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 MARKET REPORTS |
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Resident trader
Lessons from a week rather forgotten
Will Kraa, November 21, 2007
Have you heard of the trader’s conundrum? Well, this is it: ‘Should I sit back and watch this stock soar, or should I buy it and cause the price to collapse?’ I can assure you that as far as I am concerned this week has been one of those occasions when sitting back and watching would definitely have been the very best policy. Can you relate to this and do you have weeks like that? Welcome to the world of trading!
Fortunately it was not all doom and gloom for me this week and I did have some good profitable trades but the overall outcome was decidedly negative. The worst of it was that I made some silly and elementary mistakes. Things that definitely should not have happened.
Let me tell you one of the good ones first. There are times when stocks with a good turnover and good daily price moves trade in a range. When they are also in an uptrend long trades are more likely to be profitable. One of them is RIO and as you can see from the chart there are times when it does trade in a range. On some days the market is spooked by various events or rumours and prices are down. These are days when I like to buy since there are lots of people keen to sell. Then there are days when people realise the sky is not about to fall in and that things are not so bad after all so lots are keen to buy. That is when I find it profitable to sell.
These are very short term trades usually lasting only a day or two. Shares that are suitable for this kind of trading (going long) are ones that are consolidating during a strong uptrend. Any surprises in this case are likely to be on the upside.
Most weeks these trades make me good money and this week started with a reasonably profitable trade in Rio Tinto (RIO). On Tuesday 13/11/07 I noticed it opened at $135.50 and went down slightly from there. There was not much chance of a large drop in price with the takeover in play and considering the range of the previous day.
I opened by buying two contracts of 1000 each, one contract at $135.32 and the other at $135.58. My stop was at $134.50 for a risk of just under $1 per share. The total risk was therefore $2000 which was well within my 3% risk rules for my CFD accounts. If, as I expected, the price would go near the high for the previous day then the target exit price would be about $139, which is over $3 profit, and therefore a suitable risk/reward ratio.
No trade is worth doing unless the reward that can be reasonably expected is larger than the risk taken in the trade. Unless you have an extremely high ratio of profitable trades the reward needs to be at least twice the risk taken. In a very short term trade such as this one I would move my stop up to the price where my profit is twice the risk once that price has been exceeded.
In this trade the high for the day was $140.93. Near the close for the day the price had dropped to around $139 and seeing this met my profit target for the trade I closed one contract at $139 and the other at $138.90. Since the trade was done within one day there was no interest charge and the commissions totalled $549. The gross profit for the trade was $7,000 leaving a net profit of $6,451.
On the same day I noticed that Woodside Petroleum (WPL) had fallen in price for the day and was trading near the bottom of its range. Again the share is in a strong uptrend and consolidating in a range. Based on previous price action the probability of a move up towards the top of the range was high and a stop could be placed below the bottom of the range.
I opened by buying a contract for 2000 WPL at $52.19 and decided to stop the trade at $51.40 for a risk per share of about 80 cents and a target price of about $54 or more. The next day the price dipped briefly below my stop (which was a discretionary stop, not a stop order) but rallied and by the close of the day there was a small profit.
After the open next day there was a fair profit of about $2500 as the price reached a high for the day of $53.50 but by the end of the day the share price had fallen again to show a small loss of $380. It had not reached my target profit of twice the risk for the trade so I did not take the profit available earlier in the day. Since it closed near the bottom of the trading range I was prepared to let the trade continue. This was my first mistake. I knew that next day I would not be able to monitor the trade in the morning as I had to go out for a while so the least I should have done was to place a stop order. Preferably I should have closed the trade seeing I would not be able to monitor it properly.
But of course I did not know that the next day there would be an investor briefing about how wonderfully well the company was doing, and, Oh, by the way, we are expecting a drop in production of some 20%.
So there was a surprise, and it was not on the upside, but it gets worse. I was out longer than expected, much longer, and did not get back till near the end of the trading day. By that time the price had dropped dramatically (see the nice big black candle) and I was looking at a loss of over $8000. At that stage the temptation is to ‘rationalise’ and tell myself that, after all, the stock was in a strong uptrend and this selling was overdone and next day the price might recover at least a bit and my loss would not be so bad then.
There was a time when I would have said all those things and hoped for a better outcome but experience has taught me that bad news is often followed by more bad news. As I have mentioned before, hope is fine but not as a trading strategy. There was only one suitable course of action and that was to take my medicine and get out, which I did at $48.20. I’m not doing the maths for you here but you need to add commission and interest to get the whole picture. As you can see by the chart, hoping for a better outcome the next day would not have been good and I would not be human if I did not have to admit that it makes me feel a bit better.
And it could have been a lot worse. One trader I heard about left a very large profitable trade open, went to bed, the unexpected happened and he lost his account and almost everything he owned. Unexpected events can and will happen. In any trade it is necessary to make provision for the unexpected and not be so exposed that the results can ruin the trader. In this case even if WPL had even a very much larger adverse move it would have hurt more but not put me out of business.
Stops are an indispensable part of trading but I do not usually place stop orders. There are many times especially in the Australian market when automated stops cause sudden price drops which are over and done with in minutes. One stop order can take out some bids and lower the price triggering other orders and causing a cascade of lower priced orders. Once these are filled the price quickly recovers. This means a number of traders have had their positions liquidated at lower than necessary prices.
In this case, seeing this was a short term trade which needed monitoring I should have placed a stop order or else stopped the trade the day before at a very small loss. Another alternative when trading with Market Maker providers is to place a guaranteed stop order. This means that if the price gaps down well below your stop price you will still be stopped out at the guaranteed price, saving you from a greater loss. If there is a rapid drop in prices so that a stop order would likely be filled at a lower than expected price, you would also have your trade stopped out at the guaranteed price.
When using non-guaranteed stop orders you should also consider that in the case of Market Maker providers the lower the price at which your stop order is filled, the more profit they might make. When markets are not particularly liquid there is a good excuse for filling a stop order at what may seem to you to be a lower than expected price. You would be surprised at how few bids near the current price there are at times even in well traded stocks like the banks and stocks like RIO.
Even if you feel bad about it, in instances like that it is not easy to argue about the provider’s exit price. I must say that my current CFD Market Maker has always treated me well and I am not accusing anyone of filling stop orders at lower than necessary prices. But human nature being what it is you must consider the possibility. In many cases the stop order is filled by a dealer and it may take a while before the order is filled giving time for the price to drop further. I prefer to manage the stop orders myself.
With Direct Market Access providers the stop order will accurately mirror market conditions but there is still the possibility that your order will be filled at lower than expected prices due to the lack of suitable bids at times.
Getting back to guaranteed stops, there are some things to take into account in making up your mind about using these stops. The rules dictate that stops have to be placed from 5 to 20% below the buying price. In the case of WPL it would be 5% with my CFD provider and for shares outside the top 20 it would be at least 10 – 20%. Seeing the buying price in this case was $52.19, the closest price for a guaranteed stop would be at $49.58 which is not much better than the opening price after the gap down on the day of the sharp drop in price.
Also the guaranteed stop costs close to 1% of the share price which means in this case I would actually not have saved anything by having it. And, if you take into account the cost of numbers of unused guaranteed stops you might place before you actually benefit from one, the use of these stops may not be cost effective.
Some CFD providers may have cheaper guaranteed stops but you have to do your sums before deciding to use them. How often are there gaps so large that a guaranteed stop saves you money and if you add up the cost of regular use of them compared to the occasional benefit, does it make financial sense? There are instances where guaranteed stops can form part of a strategy where larger positions are progressively entered, limiting the risk and thereby making it possible to trade much larger positions than otherwise possible. These strategies may make these stops cost effective, but as I said, you must do your sums.
Direct Market Access providers (and definitely ASX traded CFDs) may not offer guaranteed stops, but in that case put options may be possible. FP Markets will soon be offering options on their webIress trading platform and that opens another range of possibilities. By buying a put option you buy the right but not the obligation to sell your shares at a predetermined price. You pay a premium for the privilege and the size of the premium will depend on how close the exercise price is to the current share price and also how long the option has left to its expiry date. The pricing will also depend on other variables which I will not discuss at present.
There are several benefits to using puts rather than guaranteed stops. The greatest of these is that you have protection against price movements without actually being stopped out of the trade. There are numerous times when a stop takes you out of a trade and then the price reverses so that the trade would have been profitable if you had still been in it. So instead of a profit you have a loss. This may sometimes be remedied by having a wider stop but then of course the loss is even greater if the stop is hit.
With a put as protection you are not forced to exit the trade and may benefit from a reversal of the price move. Another advantage is that for short term trades, the same put, if it has a suitable expiry date, can be used as protection for multiple trades. It is also possible (by paying a larger premium) to have the puts closer to the buying price than possible for guaranteed stops or even right at the buying price (“in the money” puts).
With a put protecting your trade you could stay in the trade until the expiry date of the put if you like and if during this time the trade recovers you might do very well. If on the other hand you decide that you want to exit the trade it is possible that the put will still have some residual value and can be sold again, thereby reducing the cost of the protection it afforded. Short trades can be protected by purchasing call options, which give the right but not the obligation to buy shares at a predetermined price.
In either case if the trade goes in the wrong direction the puts or calls will increase in value and can be sold at a profit to offset the loss in the trade. The limitation of this strategy is that in the Australian market there are few shares for which these options are issued and fewer still where there is a relatively liquid market in which they can be bought or sold.
If options are not available for shares you want to use for short term trades (this is only for short trades, where you sell to open the trade), it is possible to hold the physical shares as protection. In fact this is of course a hedging strategy and in a corrective move down for the share the short trade can be used to make some extra profit. In that case you would exit the short CFD trade with a profit as the share price recovers.
The tax office has published a decision which may allow this hedging strategy under certain circumstances in a SMSF. If you are inclined to utilise this strategy in your SMSF you must first obtain professional advice.
As I explained at the start, it is necessary with these short term trades that the risk/reward ratio is good. There are occasions when sharp adverse share price moves can lead to larger than expected losses. In this case I should have been more careful and that would have limited the size of my loss. But any strategy must be profitable enough to withstand such unpleasant surprises, whether due to unexpected market moves or compounded by human error. In this case both my CFD accounts suffered a sizeable dint and it will take some careful trading to make up for that. Oh, yes, did I mention that, like the two contracts in the RIO trade, there were also two WPL contracts of 2000 shares each entered and exited at similar prices? My total loss was twice $8000 plus costs.
As I said, it was not a good week.
Explanation
Put options give the buyer the right but not the obligation to sell shares at an agreed price. If for instance a share is trading at $10 there may be puts available that allow the buyer of the puts to sell the share to the seller of the put at, say, $9.50 and that right may be available for say 3 months, after which the put expires if not exercised.
If the share price now takes a tumble and finishes at $8.50 within that 3 month period the purchaser of the put can sell the shares to the vendor of the put for the agreed price of $9.50. This has saved the owner of the puts $1 and if the premium paid for the put was say 25 cents per share then the purchaser of the put has benefited by 75 cents per share.
Options are usually sold in contracts covering 1000 shares so you need to own shares or CFDs in lots of 1000 to make full use of the options.
What benefit does the writer (vendor) of the puts get? Most options expire without being exercised so the writer has the view that the share price is not likely to fall below $9.50 and if so will simply pocket the $250 gained by selling the contract for the 1000 put options at 25 cents each.
The writer of the option may even have the view that the share price will definitely be likely to rise and stay above the current price of $10 and so for a larger premium sell “in the money” puts giving the purchaser the right but not the obligation to sell the shares at the current price of $10. The premium will of course be higher for in the money puts and if the share price does go up the writer of the puts pockets a larger profit but if the share price drops by more than the premium paid the buyer profits by being protected.
Call options give the buyer the right but not the obligation to buy the shares at an agreed price and so if the price rises above the agreed price will be able to buy the shares at less than the market price. So for a person who has shorted a share this will offer protection.
If puts and calls are used with CFDs you will of course not own the underlying shares so will not want to ‘put’ or ‘call’ the shares but can be compensated for the adverse price move by selling the options at a profit to offset the loss in the CFD contract. You can see that you need to use them for shares where there is a reasonably liquid market for the options or it will be very hard to get the true value for your options. It is a well known fact that option market makers manipulate prices in their favour when they spot a keen seller. At this stage CFD market makers are very touchy if you say that about them.
More articles from this edition of CompareShares:
Resident Trader: Lessons from a week rather forgotten
Stocks: Stock picks for the long haul: BHP and Coca Cola Amatil
Superannuation: Putting SMSF eggs in one basket
Commodities: Why oil refiners are getting hammered
Stocks: Stock to watch - Wesfarmers
Markets: Markets over-reacting to US slowdown
Smart Investing: There is such a thing as a cheap lunch
Expert Panel (CFDs): Pairs trading scenarios
Companies: BHP talks Rio value, steelmakers howl
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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