Archive for May, 2012

As any seasoned trader can attest to, trying to pick bottoms in stocks can be very dangerous to one’s trading account.  With today’s disclosure of Berkshire’s new position in General Motors (NYSE: GM), Warren Buffett appears to be trying to pick a bottom in GM.  Many traders try to mimic Warren’s moves, and with the stock up over 4% today, there is no doubt there are some traders doing just that in GM today.

However, traders should use caution when following Mr. Buffett because his investing style is certainly not for everyone.  Although a majority of Mr. Buffett’s investments have worked out handsomely, some of them did so because of his deep pockets and often preferred investor status.  For example, when Mr. Buffett stepped up to the plate in Goldman Sachs (NYSE:GS) in September of 2008, he did so with preferred stock that had a juicy 10% dividend and warrants to buy $5 billion worth of common stock at $115 a share, $10 below Goldman’s share price when the deal was announced. But just a few months later Warren was down significantly on this investment as on November 21, 2008 GS traded as low as $47.41/share.  Most individual traders cannot afford to lose that kind of money on a trade, especially if they trade on margin. But Warren has very deep pockets and can therefore take more heat than the average trader can.

Mr. Buffett’s investment in General Electric (NYSE:GE) in 2008 was accompanied with preferred status as well.  He received preferred stock with a 10% annual dividend and warrants to buy GE common at $22.25/share.  Any trader that followed his strategy and bought similar long term warrants in October 2008 has yet to see any gains from those warrants, as GE has only traded up to 21.65 since that date.  But Mr. Buffett is long out of the trade as GE has redeemed his preferred stock giving Buffett a nice profit despite his warrants being out of the money. If any trader had interpreted Buffett’s purchase as a buying indicator for GE stock, they would have been under serious water five months later as the stock traded as low as 5.73 in March of 2009.  Again, most traders do not have deep enough pockets to take that kind of heat.

Which brings us to Buffett’s recently highly publicized investment in Bank of America (NYSE:BAC).  Once again, he received preferred stock at a 6% annual dividend and warrants at 7.14 (in the money as of today).  When the news hit the tape of his purchase, BAC shares spiked up to 8.80, only to fall under 5.00 by the end of year.  It once again takes deep pockets to be able to stomach those losses.

Mr. Buffett rarely discusses the risk parameters associated with his investments, although he does employ diversification in his investment strategies.  Unfortunately, the average investor does not get the “sweet” deals and must have a modicum of risk management.

Deep pockets also gives Buffett the luxury of adding to a losing position.  This is something a trader should never do.  Although many traders have reaped large profits from this mor-on strategy (put more and more on as it goes against you) there is larger amount of retail and proprietary traders who have been destroyed doing this.  Therefore, it is of paramount importance as traders to have your risk parameters well defined.  Using some type of mental stop is critical in protecting one’s trading account.  Chances are if the trade goes against you and you are stopped out, you may have another chance to get back in, and most likely at a more favorable price than your original entry price.

The bottom line is that if you do not have access to the “sweet deals” and do not have deep pockets, you must incorporate sound risk-management skills into your trading style.  So if you are following Buffett’s purchase in GM today, make sure you have a contingency plan in place if the trade moves against you.  By employing sound risk management into your trading, you’ll be a better trader and one day you may have deep pockets like Warren Buffett.