$20 Should Be Your Cutoff Point

 | Sep 08, 2017 | 8:00 AM EDT
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(This commentary originally appeared Thursday on Real Money Pro. Click here to learn about this dynamic market information service for active traders.)

Should any stock you own break down below the $20 level, well, that is a warning signal that few, if any, hear. But those who do hear it know what to do. And what they do is sell the stock, if not begin to short it.

First, you should know that it is best (as per the odds) to not buy any stock that drops below $20 for the first time in years. The reason is that by buying what you think is a bargain, more likely instead you will be creating a situation where you are buying a headache. And that headache might become the cause of far worse maladies.

My wise late mentor taught me many decades ago that any stock that has been above $20 for years (!) and then slips below $20 has one hell of a time finding new buyers. New buyers will be unable, for whatever reasons, to overcome all the new "me-too" sellers that enter the trading game for a stock that breaks down below that key $20 level.

Thinking this over, any stock that has been trading over $20, if not well over $20, has done so because that stock earned that valuation. Investors had been correctly bullish and became accustomed to be bullish on that stock for long periods of time because of that stock's continual bullish fundamentals. By being bullish, they had been financially rewarded.

But, should that said stock take out the $20 level as it breaks down in price, a rather diverse and most likely large number of long-stock holders will begin to question their thinking about owning a stock that is failing them.

The questions they will ask will be, for the most part, fundamentally focused. At that $20 inflection point, it is also highly likely that the fundamentals (earnings, PE ratio, balance sheet, et al.) of the company breaking below $20 will be their primary concern. And odds highly favor that those fundamentals have been, are, and will be, most likely, getting worse.

At this point, you must be asking "Why is that so?". I would be doing the same, if it hadn't been for five decades and counting adhering to my mentor's dictum on the $20 level rule. At times, we have to say to our trader minds: "Ours is not to reason anymore about the whys. Ours is to cut the loss, and find out later why!"

In other words, if you fight any tape, you will lose. The tape rules. All else is denial, self-parsed disillusion and erroneous logic.

Now, how this $20 level affects our world of options is: the lower in price a stock goes, the more its stock value changes to lower and lower levels. And as the stock declines, the bigger the change in its percentage moves vis-a-vis the changing of its stock price to the downside.

Mathematically, a two-point move lower basis a $20 stock is a percentage move of -10%. That same two-point mover lower from 18 is a -11% drop. That two-point move lower from 16 is a 12.5% decline. As those percentage moves increase, so will the volatility increase for that stock's options markets.

It is that rising of the stock's percentage change that catches not only the options market makers' eyes, but also the eye of the financial media. They have a tendency to hype the big percentage moves, as that catches the eyes of their readers/viewers. That in turn adds to the problem of a stock that is dealing with that breakdown through the $20 level.

The list of stocks that slowly but surely crack $20 and eventually move down into the mid-teens to low teens, to single digit prices, is a list you do want your stock holdings to be a part of. And that list is far greater in number than those stocks who move up from single digits and the teens to making the grade over $20.

Best to use my $23 level "trip wire" approach. That tactic implies that should any stock move down below $23, that is the canary singing its warning to sell now and ask questions later. And if the options volatility for that stock at that price and time are still low enough (in the $20s), shorting it using long calls as the hedge begins to make trader-sense.

An elongated in time bear cycle catalyzes a sizable list of $20 level rule candidates.

A well-publicized candidate that passed the $20 level rule test was and remains Valeant Pharma (VRX) . Just last October, VRX broke down below $23 and in November it broke $20. VRX has not even touched that $20 price level since. You might want to search online all the bullishly biased puffy articles published since last November on what a great buy VRX was. All of them well wrong, of course. We can learn from others' mistakes. It's much wiser to do that, than learning from our own errors in judgment.

One bullish article went so far to call VRX a "screaming buy". That "screaming buy" level was $16. The date was just a month ago. Today, four-plus weeks hence, VRX is almost 20% lower. But hey, if you liked it at $16 you're gonna love it at $13!

The best options trade tactic to employ with a stock perched on $20 as it's been heading down is a "synthetic put" (short stock, long call, the basis 1 to 1): Buy the at-the-money calls, with an expiry of three to max six months and short the stock at $20. The calls at that price and time will most likely be bought a bit theoretically "cheaper" than a straight buy of the puts, as it is the puts that get "pumped up" at the time when a stock is perched to soon break down below $20.

Best for any trader to at least know of this valuable rule I have adhered to for many decades. Also best to check if you own any stocks that have been declining and are now nearing the $20 level. If so, well, you know what will be happening next.

Do note that any elongated bear cycle catalyzes the set-up for a sizable list of $20 level rule candidates. Thus, when that time and price roll around again, do not fall into the "buy it because it's cheap" trap. Instead, consider shorting the stocks that crack the $20 level, using the $23 trip wire tactic to find the candidates to short.

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