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Resident trader
Running scared
Will Kraa, August 20, 2007
This has been a week I won't forget in a hurry.
It was hard to know whether to go long or short seeing no one is as yet expecting the beginning of a bear market. I prefer to trade in the direction of the long-term trend but at the moment there is no evidence of a trend either way. Neither is the market trading in a clearly defined range so there is no probable direction in which to trade. I guess something like this was to be expected after such a stellar run. With lots of people needing cash in a hurry it was a case of selling anything that could be sold but at this stage there is no way of telling where this will end.
One stock I was watching on Friday was Worley Parsons (WOR) and it was interesting to see who was doing the buying and selling. All day there were very small trades going through some as little as 10 or 20 shares at a time and most trades were smaller than a thousand. It was obvious that these were private traders selling very small lots as the price dropped rapidly after the opening and then settled to trade in a range for the rest of the day. Shortly before the closing prices dropped as low as $28.30 with the last trade at $28.50. Then came the closing auction at 10 minutes past four and now there were few trades less than a thousand and the match price at which these trades took place was $28.90, an increase of $0.40 over the last trade at four o'clock.
Throughout the day prices were set by private traders and at times you could almost see the panic as people quickly dropped in their sell orders. It is interesting that the larger orders in the closing auction were at a higher price. This may suggest that the professional traders are of the opinion that prices will open higher on Monday.
One stock that caught my attention as the recent market went into meltdown a couple of weeks ago was Brambles (BXB). It actually showed signs of recovery from its downtrend as the rest of the market was going down. As can be seen by the red trend lines on Chart 1, while prices were still trending down strongly the MACD had levelled out during July and the histogram of the MACD showed clear divergence. By 3 August the MACD had crossed positively and the price had crossed above the moving average.
I had heard some analysts comments that Brambles was good to buy at the time and the chart seemed to bear this out. This was also confirmed on the second chart where the RSI had dipped below 30 and the price had crossed above the 2.5 ATR Chandelier.
I decided to buy at $11.50 with my stop set just below the 15 day Moving Average at $11.20. The risk per share was therefore thirty cents and by buying 5,000 shares the total risk for the trade was $1,500. My account had enough free equity to accommodate the margin for this trade at $2,875 and the total risk for the trade was less than 3% of the account. This account has Direct Market Access so I was able to place my order in the market at $11.50 and it was filled at that price.
The next day the price was below my stop for part of the day but closed above the stop. On 8 August the price gapped up and moved up strongly all day to close at $12.73. I soon found out that there were rumours of a takeover which were responsible for the strong price move. There was no real confirmation that there actually was a takeover likely so the price drifted sideways for the next few days, opened lower on 15 August at $12.50 and continued down below the low for the last three days.
In view of the market conditions at the time I decided it was best to lock in the profit and so I sold at $12.45 for a total profit of $4,750. Under normal conditions I would have waited for the close of the market that day and possibly would then not have sold at all seeing the price was still holding within the range it was trading at for the last week. But with the current market volatility I decided it was better to lock in the profit available.
In hindsight it is obvious that the market was very suitable for short trades during the last couple of weeks and this would have been extremely profitable. It seemed to me that some mortgage problems in the United States were hardly likely to be the cause for a severe correction in the Australian market. I underestimated the effect this would have on an obviously very nervous world market.
As a result I tried to pick the bottom of the market in some trades and this was a costly mistake. I hope it is not too late for me to suggest to you that you do not copy my mistake.
Probably one of the best strategies currently would be pairs trading. The idea is to select a stock which is likely to underperform the market and short that stock. Then find a stock which is likely to be a strong performer and take a matching long position. If the market goes down it is likely that the weak stock will go down more and so make up for the loss in the strong stock. If the market goes up it would be expected that the strong stock would outperform the weak stock and so lead to a profitable trade.
This is not an easy strategy to carry out and definitely not for beginners. It requires a very good understanding of the stocks selected and the way they are likely to move. I have tried in the past and of the two stocks selected the one I expected to underperform went up and the one I expected to outperform went down. The result was twice the loss I might otherwise have experienced.
Unless you were right out of the market for the last few weeks it is likely you are now nursing some losses. The temptation is to recover the losses as soon as possible and under current market conditions this can be dangerous. It is much better to be patient and to wait until market conditions improve before trying to get back any money that has been lost. This is not easy to do but in view of the current volatility of the market is definitely the best policy.
Remember that if you are trading with a sole purpose of making money to cover recent losses rather than following your rules the result is not likely to be positive. With the fear, panic and greed currently evident in the market it is very easy to get caught up in these emotions and that does not lead to good trading. It is the patient trader who waits for the right opportunities who will in the end come out on top.
Explanation:
Divergence occurs when the price moves in one direction while indicators such as the MACD move in the other direction. It may be an indication that the trend is about to change. This by itself is not enough to take a trade but helps to confirm what other price action suggests.
ATR (Average True Range) has been explained before and the expression ‘Chandelier’ refers to the fact that this indicator is suspended 2.5 ATR below the price for long trades. It can be used as a trailing stop and what you see on my chart has been designed for AmiBroker by Geoff Mulhall and ‘flips’ when the price crosses the indicator. This means that instead of being a trailing stop for a long trade it now becomes a trailing stop for a short trade. It will then stay above the price until the price moves up through the indicator line and it once again beomes a stop for a long trade. It can also be used for an entry signal when the price crosses from below to above for a long trade and vice versa for a short trade.
Calculations:
Price at entry $11.50, stop at $11.20, risk per share $0.30.
Amount to be risked for this trade $1,500.
Number of shares to buy $1,500 divided by $0.30 equals 5,000.
Trade size at entry 5,000 x $11.50 = $57,500.
Margin required at 5% is $57,500 x 5% = $2,875.
Trade size at close 5,000 x $12.45 = $62,250.
Gross profit $62,250 - $57,500 = $4,750.
Commission is $57.50 + $62.25 = $119.75.
Interest is approximately $170.
Net profit is $4,750 - $119.75 - $170 = $4,460.
Margin required for the trade was $2875 plus free equity for safety margin of $1,500 equals $4375.
Return on equity required for the trade equals $4,460 divided by $4,375 equals 102%.
Note: To calculate the return on equity it is unrealistic simply to divide the profit by the amount of margin required for the trade. This would leave no spare equity for adverse price movement so to provide a realistic measure of margin required for the trade at least the initial risk for the trade needs to be added to the margin required for the trade.
In this case the initial margin required was $2,875 and the risk for the trade was $1,500 making the total amount of equity to be set aside for this trade $4,375.
More articles from this week's CompareShares newsletter:
Markets: Weathering the storm
Companies: Unloved offshore miners - part 2
Resident Trader: Running scared
International: Stronger Asia better able to deflect ripples
Credit: Eyes on central banks after US Fed move
US sub-prime: US recession on the cards
Markets: The fear spiral
Smart Investing: Tax takes shine off a great year
Stock of the week: NAB
Companies: Some transport worth catching
Software review: Amibroker
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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