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 MARKET REPORTS |
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Resident trader
Trading price and volume breakouts on microcap stocks
Will Kraa, February 6, 2007
The strategy of trading sudden jumps in price and volume of microcap stocks is one that I have mentioned in previous articles as a means of reaping substantial profits. You can read the article here and notice that in it I mention the first account I used for trading. It is interesting to see how it has fared during the recent market panics.
As stated in the article, at the start of the 2006/2007 financial year I decided to use this account with a small amount of money in it to test this method of trading. Seeing this account only has a very small portion of my capital invested in it, I have been able to show statements of the account to substantiate the trades done in it. At that time this account had in it $14,750 so it is the kind of account size that many people could afford to open. Therefore it might be a good demonstration of what could be achieved by any trader using such a strategy.
No leverage of any kind is used since most of the shares traded this way are not available for trading with CFDs and certainly not with exchange traded options or warrants. Also margin loans could not be used for trading these stocks. There is sometimes one way that leverage is possible with these stocks in that there may be options issued by the company itself and some of these trade on the exchange in the same way that the shares do. You need to be sure that there is enough liquidity in these options to use them. Once these options are ‘in the money’ they may provide exposure to the stock that is leveraged to some extent.
By the end of the first year of trading in this way the account had increased in size to $38,595 for a 156% return on the initial investment. Since then there have been two market corrections and seeing the stocks traded in this account are usually considered 'risky' it might be expected that these downturns would have had a severe impact on this account. In fact, while there have been drawdowns in the account it has recovered quite well.
I have not had too much time to spend on this account (I have bigger fish to fry) so it was not as well managed as it might have been. During the August market drop the account fell from a high of $41,000 at the end of July 2007 to a low of $33,100 by the middle of August 2007.
It did not take too long to recover and by the beginning of September it was back to the previous high of $41,000. From there it went sideways for a time (I did not have much time to do anything with it) but by early January this year it was up to a new high of $56,000. The subsequent market panic saw it go down again and by 22 January this year it was back to where it was at the end of June 2007, a total of $39,000.
This is interesting in itself since the low of the market as a whole on 22 January saw all the gains of 2007 well and truly wiped out. That did not happen to this account, it was still 80% up from where it was at the beginning of 2007 and since then it has recovered to be back up to about $47,000. In view of all that has happened lately it seems to me that this strategy has done very well. Currently it has made a profit of 213% over the last eighteen months by doing nothing more than trading microcap stocks and has survived the market volatility quite well.
In fact I could have done much better if I had been able to put more effort into it and I am not talking about a full time effort either. Since June 2007 I have done another 15 trades in this account and it has been almost fully invested most of the time. With a small amount more effort the trades could have been better managed for a better return. There is also one stock in there which has been there for almost the whole duration of this exercise for a return of about 50% so far. It is there more for fundamental reasons and is quite profitable but does not reflect the strategy used for this account and so has not contributed as much as it might if selected by this strategy.
The way the strategy works is that each day I scan the market after downloading intraday snapshot data. It can also be done using end of day data but this means that for some stocks a large part of the move is already over. In other cases there is still plenty left on subsequent days. One stock I traded with this strategy is IDL, which I initially bought at 8.8 cents. It has since been as high as 79 cents and I have made a lot of profit from it over a period of many months and several trades, none of them in this account. My investments in this stock were too large for this account. I do not own it at the moment but am using it as an illustration of the fact that some of these stocks offer opportunities over a period of time, not just the initial jump in price.
My scan of the market is done with AmiBroker and looks for stock which fulfil the following criteria:
1. They make a new high for a 20-day period.
2. Since the previous day there has been an increase in price of at least 2.5%
3. The turnover for the day is at least $200,000
4. The volume has increased by at least 50% compared to the average volume for the last 20 days.
The variables in this scan are largely arbitrary so you can change them to get more or less stocks to qualify.
After the scan I have a look at announcements to the ASX for the stock and I buy if there is a good reason for the sudden rise in price. While this is the way I trade these stocks, as I look at what happens in some instances I have come to the conclusion that some stocks suddenly rise sharply for no good reason at all but simply because people think there is a chance (even a very slim one) of something good happening. Day traders and irrational greed can drive up the price of these stocks to dizzy heights and they can be traded but are like hot air balloons, once the fire goes out the drop is precipitous. If you want to have a go at such stocks, do this only with money you can easily afford to lose. I prefer to trade those that have a solid reason for the increase in price.
The hardest part is to know when to exit the stocks, either as an initial stop loss or later to take profit. Currently I am using a second consecutive close below the 2ATR(10) as an exit but there are times when a certain amount of discretion needs to be exercised. Few of these trades are unprofitable trades and those that are lose only a small amount. If the trade does not perform over even a short time frame, it is best to abandon the trade. These trades are entered on the premise that they are rising fast and if they do not do this then they no longer meet the selection criteria.
As far as risk management is concerned I have usually invested something like 25% of the account in any one trade, especially at the beginning while the account was quite small. This means that on any one trade the risk may be considered quite high and higher than I would tolerate in one of my larger accounts. I have found that many of these trades are profitable right from the start, that relatively few trades lose and then only a small amount, and that there are (so far at least) no ‘runs’ of losing trades as there might be with the more conventional strategies.
Here are a couple of trades I did in this account recently. The first one was not profitable but might have been if I had not been preoccupied with other things at the time.
The stock was Reco Financial (REO), which suddenly jumped in price and volume on 21 November 2007. The company was acquiring another business in their industry and proposed to pay a 1 cent dividend before the completion of the acquisition. For a stock trading at 1.5 cents this was a very large dividend so it was no wonder that the price jumped. I bought 100,000 at $0.029 for an outlay of $2900 plus brokerage and set an initial stop at $0.025 for a risk of $400 for the trade.
On the day the price rose to $0.034 but then finished at my buying price. Over the next few days it did not go higher than $0.035. By 18 January the price had closed below the 2ATR(10) line on two consecutive days and I should have exited at $0.031 for a small profit.
I did not do this due to inattention and then did not think there was any point selling on 22 January during the worst of the market panic. On 23 January I did sell at $.025 for a small loss of $465 (including brokerage). While it was a good trade in that I did get out and took the loss, if I had been more vigilant I would have been out of this trade before the market drop and at a better price.
The next trade was in Flinders Diamonds (FDL), which came up on my scan on 22 November 2007. It had been trading at about 1 cent but on my scan it showed as having jumped up to 2 cents with a huge increase in volume. My scan is on 20 minute delayed data and by the time I did the scan, had a look at what the news was and then looked at the price I was amazed to see it had already gone up to 6 cents.
The news of course (to inform those who have been holidaying on the moon) was that Flinders Diamonds has land where they were exploring for diamonds. This land happens to be next to where Fortescue had just found another large deposit of iron ore. This deposit extended into the FDL land giving them the rights to a huge resource of good quality iron ore. There was also a piece of land containing part of the iron deposit, which was subject to an agreement with Fortescue to pay FDL up to $8,000,000 for the right to use the resource.
This was the sort of news that can do amazing things for the price of a stock and so, even though the price was now six times what it had been yesterday, I had no hesitation in buying 150,000 of them and at a price three times what I could have got it for less than an hour ago. By the end of the day it was up to 9.3 cents.
By next morning the price was even higher and the open profit would have paid for my new car (since this was not the only exposure I had to FDL) as the price zipped right up to almost 15 cents but by the end of the day was back to 8.4 cents. It was very exciting while it lasted but how do you know where to get out of one of these things unless possibly you sit there with a one minute chart and trade that. I am not a day trader of these things though on that day it would have been very worthwhile to have acted like one. Hindsight is very helpful here.
The profit taker (green line) is not much help at this stage either since the price was above that from the moment I bought. After a couple of weeks of largely sideways trading I seized the opportunity for a good profit when the price was well up on 13 December and I sold at 9.6 cents. For an outlay of $9000 there was a profit of $5337 after expenses in about three weeks, which is very good.
Only looking back on it I don’t think it is good at all. I had cut my profit short instead of being willing to allow the trade to develop. I could have exited when the close was above the 'take profit' line at 15 cents or so. Or I should have waited till the price closed below the 2ATR(10) trailing stop twice on consecutive days at about 12 cents.
Either way would have been a legitimate exit strategy and the profit would have been much better. So this very profitable trade was not really a winning trade since I did not do what I should have done: sticking to the rules. The lesson to learn is that even for this type of trading the ATR Chandelier stop works well when it is used properly. This means waiting for a second close below the line to confirm that the stock has most likely changed direction and taking this as a legitimate exit.
There is now much more capital tied up in this account and I intend to keep using it for the purpose of trading the price and volume spikes. I intend to be more careful in trading it and hope to have more good results to share with you as time goes on. In the meantime I hope you learn something from my mistakes as well as from the good profits made by using this strategy.
More articles from this edition of CompareShares:
Trader profile: Two market crashes later – Robert Kreft, a story of a full-time trader
Fundamentals: PEG ratio gaining in popularity against the P/E, but beware of its flaws
Stock Lab: Stock Lab: The best stock to invest in
Resident Trader: Trading price and volume breakouts on microcap stocks
Stocks: Stocks to rebut US recession – engineering sector
Companies: Moore to succeed Moss at Macquarie Group
Companies: BHP launches improved bid for Rio Tinto
Rates: Major banks review rates after RBA hike
Stocks: US stocks tumble 3 per cent
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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