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Resident trader
A trade explained: biotech frenzy
Will Kraa, July 23, 2007

There is a theory that postulates that stock markets are efficient - that is all data available for each company is fully reflected in the market price for the company. The corollary of this theory is that there is no way of finding stocks that are wrongly priced, ones which are bargains to buy and can be traded to gain from the price rising to where it should be. And also of course there are no stocks, which are so overpriced that you could profit from shorting them.

This would make it hard to make money from the market except by finding companies that are improving their business in such a way that their return on equity increases and therefore they become worth more with a corresponding increase in price. Unfortunately it may even be hard to profit from this since the market often prices such companies on the expectation that they will do well in the future and therefore people are prepared to pay a high price for them now. The stock will trade on an extremely high PE and the slightest bit of unwelcome news will send the price tumbling.

To my mind the best way of making money from investing in the market if this is your view is to find companies that have consistently had good and, better still, increasing return on equity over the years. It would be reasonable to assume that it is likely that they will continue to do so in the future. Such companies could be expected to have a growing business, which will lead to an increasing share price. There is software available that will find these companies for you.

Now all this presupposes that the people who trade the market are rational and usually make rational decisions when buying and selling shares. The reality is that the market is often not at all rational and it can be this very lack of rationality that enables traders to make money from the market; neither is the market ‘efficient’ as claimed in this theory - and so it is possible to make money from trends that commonly occur. These trends don’t always make sense from a fundamental viewpoint but they happen.

Many times I have seen ‘sell’ recommendations on stocks which brokers and analysts considered overpriced only to see them trend up strongly for a considerable period. In 2003 someone from a very well respected fundamental software vendor told me personally that people were misguided to buy Caltex when it was trading at about $2. In fact this even influenced me to some extent. I held them and - with the idea in the back of my mind that it was a poor investment - sold when there was a slight downturn and did not buy again. Afterwards, they ran up so steeply that there never seemed to be a good time to buy! I know better now but it was a great opportunity lost.

So let’s return to consider those occasions when sentiment in the market becomes totally irrational. When this happens there may be opportunities to make large gains by using what I call the ‘market madness’ stop as mentioned last week. A trade that illustrates this perfectly is one I did years ago when I first started trading CFDs.

It was in July 2003 that I noticed Ventracor was in a good uptrend. There seemed to be increasing interest in the stock as the overall volume of shares traded had increased (see the first chart below) and its price was rising strongly. It might seem to some that it would be risky to trade since the price had risen so strongly already and the company was not making any money. However they were trialling a really good mechanical heart device that had (and still has) good potential to become a market-leading product. Many people no doubt considered it might be another Cochlear and so were prepared to pay ever-increasing prices to ‘get in at the bottom’ as it were. After all, who would not like to have had the foresight to buy Cochlear when it was still trading at just $3 or even $6 or $12?



So regardless of the earnings, or lack thereof, market sentiment at that time was that this was a good stock to own and it was worth paying whatever was necessary to buy it. That is what the chart was telling me and the probability was that this could continue. If it should turn out that it stopped going up just after I bought it then my stop at $1.58 would get me out of the trade at a planned loss and I would go on to another trade. It is not easy for most people to get into a trade once the price has already had a substantial rise in price and it may take some self-discipline to ensure that these trades are taken.

At this time the chart had completed what is called a Darvas box and I opened a CFD for 21,000 shares in VCR at $1.78 on 30 July 2003 with a stop at the bottom of the Darvas box at $1.58. After entering the trade, prices went sideways for a few days before again taking off. Following several days of prices gapping upwards with increasing volume, the market on 22 August went into a frenzy over the stock as prices rose and fell rapidly over a huge range on extremely high volume. I really don’t understand what gets into people to do this but it seems that, after the steep rise in price over the preceding few days, there were many who concluded that the stock was about to take off in price and that they must get a piece of the action.

This was clearly ridiculous and an instance where the ‘market madness’ stop was appropriate. Accordingly, I decided to exit as prices began to drop from the high of $3.69 - but there was one problem.

If I had traded this stock on the real market there would have been no problem at all to get out near the high for the day, but since I was dealing with a market maker CFD provider I could not get a price anywhere near where the market was trading and could only get out at $3.20. They widened the spread to an unbelievable extent and so I was forced to take a price much lower than what the market was trading at.

This is one of the disadvantages of dealing with a market maker CFD provider. Nowadays, it is possible to deal with Direct Market Access dealers where they actually place the orders into the real market on your behalf - avoiding this problem. But I must say that the market maker CFD providers I currently deal with have - so far - always given me prices that accurately reflect prices in the real market. However, I have not yet tested them in the kind of situation where there is extreme market volatility such as this occasion.

As the second chart below shows there was another day of similar price action a month later, but since then the price has steadily declined to the support level of 60 to 75 cents. Occasionally there is some good news and prices jump again but not to the extent of late 2003. Using the exit on 22 August where it was plain to see the market had gone mad over a stock on this occasion enabled me to lock in a profit of nearly $30,000.



This kind of frenzy is not unusual for biotech stocks. People get all excited when there is some discovery or new technology but then eventually there is a return to sanity as it is realized that there is still a considerable time to go before something in the trial stage can be turned into a profitable product. There are also many risks, meaning that there may never be any profit at all due to any number of things that can go wrong. In many instances there is a very promising technology but with no successful outcome for years - if ever - and prices go nowhere. Some of these companies go broke and in my opinion it is futile to hold them for years hoping to get lucky and make massive profits. This is pure gambling.

The steep market trends in stocks like these biotechs can be traded successfully but it is absolutely necessary to be very strict about risk management. If you are not able to remain detached from the misplaced enthusiasm and mad scramble to get into these stocks then it would be much better to stay away from them completely. The greed and fear of losing out are dangerous emotions that are incompatible with successful trading or investing.

If the stock breaches your stop you must have the discipline to get out and not hang on in the hope that somehow you will recover your loss. It may lead to the loss of the whole investment or, more likely, years of lost opportunity as the share price goes nowhere.

There are some people who bought VCR at over $3.60 and time has proved that this was a very poor investment decision. Maybe the stock will again rise to those levels but it may take a long time if ever. If the company is able to get over all the hurdles to sustained profitability, prices will start to trend up – allowing time to get in at a price sufficient for a profit to be made. Even Cochlear took years to get to $50 and there was plenty of time to get in and make a profit from the trend.

It is poor trading to follow the crowd when irrational desire for profit leads to an unwarranted leap in prices. If, as in this trade, you already own a stock where this happens then watch closely and get out as soon as prices start to retreat from the irrational high. When you do not own the stock and you see this happen it may be possible to profit from the move but it will be a wild ride and you must have discipline, access to an intraday 5-minute chart and be dealing through direct market access to facilitate instant exits at the market price.

Common sense would indicate that these trades are best left alone unless you already have a position in the stock. Market madness is best observed from a safe distance and if you are already in then get out. I will illustrate later what can happen if you don’t.

Calculations for this trade:

Opening trade size 21,000 x $1.78 = $37,380

Closing trade size 21,000 x $3.20 = $67,200

Profit $67,200 - $37,380 = $29,820

Interest was about $180 so net profit was $29,640.

There was no commission (They were called ‘Deal for Free’ at the time) but the increased spread gave a big slice of the potential profit to the CFD provider. Much more than commission would have been. It is possible I even paid too much at the entry; my chart shows that the high for the day was $1.73, five cents less than what I paid to get in. Maybe the chart data is wrong.

Explanation:

Darvas was a dancer who traded by telegraph to his dealer as he travelled the world. He made an absolute fortune. His book is called ‘How I Made $2,000,000 in the Stock Market’ and remember this was in the 1950’s. It is an excellent read and quite instructive. There is an article about him in Wikipedia.

The Darvas box itself takes a bit of explaining which will have to wait till another time.

More articles from this week's newsletter:

A comeback for futures trading
Motor vehicle aftermarket ready to roll
The rise of the moral investor
Weapons of wealth destruction
Stock of the week: ANG
Wine still a little sour
Forex: managing volatility
Energy stock correction
USD/AUD: rollercoaster to parity