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The Australian Internet Trading Weekly
THE TRIAL EDITION IS AN EXTRACT FROM THE FULL SUBSCRIBERS NEWSLETTER. IT IS BETWEEN HALF AND ON THIRD OF THE LENGTH OF THE FULL SUBSCRIBERS NEWSLETTER. SUBSCRIBERS NEWSLETTERS ARE DELIVERED BY EMAIL ON FRIDAY EVENING. A RECENT FULL SAMPLE COPY IS ALSO AVAILABLE.
Includes free spreadsheet available to subscribers only
Weekly for Monday March 10, 2003 Based on Thursday’s Close 24 pages
With contributions from J Atikinson, P Rak
Guppy Trading Essentials Chart pak, Metastock , Ezy Charts & SuperCharts. Data from JustData, Paritech, MarketCast & Keyquotes.
CONTENTS
· Speculative Bears p1
· It’s All About Control? P5
· The Do Nothing Approach p9
· Exit Efficiency p11
· Readers Questions – Sudden Jumps Prt2 pP15
· Chart Briefs –Surface Mount Technology p 19
· Newsletter Outlook – Freefall p20
· Newsletter Notes p21
· Sample Portfolio Performance p22
IT’S ALL ABOUT CONTROL
One of the most difficult aspects of trading, or investing, to accept is that we do not know what will happen once we buy a stock. Although this sounds an obvious statement, easily dismissed by those who have only the smallest passing association with the market, it remains the major barrier standing between success and failure. Take a moment to examine your beliefs about the market. Do you believe that success depends significantly upon any of these factors?
· Getting access to the best research on stocks available, including good analysts reports, reliable news services and information.
· Developing an understanding of the best methods used to analyze the fundamentals of the company, its business and its products so you can do your own research and verify the research complied by others.
· Finding the best trading or investment system by emulating the activity and methods used by Peter Lynch, Warren Buffet and others.
· Finding the best technical trading system, based on the track record. This may mean paying money for a system already developed, or spending the time to develop and back test your own.
· Finding the most reliable chart indicator, or combination of indicators that reliably identify trading opportunities.
· Finding a large investor, analyst, brokerage, or newsletter with a good history of successfully identifying companies that go up in share price. The objective is to follow their actions or recommendations.
Each of these approaches is a useful component in understanding individual stocks and identifying trading opportunities. But if we stop just at this point, we are unlikely to achieve consistent success. People who have stopped at any of these destinations are the ones most likely to complain that the market is impossible to understand, or that they are being mislead by investment professionals. While there is some truth in each of these, none of them provides an answer to what will happen once we buy a stock.
Despite all our research, the successful investor and trader accepts that ultimately he does not know what will happen. This is an extremely uncomfortable answer. Most of us instinctively shy away from situations where we do not know what will happen. They are uncomfortable places to be and we seek some guarantee, or pretence, of certainty. It is a very powerful factor, and difficult to consider objectively in the emotion charged atmosphere of the market where we can make or lose money.
Whenever we see disorder, we attempt to impose order. The attempt does not have to be successful, but making the attempt is more important than just accepting the disorder. Our attitude to the weather is a good example. For the bulk of the population, the weather is an irritant rather than an elemental factor upon which on livelihood rests. Understanding the weather is vital for a farmer, but less important for the office worker in an air-conditioned office building where the only danger is getting wet in the dash between the office door and car park.
Despite this we expect the weather forecast on TV to be accurate. Our interest in understanding this complex phenomena is such that, by popular demand, we now sit through 3 day weather forecasts. They give us a sense of comfort even though the accuracy rate in predicting the maximum temperature is less than 80% on a one day basis, and less than 50% on a 3 day basis*. Of course, by the third day you have forgotten the original 3 day forecast. It is somehow comforting to believe that we have somehow mastered the forecasting of the weather, to the extent that the Weather channel now offers a 28 day rain forecast. Perhaps it is possible to impose the same sort of order on the market?
Rain and temperature is unimportant for most city dwellers but it is still important enough for us to want to impose a sense of order and predictability. We do not like the idea that we simply do not know what is going to happen in the future.
I have labored the point for a single purpose. Although we say that we know that involvement in the market is not about prediction our actions often prove otherwise. We desperately want assurance that the method or approach we are using gives us an advantage. It is true that some approaches are more successful at identifying opportunities and it is worth taking the time to find those that match our preferred approach to the market.
However, once we have decided upon an approach and selected a stock we must be brutally honest with ourselves. We THINK we know what will happen, we HOPE we know what will happen, but the reality is that we DO NOT KNOW what will happen. As teenagers say, we must learn to ‘deal with it.’ How we deal with it is the true way to market success.
Using the case study NBL trade we can summarize what we do know, and do now know about this trade. Strip away the non essentials and the distracting detail and the result is stark. We simply do not know with any degree of certainty anything about the future for NBL. We have hopes and dreams about how far price might rise or fall, but that depends on the stability of the up trend. Although we have used a selection method, discussed last week, that we believe will help us to select stocks that are more likely to continue rising – the truth is that we do not know for sure.
The first step to market disaster starts with the confusion between hoping and knowing. Just because we hope something is going to happen does not mean we know it will happen. Just because we spent $5,000 on a trading system doesn’t mean we know what will happen. Just because we spent $1,000 a year on market research from a guru doesn’t mean that we know, or he knows, what will happen.
This is a very uncomfortable answer – so uncomfortable that most people refuse to accept it. Instead they continue their search for a solution that gives them a higher level of certainty about the future. They are most often the losers in the market.
Against what we do not know about the stock we can provide answers to what we do know. Forget the research, the details of company products and management. Once a stock is purchased these factors become less important to the success of the investment or the trade. Once we buy a stock we have a single objective in mind. We expect to make money. The mechanism which leads to this vary. Some expect to make money as the company improves its production or market share. Others expect to make money as the share price rises. The details obscure the underlying objective. We expect to make money, and the ability to do this lies in our own hands.
We know three things about every stock we buy. We know our entry price. We should know exactly how much we are prepared to lose before we abandon the stock. For traders this will be a small amount. Investors may let this grow larger, although they must be careful not to use this as an excuse for doing nothing.
Finally we must have a mechanism, or method for protecting a profit.
There is a lot of information vital to the success of our trade that we do not know about. But these are three important factors that we do know about every trade or investment. If you do not know how much you are prepared to lose, or do not have a plan to protect profits then you will lose in the market.
If we accept this uncertainty then we can deal with it realistically. The single most important advantage offered by the market is the ability it gives us to control our reactions to developing events. We can take the easy way out and panic, or gloat, but better traders assess unfolding events against a planned framework of action. This plan of action is built around what we do know about the stock. Our entry point is the starting point. This is the price from which all other calculations are drawn. The entry price determines if the trade is in profit or loss, and by what amount. The market provides a perfect mechanism for measuring success or failure. It shows up in your bank balance. These are hard figures and they are easily obtained by calculating the value of your trade or investment today and comparing it with the original value when you purchased the shares.
The only factors we know with absolute certainty are our entry price and how much we are prepared to lose. How much we hope to make is guesswork. We attempt to lock in a profit using a protect profit method, which is usually related to the same method we use to cut short a loss.
There are many ways to set up a stop loss condition. We look at two methods with NBL below. The important point is that you must have at least one method.
Understanding what we do not know, and what we do know allows us to realistically establish what we can do. If our actions are grounded on a realistic understanding of the market then we can succeed. This realistic understanding starts with accepting the idea that we do now know what will happen.
The case study NBL trade shows how this understanding is applied. Our entry point at $1.23. This is the first thing we know about the trade – our entry point.
The second thing we must know is our planned exit point designed to protect our trading capital. This can be set in one of two ways. The first is a financial stop loss point. This is created by measuring the size of the loss in dollar terms, and relating it back to the size of our portfolio in percentage terms. For this we use the 2% rule. This lets us risk no more than 2% of our total trading capital in any single trade. In terms of this trades, it means that if we buy 16,300 at $1.23 then by the time price falls to $1.10 we will have lost 2% of the sample $100,000 portfolio. This is a simple calculation and it is an very effective risk control measure.
The problem arises when the financial calculation bears little or no relation to the mechanics of the trade. For instance, depending on our position size, this calculation might call for an exit at $1.22. Clearly this does not make any sense in terms of the chart because the nearest support level is at $1.21. We could reasonably expect prices to fall to this level and rebound without any threat to the trend. Some traders may prefer to use $1.16 as a support level. The significant point is that the financial stop loss calculation must also be related to a logical point on the chart.
To establish this logical chart point we have a choice of many methods. Consistent with our discussion last week of stop loss techniques we propose to manage this trade using a combination of two stop loss approaches. The first is based on the count back line. Using the chart based on the day when the trade was entered, the stop loss point is set at $1.18. This is a long way behind the current price action.
We also apply a 2xATR technique to set a second stop loss point. This looks at the average true range of prices over the past 5 days, and then multiplies this value. This value is used to set a trailing stop loss. This sets the stop loss at $1.185 on the day the trade opened. By the open of trade on Monday, as shown on the chart, the 2xATR stop loss had lifted to $1.225.
The management technique used to control the erosion of our trading capital is to act when the first of these two indicators, CBL, or 2XATR, generates an exit signal. The objective is to ensure that the loss on the trade is as small as possible, preferably less than 10%.
Although we cannot tell how far prices might fall with NBL we do know how much we are prepared to lose. We think that the best solution in this trade is to apply an indicator based protect capital solution. Others may believe that a financial based solution is more appropriate. No matter which solution you select the important point is that this preplanning gives you a way to control what happens to this stock. You cannot control what price will do, but you can control how you will react to changes in price.
This changes a DON’T KNOW – how low price might fall- into a DO KNOW- we set a limit on the loss. This leads to a CAN DO solution because we can control our exit price to protect our trading capital. Prices may move faster than we expect, and we may end up taking a larger loss than we expected because by the time we react to the exit signal prices have dropped lower. No solution is perfect, but if we do not have a planned solution then we often end up holding onto a stock as it slowly destroys our trading capital. Without a plan we fail. With a plan we improve the chances of success.