategy.
Step 1: Determine how much you can afford to commit to this strategy.
All stock market investments involve some degree of risk, no matter what your approach to the market. Bear markets, national emergencies, and other factors are unpredictable and cause most stocks to decline temporarily when they do occur. Because of this unpredictability of short-term stock market performance, you should only invest capital which you will not need for at least five years. Therefore, it’s necessary to establish exactly how much you can afford to commit to a longer term strategy such as the one we’ve just developed – your pool of “risk capital.” The term “risk capital” means different things depending on the psyche and risk tolerance of the individual involved, and determining that number for you personally is outside the scope of this book. You alone must determine how much you can commit, but the following are some things to consider when making that decision:
- 1) Investment experience.
- If you have never before traded stocks, start small in using the Reverse Scale Strategy until you are very comfortable with the Strategy and with your understanding of the mechanics and practices of stock trading. If you lack confidence, there is no use compounding your discomfort by adding the stress of trading with the lion’s share of your money. You will learn things as you trade that will give you confidence in handling larger amounts. Be patient and give yourself time to learn before committing big money.
- 2) Establish an emergency fund.
- By definition, if you are not going to commit funds which you will need in the next five years, then you must establish an emergency fund. No one, no matter what position they are in, can rule out the possibility of a personal emergency over the next five years. Most financial experts recommend six months’ living expenses, and I would consider that the minimum amount necessary.
- 3) Age.
- The older you are, the less years you have to recover from reverses in the stock market. If you are only five or ten years away from retirement, it goes without saying that you may want to be a little more conservative in the amount of capital you devote to an actively managed stock portfolio. More predictable investments such as bonds, CD’s, convertible securities and such may need to compose the majority of your holdings.
Using these factors, you need to take an honest look at your situation and assess just how much you want to commit to a relatively risky, longer-term investment program. I do not recommend that you trade on margin with the majority of your money!
Do not speculate in stocks with money that you will need to consume within the next five years.
Step 2: Choose an Appropriate Brokerage Firm
As I see it, there are several criteria to use in choosing a brokerage firm to handle your account: 1) Commission structure, 2) Insurance, and 3) Attitude.
- 1) Commissions.
- With this method (or any other, for that matter), it is vital that you cut your commissions to the bone in order to maximize net returns. In most instances, this will mean using a discount broker instead of a full-service broker. To enhance net returns, commissions should total no more than 1% to 2% per trade, or else you are paying too much. The techniques in this book work with accounts of any size above $5,000. But the smaller your account size, the harder it becomes to maintain reasonable diversification without incurring large commissions as a percentage of your account value. So if you have a relatively small account and are buying stocks in $2,000 increments, choose a broker which will handle your trades for less than $40. You should have no trouble finding a discount broker that will handle your trades for less than that amount actually, and I recommend you do so. My broker charges $25/trade and I get a level of service that has always been more than adequate. The smaller your account size, the more closely you’ll have to pay attention to finding a broker who can keep your commissions down to 1% to 2% of the principal amount per trade.
- 2) Insurance.
- Make sure your brokerage account is insured in case they should go bankrupt. Before you open an account, ask to see (in writing) what would happen in the case of the brokerage firm’s bankruptcy. The vast, vast majority of firms these days have adequate insurance in case of failure through the Securities Investors Protection Corporation (SIPC), but the possibility that a firm wouldn’t have insurance exists and it’s good to inquire about such things before committing your funds.
- 3) Attitude.
- Discount brokers are essentially order-takers who offer no advice, which is precisely what we want and need. Even so, before you open an account it is good to call the firm’s customer service department and ask a few questions, even if you have to make some up. I believe that you can learn a lot about the attitude of the brokerage firm and its employees by speaking with them personally. This provides a good reality check on whether you will be able to do business with them or if there will be a clash between their culture and your personality.
Step 3: Determine how many stocks you will invest in.
It’s best to pursue the Reverse Scale Strategy with ten stocks or more if you can, with five stocks being the absolute minimum number to achieve adequate diversification. Because of the practical constraint of trying to mimimize commissions as a percent of the value of your portfolio, the goal of owning ten or more stocks is probably only realistic with accounts of $20,000 or more. If your account is small (between $5,000 and $20,000) you may have to settle for five to nine issues and get a very inexpensive discount broker in order to keep commission expenses manageable.
| Amount of Capital Available | Recommended Number of Stocks |
| $5,000-$10,000 | Five |
| $10,000-$15,000 | Six or Seven |
| $15,000-$20,000 | Seven to Nine |
| $20,000 & Up. | Ten or More |
If you are adequately capitalized, though, ten issues represents an acceptable level of diversification and is a manageable number of issues to track daily. This number is not critical, though. If you feel you have time, and a fairly large amount of risk capital (say, more than $100,000) you can have fifteen or twenty stocks in your portfolio. I would not try this method with less than five issues, because the volatility in your account will likely be emotionally taxing. One thing to keep in mind is that the more stocks you have, the better your chances of finding an exceptionally good-performing stock.
To determine the dollar amount you will invest in each position, take the number of dollars in your trading account and multiply by 65%. Then, take this results and divide by the number of issues you will be trading in your account. This will yield the dollar amount you will initially invest in each issue.
As an example, let’s say you have $15,000 in your trading account. Multiplying $15,000 by 65% yields $9,750. $9,750 represents the total amount that you will invest to begin with. Now, if we tried to split $9,750 up into ten stocks, we would only be investing $975 per stock. Since we would have a hard time keeping our commissions down to the 1% to 2% of principal level on a $975 trade (for instance, if our commission was $25 per trade we’d be spending $25/$975 or nearly 2 1/2%), we opt to trade six issues instead of ten, after referring to the chart above. $9,750 divided by 6 yields about $1,625 per stock. This amount, $1,625, is the amount we will invest in each of our six issues.
The reason we are using only 65% of our capital at first is that we want to abide by the margin trading rule we developed in Chapter 8:
To control our use of leverage, We will choose our initial position size in a stock so that we will always have enough cash on hand to make our inital purchase and half of our second purchase without borrowing anything.
Using no more than 65% of our capital for our initial positions in our six stocks ensures that we are in compliance with this part of our trading strategy.
Step 4: Determine which issues you will invest in
Keep it simple. Use the criteria for stock-picking presented in Chapter 4, which is essentially:
- Restrict your stock picking to the 52-week highs list (better yet, use stocks making new all-time highs in price).
- Weed out defensive issues such as precious metals, oils, utility companies, closed-end mutual funds and food/grocery issues.
- Weed out stocks selling for less than $15/share.
- Lean toward the smaller-capitalization stocks remaining on your list that meet criteria 1 through 3 above.
- To maintain adequate diversification, select stocks from several different industries.
- Check out the chart of the stock for clues on goodness of trend, volatility, and whether or not a buyout situation is responsible for its being on the 52-week highs list.
You can be assured that these stocks are high-potential and they will have a excellent chance of leading the market in a bullish environment. If we use this criteria to choose the six stocks we will buy and follow in our example, our chances of having some really big winners will be increased dramatically over just about any other method. Why? Because we are getting our recommendations directly from the market, where investors are voting with their dollars. Not from a broker who may not even have his own money invested in the stock he’s selling to you. Remember, stock brokers are successful because they know how to get people to buy stocks, not necessarily because they know how to make money.
To continue our example, after applying the criteria above, let’s say we end up choosing the following six stocks (these are hypothetical examples only):
| Stock | Purchase Price |
| Zeneca | $56 3/4 |
| Hummingbird | $50 3/4 |
| CUC International | $31 1/8 |
| Tiffany | $46 3/4 |
| First Data | $69 1/2 |
| Imperial Bcp | $24 |
As we determined earlier, we will purchase $1,625 worth of each stock.
Step 5: Buy your intial positions in each stock
Now that you have chosen which stocks to build positions in, calculate based on the most recent closing price of each stock how many shares you will initially buy in each issue. Don’t worry that they are not in even 100-lot quantities, which they almost certainly will not be. Instead concentrate on buying an equal dollar amount in each issue purchased. For example, we previously calculated an initial position of $1,625 for each of our six issues. Therefore, if one of the stocks on our buy list is Zeneca and it is selling for $56 3/4, we would place an order to buy 29 shares ($1,625 divided by 56 3/4, rounded up to the next even-number share quantity) at the market price. This calculation would be repeated for each of the other five stocks you are buying using their specific closing prices from the previous day.
Here’s a helpful hint: Try to place the orders well before the 9:30 AM market opening so that you will receive the day’s opening price. Odd lot trades (less than 100 shares) are usually upcharged some amount for a handling charge, but this is often waived if the order is entered before the market opens. Also, you’ll be more likely to get a price closer to the previous day’s close by getting in when the market first opens. As always, use market orders and not limit orders.
Once your orders are filled, be sure to make a note of the price per share you actually paid for each position.
Step 6: Construct your predetermined entry and exit plan matrix.
Now that we have taken our intial positions, all that is necessary is to finish filling out the Reverse Scale Strategy Decision Chart, as shown in the example below. In this chart, we define the first few Decision Points (more can be added later, for those stocks which make hefty advances) for each stock based on your initial entry point into that stock. The number of shares we acquire at each decision point can be penciled in as these acquisitions occur, as well as the total number of shares owned. For each stock individually, the sell point is always one level (33%) below its highest Decision Point reached, as covered in Chapter 7. Once we have constructed this worksheet we can carry it with us and pencil in acquisitions as our decision points are reached. Then we will know which Decision Points have been reached, and hence we will also know just by looking at the chart what our current sell point is for each stock, as well as the next buy point. In keeping with our example, here is how the chart would be filled out for the six stocks we picked out for our example portfolio, once we’ve taken our initial positions:
| Reverse Scale Strategy Decision Chart | ||||||||
|---|---|---|---|---|---|---|---|---|
| Company | Zeneca | Company | Hummingbird | |||||
| Symbol | ZEN | Symbol | HUMCF | |||||
| Target Price/share |
Shares Purchased |
Total Shares Owned |
Target Price/share |
Shares Purchased |
Total Shares Owned |
|||
| Initial sell point | 37 7/8 | (n/a) | (n/a) | Initial sell point | 33 7/8 | (n/a) | (n/a) | |
| Inital entry point | 56 3/4 | 29 | 29 | Inital entry point | 50 3/4 | 32 | 32 | |
| Decision point 1 | 85 1/8 | Decision point 1 | 76 1/8 | |||||
| Decision point 2 | 127 3/4 | Decision point 2 | 114 1/4 | |||||
| Decision point 3 | 191 1/2 | Decision point 3 | 171 1/4 | |||||
| Company | CUC Int’l | Company | Tiffany | |||||
| Symbol | CU | Symbol | TIF | |||||
| Target Price/share |
Shares Purchased |
Total Shares Owned |
Target Price/share |
Shares Purchased |
Total Shares Owned |
|||
| Initial sell point | 24 3/4 | (n/a) | (n/a) | Initial sell point | 31 1/8 | (n/a) | (n/a) | |
| Inital entry point | 37 1/8 | 44 | 44 | Inital entry point | 46 3/4 | 35 | 35 | |
| Decision point 1 | 55 3/4 | Decision point 1 | 70 1/8 | |||||
| Decision point 2 | 83 1/2 | Decision point 2 | 105 1/4 | |||||
| Decision point 3 | 125 1/4 | Decision point 3 | 157 3/4 | |||||
| Company | First Data | Company | Imperial Bankcorp | |||||
| Symbol | FDC | Symbol | IBAN | |||||
| Target Price/share |
Shares Purchased |
Total Shares Owned |
Target Price/share |
Shares Purchased |
Total Shares Owned |
|||
| Initial sell point | 46 3/8 | (n/a) | (n/a) | Initial sell point | 16 | (n/a) | (n/a) | |
| Inital entry point | 69 1/2 | 23 | 23 | Inital entry point | 24 | 68 | 68 | |
| Decision point 1 | 104 1/4 | Decision point 1 | 36 | |||||
| Decision point 2 | 156 3/8 | Decision point 2 | 54 | |||||
| Decision point 3 | 234 5/8 | Decision point 3 | 81 | |||||
Step 7: Monitor your positions
After we have taken our positions, it’s pretty much a game of waiting to see what happens next. We must check performance of all the issues in our portfolio after the close of every trading day in order to see if you need to add to any of your positions or sell any of them. If you can, check twice a day, but this is not a requirement for success. Even though our decision points are placed far apart, under certain market conditions large moves can happen in a single day, so it’s critical to keep on top of developments – and so the necessity of checking in every day. The way to accomplish this is by using a discount broker that offers a touch-tone quoting and order entry service, which should bring the time necessary to check up on things down to about about two or three minutes a day. Who knows, we may become a “Less Than Five Minute” Investor! If your discount broker does not offer this service, find one who does and save yourself a lot of time. These services allow you to set up a list of stocks whose closing prices will be automatically reported to you at the end of the day when you call. With this type of service, monitoring your stocks can easily be accomplished by even the busiest persons. I like the touch-tone quote retrieval services because even if I am on a business trip, I can check my investments at 10PM in my hotel room, and I don’t need a computer to do it. If a buy or sell point has been reached, I can enter the necessary orders right there on the telephone, without talking to anyone or having to wait until the broker gets in in the morning.
I strongly recommend that when you have built a fairly large size position in a successful stock, use good-til-cancelled stop-loss orders, which were described in Chapter 8. I use these whenever I have made two or more purchases in a stock, because at that point I have enough invested in the stock to warrant protecting myself with such a mechanism. However, there is no reason you can’t choose to use a stop-loss order on every position in your account. This helps to avoid the situation where you call in at the end of the day only to find that your stock has fallen to substantially below your Decision Point for selling. Stop orders give you peace of mind for keeping your mind on your job during the work day, without the distraction of needing to watch your investments. One necessary discipline for the use of good-till-cancelled orders of any kind is that you must keep meticulous records of your orders, so that you know exactly which orders you have entered and which ones you have cancelled. Otherwise, you may end up executing orders which you did not intend to execute.
Step 8: Know and Apply the Trading Rules
As you monitor the stocks in your portfolio, eventually one or more of the stocks will reach the next decision point above where you got in, or will decline below the decision point previously reached. In either case, action on your part is required. Thus it is good to review and know the trading rules well so that you can apply them decisively.
Trading rule #1: Whenever a stock advances so that it touches a Decision Point not previously achieved, add a dollar amount to your position in that stock approximately equal to the dollar amount originally bought.
In our example, we bought $1,625 worth of Zeneca at $56 3/4, so if Zeneca rises to touch $85 1/8, we will call the broker and add 19 shares ($1,625 divided by $85 1/8) to our position. We would update the Zeneca portion of our decision chart as follows in the highlighted area:
| Company | Zeneca | ||
| Symbol | ZEN | ||
| Target Price/share |
Shares Purchased |
Total Shares Owned |
|
| Initial sell point | 37 7/8 | (n/a) | (n/a) |
| Inital entry point | 56 3/4 | 29 | 29 |
| Decision point 1 | 85 1/8 | 19 | 48 |
| Decision point 2 | 127 3/4 | ||
| Decision point 3 | 191 1/2 |
No other stocks’ decision charts are affected by this change. We are making decisions for each stock separately, based on the performance of that stock alone. Now that the chart has been updated, we can see all the information we need to know: We can see that the Decision Point of $85 1/8 has been reached, that we now own 48 shares, and that in order for us to sell our entire position Zeneca would have to decline to $56 3/4 or lower. This scenario is covered in the next trading rule.
Had Zeneca risen to $191 1/2 or higher over the next several months or years, we would have added positions at $127 3/4 and at $191 1/2, for a total position of about 68 shares. At that point, the new sell stop for all 68 shares would be at $127 3/4.
Trading rule #2: Whenever a stock declines to touch the previous Decision Point, sell the entire position.
If, instead of advancing, Zeneca had declined instead of advancing and had dropped as low as $37 7/8 after we took our intial position, we would have to sell out the intial position (29 shares) for a loss. Obviously, we never got the signal to add to the position because we are assuming here that it reached $37 7/8 before it got the opportunity to hit $85 1/8.
Once one of the sell points is reached, do not hesitate. Sell. Likewise, do not hesitate to buy whenever a new decision point is reached during an uptrend. Sometimes the best stocks rise very quickly, so to act decisively is all-important whether buying or selling. He who hesitates is lost. If you believe in your plan, there is no reason to be hesitant.
Trading Rule #3: Once you have sold a stock, re-commit the proceeds of that sale to a different stock (or stocks) than the one you’ve just sold. To pick this new issue, use the same criteria used in choosing your original list of stocks.
As we’ve reviewed, some people, once they’ve taken a loss on a stock, take it personally and they keep trying to “get even” with the stock by looking for an opportunity to buy it again. Don’t fall into this trap, because if you do you are acting like the Ego-Driven Investor described earlier in the book. Forget the loss and the stock. If a stock has fallen far enough from its highs that it’s now down at least 33% from the peak (the percentage difference between every Decision Point and its next lower Decision Point), then it may be entering a downtrend, and you don’t want it. Take what’s left and buy a different stock, one now making new highs. Your money will be better employed and your account won’t end up looking like the dog pound.
A Trading Rule for Bear Market Insurance
In any trading system, the most important thing is to preserve your capital. Capital preservation is all-important because if you seriously deplete your trading capital, it becomes very difficult to get back even to where you started out, much less make a profit since you are then working with a smaller amount of capital.
The two main sources of capital depletion are from whipsaw losses (rapid-fire in and out trading, which almost always results in lots of small losses and large commission expenses) and from failing to cut losses on poor investments. The Reverse Scale Strategy already has many capital-preserving mechanisms built into it. Among these are diversification among many securities, our loss-cutting decision rules, and the fact that we do not add to positions until they are showing us a good profit. Also, our decision points are set far enough apart (50%) so that whipsaw losses are extremely unlikely, especially when applied to stocks selling for more than $15 per share.
However, for good measure we need to address the worst-case scenario in order to short-circuit the prospect of several losses coming in quick succession. These types of events tend to occur during bear markets. Since bear markets are a reality and are unpredictable, we need to add the following trading rule to ensure that we can survive those inevitable times when the market goes down for an extended period, pulling almost all stocks down with it:
Trading Rule #4: When you’ve been forced out of a stock position (by applying trading Rule #2), do not reinvest the proceeds of that sale into another stock until the Standard and Poor’s 500 stock index (commonly referred to as the S&P 500) makes a new 52-week high.
The purpose of this trading rule is to force us to wait until the market as a whole is showing signs of positive momentum before re-committing funds. In other words, we do not want to get into a situation where we are buying a new stock, selling it for a loss, using the proceeds to buy another new stock and then being forced to sell it for a loss, and so on in quick succession. This can happen during very severe market downturns. That’s why we want to wait until the market has shown some strength before re-committing funds to a new position. Your win to loss ratio will be much better if you observe this rule.
Since the market (as measured by the S&P 500 index) is commonly making 52-week highs, most of the time you will not have to wait too terribly long to reinvest proceeds of a sale. If Trading Rule #4 does prevent you from reinvesting for a long period of time, there is a very good reason for it, and you will no doubt be glad that you were patient in waiting for a new 52-week high for the S&P 500 before recommitting funds.
Of course, it goes without saying that any stock you would pick for reinvestment needs to be chosen using the criteria from Chapter 4.
Step 9:Periodic Adjustments
As your account value grows, you will have to periodically adjust the size of the initial positions you are taking in a stock. For instance, if our $15,000 account equity grew to $25,000 and we sold one or two stocks, we probably wouldn’t want to take new initial positions to replace them that were as small as we originally took. Instead of taking $1,625 initial positions, we might decide to take positions that were proportionally in line with our new account equity balance, say $2,700 in this case. With any successful investment plan, these types of adjustments need to be made as the amount of money you have to invest grows.
The other thing you could do in such a case is to stick with the $1,625 initial position size and simply work with a larger number of stocks. For diversification purposes, this is the preferred route to take, at least until you reach the goal of having ten stocks.
The main thing to beware of is that you don’t over-commit yourself. When you sell a stock, don’t invest more in new stocks than you received in proceeds from the one you’ve sold. If you adhere to this rule, you will never overcommit yourself.
Five Minute Investing Course
Introduction
Chapter 1: Replacing Our Stock Market Myths
Chapter 2: Things to Avoid
Chapter 3: Know Yourself
Chapter 4: Stock Picking
Chapter 5: How to Evaluate a Trading Strategy
Chapter 6: The World’s Worst Trading Strategy
Chapter 7: The Reverse Scale Strategy
Chapter 8: Margin Power
Chapter 9: Implementing the Reverse Scale Strategy
Chapter 10: Getting Started