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Resident trader
Shares: rules to govern your trading
Will Kraa, July 9, 2007
Will Kraa is a full-time trader who will be describing the ins and outs of his trades on CompareShares.com.au. These are all actual trades conducted by Will, using his own accounts at various providers. Note that this information does not constitute a recommendation of any sort.
In order to have as many winning trades as possible (and in fact to aim to make all our trades winners) it is necessary to have rules to govern our trading. Then every time we stick to the rules for the trade it will be a winning one regardless of whether we make a profit or a loss. You will remember that we are to do battle not against the market but against our tendency to disregard stops and to take profits too quickly.
If you do not remember this then I would suggest that you read last week’s trade discussion again to ensure that you get this idea firmly planted in your mind. To trade successfully we need to plan our trades carefully and to follow that plan without question. I cannot overemphasize the importance of this to the success of your trading or investing. Most people do not do this and this is why most do not make money from trading in the markets.
So far I have demonstrated ways of setting a price at which I will abandon the trade at a loss in order to avoid greater losses. This is the initial stop loss and is set before the trade is opened so that the risk for the trade can be calculated. Now I want to show one way of protecting profits in order to capture as much of a move as possible but also to ensure that we do not give all the profit back to the market.
During the ‘tech boom’ there were many people who saw their stock rise to dizzy heights and then allowed the price to fall again to lose all the profit they could have taken and in some cases to finish up making a loss. The trouble is that once a stock has reached a high price and then retreats from the high a reluctance to take a loss by giving back some of the previously available profits again kicks in. If we have resisted the temptation to lock in the profit too early we may still be defeated in the trade by allowing the potential profit to slip away again.
Let’s say the price has risen and then retreats somewhat and so we cannot now sell at the higher price which was available maybe just a few days ago. We are now facing the loss of some of the profit and a loss is one thing which is not easy to take. So we start to hope that surely prices will again rise to their former height or beyond. And now (instead of locking in the profit when we should) we wait as prices retreat and we finish up giving back all or most of the potential profit in the often forlorn hope of recapturing the previous high price.
This week I will show you one of my trades in ‘real’ shares, not CFDs. One of my favourite ways of trading shares is to look for ones that have been trading in a very lacklustre way and then suddenly spring to life as some good news convinces the market that the share is worth much more than the prices it has been trading at. Usually this shows up as a sudden jump in price accompanied by a considerable increase in volume traded. Every day that I trade I look for such stocks by scanning the market for these events. How I do this will have to wait for another time as for now we are talking about protecting profits.
A small cap stock called D’Aguilar Gold (DGR) had been trading largely in a downtrend but in late 2006 there appeared to be renewed interest in the stock and volume traded increased. Then on 3 April this year there was a sudden jump in price on huge volume (see the light blue histogram at the bottom of the chart) and by the end of the day it was making a new high.
This was the result of news released on the day of a doubling of the net present value of their molybdenum project at Anduramba. One thing that caught my attention was the fact that Anduramba was the place where long ago I had been headmaster of the one teacher school soon after the start of my teaching career. I decided to buy at 14.5 cents (first red arrow on the chart).
Now when you look at the chart you will notice there is a blue line which was not seen on my previous charts. This line is a ‘chandelier’ exit and is so named as it ‘hangs’ below the price in order to give a signal when it is time to get out of the trade. In AmiBroker it is plotted using a plug-in designed by Geoff Mulhall and freely available in the AFL reference library. This actually ‘flips’ to be above the price once the price falls below it and then becomes a stop for a short trade.
It is based on what is called the Average True Range, an important concept which I will explain right here rather than in a footnote.
When we want to exit a trade we do not want to do so simply because of the everyday ‘noise’ of prices moving more or less at random. We need to stay a safe distance away from this everyday volatility so we do not exit when it is not appropriate. It is therefore important to be able to calculate the range of price movements which is usual for the stock at any particular time.
The first step is to understand what the ‘range’ for the day is. It is the difference between the high and the low for the day and on a candle it is represented by the extremities of the ‘wicks’ at the top and the bottom of the candle. Sometimes there are no wicks but just the body of the candle and this means that the market did not go beyond the opening and closing prices and the high and low for the day were the same as the opening and the closing.
So on the day I opened the trade the market opened at the low for the day (therefore no ‘wick’ below the candle) at 11 cents, then went up to a high of 16.5 cents and closed at 14.5 cents. The range for the day then is 16.5 cents – 11 cents = 5.5 cents. There are also days when there is a gap between the opening price and the closing price of the day before. You can see this on the chart where I have marked one of the gaps with the two black arrows. These gaps are really part of the trading range and so need to be accounted for. When this is done in the calculation of the range for the day this is called the ‘True Range’.
To get a better picture of what is happening with the prices and to get a reasonable idea of the volatility we need not just the data for one day but over several days in case one day has an unusual range of price action. To smooth things out the True Range is best calculated and averaged over a period and this is then called the ‘Average True Range’ (ATR). This actually is also a kind of moving average since each new day is added into the calculation and the last day dropped off. This is usually calculated and averaged over a period of 10 to 15 days.
The figure resulting from this calculation is not very useful since it still is too close to the price action to prevent inappropriate exits. So it is usually multiplied by a factor of somewhere between 2 and 3.5. I usually use 2.5 and the blue line on the chart plots 2.5 times the ATR for a 10 day period subtracted from the closing prices (or added to the closing prices once it flips to become a stop for a short trade). It actually has some uses other than as a stop as well but that is something to be discussed another time.
Now we can go back to the trade. As you can see from the chart the price rose steadily from my entry on 3 April and by 11 May had risen to a high of 39 cents before retracing until on 28 May the price had decidedly dropped below the chandelier exit line and I sold at an average price of 27.1 cents. The low for the day was 26 cents but after a couple of days the price resumed its upward trend. However I did make a profit of 86%.
It is therefore debatable whether I should have exited then or continued the trade for an even larger profit. My plan was to exit when the price dropped below the exit line and that is what I did. Certainly at the time there was no guarantee that the price would continue in the upward trend and it was quite possible that prices could have gone much lower and I could have lost the profit I did get. It would have been nice to get out at somewhere near the 39 cent high but there is no way of knowing that it is the high at the time. The temptation to hope that the price will again go to the high is to be resisted if the plan gives an exit signal. In this case it did go up again and if I had ignored my exit signal I would have been rewarded.
That would have been the worst possible outcome as it would have encouraged me to ignore my signals and trained me to do bad trading. It has happened many times that people have done very well for a time by ignoring their signals only to lose all their profits and more through trading without proper risk management rules.
So it is necessary to give back some of the available profit in order to give prices room to move and profit to grow until there is some evidence that things have changed and that there is the possibility of an adverse move. Once prices move below the exit line it shows that prices have moved more than the usual measure of volatililty and the probabilitiy is that there could be a reversal of the trend.
In this case that did not happen and the uptrend resumed but we have to go with the most probable scenario and follow the plan. Arguments will never stop over where is the best place to exit a trade in order to protect profit and at the same time not limit the possibility of more profit. It is always a compromise but there has to be some place where the risk of staying in the trade is greater than the risk of losing out on greater profits. This exit line does a reasonable job of balancing these risks.
It would have been nice to show a trade where prices went into a decided downtrend after my exit but we have to deal with realities and the reality is that the market is not obliged to follow our plans. However if we stick to the plan we have a much better chance of doing well than by trading in a haphazard fashion and following the dictates of our psychological biases which are usually contrary to profitable trading.
An interesting observation on the price movements of these small cap stocks is that when prices move from 14.5 cents to 27.1 cents as in this trade over a period of less than two months it is nothing out of the ordinary. If prices had moved from $14.50 to $27.10 in the same time for a large cap company it would make headline news in the financial market. The result for the trader is the same, I just have to buy a larger volume of shares and so long as there is the liquidity to do this safely then to me it represents a wonderful opportunity. That is why I like trading these stocks and make a lot of money from trading them.
Calculations for this trade:
Entry Price 14.5 cents. At the time of opening the trade the chandelier exit line was at 11 cents so the risk per share was 3.5 cents.
The profit was 12.6 cents per share giving a reward/risk ratio of 3.6 which is quite good.
Profit of 12.6 cents per share gave a return of 12.6 cents/14.5 cents = .87 or 87% of initial outlay. There was 0.1% commision each way and no interest so the net result was still over 86% profit without using CFDs.
It is usually not possible or practical to trade these stocks with CFDs. There are some CFD providers who allow the trading of some of these small cap stocks but the margin is usually over 80%.
The result is that you pay interest on the whole value of the trade while a good slab of your capital is locked up as margin. To my mind that is not practical since you are not getting the benefit of useful leverage.
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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