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Resident trader
Trading against computer-generated stops
Will Kraa, September 10, 2007
Since early 2006 IBA Health Ltd (IBA) has been a stock I have traded from time to time as its price moved from $0.60 to about $1.50. These trades were very profitable and made me a lot of money. It is good when you can find a stock, which is in a good uptrend supported by favourable company news. In this piece I will share with you a couple of these trades. The first one is a short-term profitable trade taken under unusual circumstances and the other a more recent one which was not profitable.
An interesting feature on the first chart is the long tails seen on the candles as indicated by the red arrows. The second arrow in the middle of September shows the price dropping from $0.84 to $0.66 and recovering to close at $0.78 all in a very short period of time. At the time I had a very large open trade in the stock in one of my CFD accounts and during the day as I came to check what was happening in the market I discovered that my account had suffered a large drawdown. I was shocked to see that IBA, which had been trading close to $0.90, was now trading at $0.70. I quickly looked to see if there had been any news to cause this sudden drop in price but there was nothing.
Then it dawned on me what was really happening and as prices started to recover rapidly I quickly placed another order in the market to buy more of the stock. Over the next few days the price recovered and made new highs and the extra stock I had bought quickly added to my profits. Normally a large drop in price such as this would be a reason to exercise a stop and exit the trade. In this case I did not do that but rather added to my trade.
There is a good reason for my action in this case. The large tails seen on these candles are not the result of normal trading. Rather they are the result of computers placing orders in the market to fill stop orders. There are times when normal price action results in a few stops being exercised. In case of stocks like IBA, which have times when they are not very liquid, there may not be very many bids close to the price at which it is being traded. The result is that the sell orders are executed at lower prices resulting in more stops being placed into the market. This becomes a cascade of sell orders at lower and lower prices taking out the bids.
In this case it pushed prices down to as low as $0.66, which interestingly enough was the exact low seen almost four months ago (as shown by the red line on the chart). Some unfortunate individuals locked in large losses at these very low prices after which the prices recovered substantially in a matter of minutes. It is for this reason that I am reluctant to place automatic stop orders in the market and I usually execute these orders myself rather than relying on computers to do it. I have the advantage that I can access the market any time I like so if you are not able to do that you may have to rely on placing stop orders with your dealer. (On the other hand, wouldn’t it be good to be the lucky trader who got the stock at the give-away price of $0.66 for an instant profit as the price recovered!)
For those who are using the WebIress trading platform this problem can be overcome because it is possible to put a limit on your stop order below which you are not prepared to sell. It is also possible with this platform to specify a time that you want your stop order placed into the market. It is less likely that these extreme price actions will take place in the last half hour of trading and it is possible with WebIress to specify that if price is still below the stop at that time that the order will be placed in the market. Of course this may mean that if the market stays down you may lose more than you might have if you had not placed restrictions on the execution of your order. Nothing is ever simple and straightforward is it?
All this again points out the risks associated with trading leveraged products. Such unexpected and unusually large price movements can cause large losses when they are amplified by the leverage. It is very important that risk management strategies take this into account so that overall position size is not too large in comparison to the size of the account. Slippage and gaps in prices can wreak havoc with your risk management and it is necessary to take these things into account and make provision for them.
This not so much a problem if guaranteed stops are employed but when ordinary stops are placed in the market there is no guarantee at all that they will actually be exercised at the price you specify. On one occasion I had placed a stop in the market for a long CFD trade with a market maker CFD provider. I was watching the course of sales as my stop order was hit and was interested to see what would happen. There was sufficient volume traded at the stop price for my order to be executed at the price I set but it was done at a significantly lower price. When I enquired about it I was told that there was a delay before the dealer could place my order in the market and that this led to the lower price at which my order was done.
In the present circumstances there may be times when short trades are indicated and guaranteed stops can be useful then. It is important to realise that in a short trade your potential loss is unlimited since there is no limit to how high a stock price can go. Some good news for the stock could easily result in a large gap up in price and this again would mean that your losses could be much larger than anticipated. Guaranteed stops can help in limiting the risk of short trades but of course guaranteed stops may be costly. Some providers allow you to move guaranteed stops without extra cost to follow the trade, others charge again if you want to move it in the direction of the trade as you would have to do to protect profits.
The IBA trade I placed on 15 September when there was this large drop in price (second arrow on the first chart) was purely a short term one to take advantage of the lower prices available. Since prices recovered rapidly after the large drop my order was filled at $0.827. If I had realized sooner what was going on I might have got even lower prices but the rapid recovery in price showed that the low prices were just an aberration and that the uptrend was likely to continue. The 3.5 ATR Chandelier stop (blue line) was at $0.775 and this meant a risk per share of 5.2 cents so the contract for 50,000 IBA worked out as a risk for the trade of $2600 which was well within the limit of risk I could afford.
Even though the price had recovered so rapidly the large dip in price did have an effect on traders as by the end of the day the market closed at $0.78, only just above my stop. Over the next few days the price recovered as expected and by 28 September had reached about three times my initial risk and I decided to lock in the profit at $0.97. As mentioned before I did have another long term trade in the same stock at the time and that one was allowed to remain open as the trend continued. The gross profit for this short-term trade was $7150.
The uptrend for this stock continued until it reached the recent high of just over $1.50 in mid February when news came out about a possible takeover of iSoft, a UK firm with a similar business. The market was not altogether impressed and neither was I so for some time I did not trade the stock.
Then by early July the funds had been raised for the acquisition through successful share placements and as can be seen on the second chart the price broke through the down trend line and also through the 3.5 ATR Chandelier (blue line). IBA was trading below the 30 week (150 day) moving average but the MA was still rising.
On 3 July I decided to place a trade for 32,000 IBA at $1.19. My stop was just below the most recent low at $1.06 for a risk per share of $0.13 and a total risk for the trade of $4160, appropriate for the CFD account in which I was doing the trade. Over the next few days the price went up and my stop was raised to $1.22 (blue Chandelier line). But by 24 July the price had fallen below my stop and I exited the trade at $1.105 for a loss of $2720 plus commission and interest. This was a successful trade resulting in a loss.
Subsequently the price dropped in line with the panic that gripped the whole market and in spite of several good news stories for the company. The break above the downtrend line (on which I based my trade) did not follow through - and getting out of the trade at $1.105 saved me from a much larger loss. But there are times when getting out at a stop seems wrong: prices recover and you feel you should have stayed with the trade as it would have become profitable. Do not start to punish yourself for exiting in such instances. Getting out of trades, which did not perform as expected, is a necessary part of risk management as it protects you from much larger possible losses. Make sure you tell yourself you have done the right thing and remember that protecting your capital must take precedence over making profits.
Calculations:
Trade 1
Buying price $0.827, stop $0.775, risk per share $0.052.
Risk for the trade 50,000 x $0.052 = $2600.
Opening contract value 50,000 x $0.827 = $41,350. Closing contract value 50,000 x $0.97 = $48,500.
Difference a gross profit of $48,500 - $41,350 = $7150.
Commission $41.35 + $48.50 = $89.85. Interest about $130.
Net profit for this trade $7150 - $220 = $6930.
Trade 2
Buying price $1.19, stop $1.06, risk per share $0.13.
Risk for the trade 32,000 x $0.13 = $4160.
Opening contract value 32,000 x $1.19 = $38,080. Closing contract value 32,000 x $1.105 = $35,360.
Difference a loss of $38,080 - $35,360 = $2720.
Commission $38.08 + $35.36 = $73.44. Interest about $100.
Total loss for this successful trade of $2720 + $175 = $2895.
More articles from this week's CompareShares newsletter:
Stocks: Uranium heavyweights come back fighting
CFDs: Hedging your losses, and making profits, using CFDs
Fundamental analysis: What is the price/earnings ratio of the overall market?
Smart investing: Home sweet debt
Resident Trader: Trading against computer-generated stops
Stock of the week: ABC Learning
Analyst report: The right insurance for investment
CFDs: Slippage - the sworn enemy of CFD traders
Options: Trading options close to expiry
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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