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Former NYSE veteran breaks down risk management while trading AMD

Jared Blikre
·4-min read

Newbie traders and experience pros alike need to heed one word of advice to avoid catastrophe: Always have a plan before the trade is made. Otherwise, traders are simply throwing themselves at the mercy of their own emotions.

That's what Stephen "Sarge" Guilfoyle, president of Sarge986 LLC, said at the latest Yahoo Finance Premium webinar, where he broke down some key tenets of risk management. "What did Mike Tyson say? Everyone has a plan until they get punched in the face. In the infantry, we used to say, everyone has a plan until you make first contact. Here, you need a plan. And you need to stick to it ... Your plan can change. But you can't forget you have a plan once you get into trouble, because that's the only way to keep emotion, as best you can, out of the equation," he said.

During the webinar on Wednesday, the Nasdaq Composite (^IXIC) was selling off, with software and chip stocks getting hit hard. While fielding a question, Sarge looked at his trading screen and felt obliged to take action on one of his long-term bullish holdings, Advanced Micro Devices (AMD).

"[Y]ou know what I'm going to do right now? ... I'm going to sell a little AMD right now, which is one of my favorite stocks ... [I'm going to] take off about 20% of my position — just so that I don't make the fool's mistake of giving away money I've already made, because I have a big profit in this name. But it's been on a way south a little bit lately," said Sarge.

He then walks through his reasoning for taking some profits in AMD, defining the terms he uses in the course of his trading. AMD had hit his "panic point" of $82, which is the theoretical level at which he may need to take action to preserve his capital — in other words, it's a sell stop for at least part of the position. But despite the phrase's namesake, there's no need to "panic" at this level — he simply pays attention and assesses his plan.

"I don't have to sell it all there. In fact, I will never sell all my stock or buy all the stock I intend to buy at the same price. But I'm going to ... take something of a profit here, because, hey, this stock was a $99 stock. I've already lost out on some of my profits. I don't want to give them all away. So I take something off. I reassess. And by tonight, I'll have a new panic point," said Sarge.

Breaking down key concepts

Also key to the discussion are the terms "pivot point" and "cost basis." Sarge defines the pivot point as the price level that provokes action on the trade entry. 

"[Y]ou most likely want to set your pivot based on some kind of setup. You want your target price to be a minimum 20% higher. And you want your panic point to be a maximum 8% lower. This way, you could screw up almost three times as much as you can be right and still break even if ... all things are equal."

A 20% price target with an 8% panic point sets up a favorable reward-to-risk ratio of approximately 3-to-1 — one that is favored by many successful active traders.

A trade's cost basis is the theoretical entry price for the entire position after netting out all the entries and exits, including any money harvested from derivative plays (like options) over time. Amid another tech sell-off the day following the webinar, Sarge tweeted that he bought back those AMD shares at a price cheaper by $5. This lowers his cost basis on the trade.

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Back to risk management, Sarge makes an example of Melvin Capital Management, the hedge fund manager that got caught on the wrong side of the GameStop (GME) short-covering rally — suffering a 53% drawdown in January and taking in a $2.75 billion capital infusion from Citadel and Stevie Cohen's Point72 (but don't call it a bailout).

"As for the guys over at Melvin Capital, I cannot believe — I mean, I just cannot believe — that any 20-year, 30-year veteran of the business didn't hedge his position in any way — that he was able to get run over so hard that he had to run to his old boss for money," said Sarge.

Jared Blikre is a correspondent focused on the markets or Yahoo Finance Live. Follow him @SPYJared