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 MARKET REPORTS |
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Resident trader
Perils of trading when short-term market activity is often random
Will Kraa, February 27, 2007
A few weeks ago one of our readers posted a question on the message board regarding a trade I wrote about quite some time ago. It was an interesting question that seemed simple enough but has wider implications. I thought it was worth a more extended answer.
Below is a chart duplicating the conditions that existed when this trade was done.
The stock is TLSCA and you can read the original article to get all the details but here I will give a summary.
The stock had been trading in a downtrend and as you can see I did a countertrend trade. The question was as follows : “I am having difficulty understanding as to what lead you to think that there could be a rally in the stock. I cannot see this in the chart, for all I know the low of the 27th of July could have been breached the very next day. Could you please explain this?”
This is quite a good question and it is correct to suggest that there was just as good a chance that the stock could have continued trending down.
My reason for doing the trade is that I was looking for a retracement in the trend which did in fact take place just after I exited the trade. I got in at $3.11 on 2 July 2007 with a stop at $3.06 just below the last low. The risk was 5 cents and I was looking to make three times the risk or 15 cents so my target was $3.26. The price came very close to that and went up enough for me to move my initial stop to break-even at $3.12. The price then fell again and activated my stop.
So let's address the issue raised by this question and some further implications, which are not obvious at first glance.
In my opinion the short-term movements in price are mostly random and there is not much we can do by way of predicting what the price may do in that time frame. Even if I had a raft of indicators lining up to support the trade it makes little difference. Have a look at the chart and it is plain to see that there is little to give any indication of how prices might go up or down from day to day as shown subsequently on the chart.
The answer to the question is that indeed there was a very good chance that the price could have gone the other way. I was looking to have probability a little in my favour in that the price had fallen strongly for a period and most of these moves are punctuated by retracements. There was some support over a few days, which gave me a level to place an initial stop.
Even if there was a slightly better than 50/50 probability of the price moving up this does not mean that it will move far enough in my favour to make a profitable trade. In fact the probability of that is very hard to assess and is likely to be less than 50%. That is why I look for a profit of three times the risk taken. If one third of the trades are stopped out at a loss, one third are break-even and one third reach the profit target then the overall outcome will in time produce a profit.
There are however a number of difficulties to overcome in this kind of trading.
We all have the tendency to deny or ignore the fact that much of life and especially trading is influenced by random events. We see patterns and find meaning where there may in fact be none. When studying charts we draw lines, look at indicators and fancy that there are patterns, which predict certain outcomes. We read and hear that this is the case and accept these things as facts without too much question. It suits our natures to have it so.
Time after time we see even those who run very large businesses ignoring the possibility of random adverse outcomes converging to create situations that can produce widespread financial disasters as we see happening at the present and as we have seen in the past.
At times I have spoken to experienced traders and asked them why it was necessary to have complicated ways of finding an entry signal for a stock that was trending upward strongly. Why not simply buy it seeing it was going up? Waiting for an entry signal could often keep you out of an excellent trend. One answer was that it was most likely to make people feel comfortable with buying into the trend.
This to my mind illustrates the fact that we need to feel we have some measure of control over the market and find it hard to accept that much of what happens in the market is random. Of course there are ways of indicating that a trend is in place or when it is a probable that a trend has changed just as it is possible to tell that temperatures are rising as summer approaches or that an approaching front is likely to lead to a change in temperature. Even so we all understand that the forecast is not always accurate and that random events can change things. And again it is often the very short term forecasts that are most subject to the influence of randomness.
When trading, the fact is that the shorter the timeframe of our trading, the more random the outcomes will be and the harder it is to make consistent profits. This is not easy to live with and makes short term trading something not many people can do successfully.
This is not the only thing that makes short term trading hard to do successfully. There is also the fact that unless losses are taken promptly when necessary this kind of trading will be spectacularly unsuccessful. Taking losses can hurt even when it is done as part of a trading system and there is evidence that it takes two or three good outcomes to make up for one hurtful outcome as far as our emotions are concerned. So using a trading system which may have more unprofitable trades than profitable ones can lead to damaging stress even if the system is profitable overall.
One way of avoiding the emotional damage of taking losses is a way of thinking that I have advocated before. When a trade leads to a loss because of the execution of a stop it should never be called a losing trade. It is in fact a winning and successful trade since the trading strategy has been followed. The trader needs to feel that a successful execution of the trading plan is a win regardless of whether it means a profit or a loss.
Now we will have a closer look at the effect of some modifications of the strategy in short term trades. I will assume we are going long but the same effects will apply if going short.
Moving the initial stop closer to the entry price. This will reduce the risk per share bought and so increase the number of shares that can be bought. If I am willing to risk $1,000 for the trade and the risk per share is 10 cents then I can buy 10,000 shares. If I reduce the risk per share to 5 cents by moving the stop closer then I can buy 20,000 shares (assuming I have the capital and it does not conflict with other risk management considerations).
The effect of this will be that I am more likely to be stopped out with a loss. This will therefore increase the proportion of unprofitable trades. On the other hand it will also mean that my target exit price will be closer to the entry price (assuming I aim for a profit of something like three times my initial risk). This will make it more likely that the target price will be reached and so increase the probability of profitable trades. These two effects will work to cancel each other out to some extent.
In the case of this trade in TLSCA, if I had set my stop closer to the entry price, for instance at 4 cents below my entry (at the exact previous low), then my profit target would have been at $3.23 ( 3x4 cents = 12 cents above my entry at $3.11) and this target price was actually reached. I would then have exited with a profit of 12 cents per share ($4800) rather than a break-even trade.
Not moving the stop to break–even. In this case there is only the initial stop and the target price. In this case the number of unprofitable trades will increase since those trades that might have been exited at break-even could go on to stop out at a loss. But again there is a trade-off. Some trades that might have been stopped out at the break-even stop might not go all the way down to the initial stop and then reverse and go on to make a profit.
For instance my TLSCA trade went through the break-even stop at $3.12 and I exited but it did not go down to the initial stop, it went sideways for a couple of days and then up to well and truly exceed my target price. If I had not moved my stop up it would have been a very profitable trade of 15 cents per share ($6000).
There are many other variables that could be changed in a trading system to bring about different probable outcomes. This is where each trader’s personality needs to be taken into account. Are you able to take frequent relatively small losses? Are you disciplined enough to abide by stops? Is the process of taking losses on a daily basis going to have an emotional impact?
In trading a short term system the ratio of profitable trades may be quite low (some profitable systems may have only 25% profitable trades) and this means there may be quite extended runs of unprofitable trades. Do you have enough confidence to keep on trading the system regardless and so do enough trades that the system can become profitable? The temptation will be to start tinkering with the system before it has gone through enough trades for the odds to start working in your favour.
Trading short term (I mean trades that last just a few days) is not for everyone. Price moves are to a large extent random and many trades may have to closed at a loss. Those trades that are profitable have to make up for the losses as well as provide an excess profit that makes the whole system profitable.
Most trend following trading systems are not finding much in the way of entry signals in the present market. Therefore short-term trades may be more likely to provide the opportunities to make a profit in the current markets.
If that is the kind of trading you want to do you need to do some serious thinking. It is my opinion that fundamental analysis is useless here and technical indicators not much better. Price action may give some indication of possible direction to give a slight edge. Some people would use candlestick analysis but again it is my opinion that they are very good in hindsight. By the time a candlestick pattern is confirmed the move is well on its way and in a directionless market like the present it may be too late to trade the pattern.
So you need to be able to accept random moves, to be disciplined in executing stops, to be able to handle frequent losses, to be persistent and confident, you need to work out what suits you best in the way of setting stops and be good at risk management. No wonder few people make money trading this way and so the majority opinion is that it is too risky and can’t be done.
It is also important to select the right stocks for this kind of trading. Some stocks may have a good daily turnover but if the price of each share is high the spread may still be large and the number of shares in the bid and ask queues may not be large. I have tried short-term trading in stocks like WOR or COH and found it frustrating as there were many traders putting in orders for tiny numbers of shares and thereby moving the price quickly when there were similar small orders on the other side. It is imperative that it is easy to be able to execute orders at the prices where you want it done.
At this time do not be in a hurry to make up for losses or to try to make lots of money. If a period such as the present is going to make it hard to survive financially it may be that you are not ready to rely on trading as a sole means of support. It needs more than a minimum size trading account to get through the difficult times.
The important thing to remember is that the main area where we can have control is in deciding when to exit the trade. This is something that is not to be random and largely determines if the strategy is profitable or not. That and good risk management as well as the right mental attitude.
More articles from this edition of CompareShares:
Investor Profile: The story of an investor - Owen Richards
Investing: Rent out your home and still sell it capital gains tax-free
Resident Trader: Perils of trading when short-term market activity is often random
Advisor Lounge: Reducing tax on investment properties with DIY super
Sectors: Mining sector will continue to boom, analysts say
Commodities: Gold still shining brightly
Expert Panel: Receiving dividends with CFDs
Companies: Woolworths denies greenwashing claim
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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