Posts Tagged ‘Trading Strategies’

Three Fatal Trading Mistakes

Friday, February 3rd, 2012

There are a wide variety of mistakes you are likely to make while learning to trade, but there are three mistakes you had better learn to avoid very early in your trading career. Before you start trading you must verify your trading strategy works by testing it both historically and on real-time data. Controlling the size of your losses is essential and without sound risk management you’ll never trade successfully. But controlling losses is not enough; you must also resist the temptation to over trade. Any of these three mistakes can be fatal to your trading success.

Trading untested ideas

Poor analysis or research is common among new traders. You may hear a news report about a particular company and decide it would be a great idea to trade the company based on the report. Unfortunately by the time the news gets to you many other people already have the information and have made their trading decisions. There’s a saying in the stock market: ‘buy the rumour, sell the fact’, meaning that when the news is finally released it’s very often too late to enter a trade. Following tips or rumours is a sure sign that you haven’t adequately prepared to enter the market. By doing your own analysis you can determine what works and what doesn’t.

Back test or forward test your trading idea before ever entering a trade. Back testing involves testing your idea on historical data and allows you to test a large number of ideas very quickly. For example, you may scan a lot of charts and identify a particular pattern that appears before significant moves in a share. This is back testing.

Forward testing (often referred to as paper trading) involves testing your idea on current data as it becomes available. To verify that your idea works, look for opportunities as they unfold because your chosen pattern may occur without a strong move following it. This is using forward testing to confirm your idea. Forward testing is more reliable than back testing, but much slower to perform.

In its simplest form you can back test by looking at lots of charts so you can begin to recognise patterns that occur before a strong move unfolds. When I started trading I studied thousands of charts to find out what worked and what didn’t, then narrowed down a few ideas to follow through with forward testing to see if they continued to work. Ensure you complete a thorough analysis before entering a trade, or follow a more experienced trader’s strategy.

Allowing losers to get out of control

Failure to cut losses can quickly result in disaster for any trader because the market can move far more than you expect. This is probably the most common mistake we see new traders make. The trader hopes the trade will reverse direction and move back into profit. Refusing to take the loss, the trader continues to hold the trade while willing it to turn into profit. While this may happen occasionally, when the trade doesn’t turn around it can do severe damage to your trading account. Cut your loss and look to re-enter if another entry signal appears. Ensure you develop the discipline to enter a stop loss into the market every time you enter a trade. This ensures you never get hit with large losses.

Mental stops are stop-loss orders that you place in your head instead of the market. For example, you decide to exit a long trade at $3.10, but when the market approaches $3.10 you convince yourself the market will move higher soon so you don’t take the exit as planned. The loss can now get seriously out of control and you could lose a lot of money. The problem with mental stops is you have to act on them. This can be difficult because when you are required to execute the trade you’re often in a losing position and hoping things will turn out ok. Even if you have been able to develop the discipline to act on your stops, the market sometimes moves very rapidly and you may end up losing more than you expect.

Mental stops may be used by experienced traders, but must never be used by beginners. Until you master the discipline to take exits when they’re signalled, stay well away from mental stops. Focus on good stop placement to avoid getting stopped out.

Overtrading

Another common mistake traders make is overtrading. It’s possible to make very nice annual returns from just a few good trades a year. High frequency trading is not required to make a profit. If your strategy has a sound edge then the more opportunities you have to trade it the better, but don’t confuse trading a lot with trading successfully. A few good trades can make a good year. It’s not necessary to be in and out of trades 20 or 30 times a day to make a profit.

Some of the most valuable time you can spend is identifying the best opportunities. There are millions of trading possibilities. It becomes necessary to make some choices and narrow your selection of what you will trade. To do this it’s necessary to overcome the fear of missing out on an opportunity. Remember the opportunity of a lifetime comes along every week! Many great opportunities will appear, so stop wasting your time and money on half-rate opportunities. Accept nothing less than the best when selecting trades. This
more selective approach can dramatically improve your profitability.

Eliminating mistakes

Eliminate these three fatal mistakes we’ve just discussed and your trading will improve dramatically. However, to eliminate the mistakes, first you must identify when you’re making a mistake. Your trading diary where you record your trades, wins and losses allows you to identify areas where you’re failing to stick to your plan. In particular be honest about the reasons you entered a trade. This honesty may take some time to develop because it’s not nice to admit you took a trade because you wanted to make back the money you lost in the morning. It’s easy to justify that a setup was in place, but tell the truth. You’re only lying to yourself.

Identify why you fail to stick to your plan and what you must change to eliminate the mistake. If the reason you fail to execute the core skills is emotionally based then monitor how you’re feeling when you’re trading and notice when particular emotions appear. Address each bad habit, one at a time, to change your behaviour.

Refining your trading skills takes practice to improve on the areas in which you’re weak, but the rewards are worth the effort. Becoming a better trader requires you to become a better person. This is one of the reasons you can find trading challenging to learn. Fortunately once you’ve changed a few habits, successful trading becomes much easier.

Jeff Cartridge
Education Manager

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Core Trading Skills

Friday, January 20th, 2012

There is a series of core trading skills that you will be required to develop to trade successfully. Mastering these core competencies is essential to mastering trading. The core skills start out with analysis, first and foremost. Following this the position size is determined in conjunction with your entry criteria and your stop placement. By religiously placing a stop on every position, you cut your losses, but still have to work out when to take profits. Scaling in can be used by intermediate traders to reduce the risk when entering a trade and scaling out can be used to lock in profits as they occur. And then one final skill to master is re-entry after you have been stopped out or taken profits on a position. It does not matter whether you trade shares, currency, futures, commodities or CFDs, the core skills required are all the same.

Analysis

Before you place your first trade you must decide how you will develop a trading edge. Your trading edge is your advantage that you intend to exploit for profit and is critical to your success. Your edge will come from a thorough analysis of the market you intend to trade. It is not essential for you to do all the research yourself as you can utilise analysis from a third party, but it is essential that you find an edge before you enter the market.

Methods of analysis can include a wide range of variables including economic factors, technical indicators, seasonal influences, fundamental criteria, relative performance, news releases, special events and valuation measures. It does not matter which school of analysis you subscribe to as long as the method of analysis provides you with an edge.

Position Sizing

Sound position sizing methods are critical to your trading success. It is essential to size your positions to control losses. No matter how good your analysis is, YOU WILL BE WRONG. Accepting this is important to survival when trading. The market you are trading is made up of thousands of participants all making independent decisions. No analysis available can take into account all the possible outcomes of these individual decisions, so no analysis will be right every time. If you have placed too large a position on the trade then you can blow up in spectacular fashion as the result of a strong move or gap against your position.

Low Risk Entry

Low risk entry points improve your chance of success when trading. A low risk entry point means you will lose very little if the trade does not go as planned and by keeping your losses small this can improve your risk reward ratio and your overall profitability. There are a variety of methods for determining a low risk entry point, however with all of these entries you will quickly know if your analysis was wrong. Low risk entry points not only make trading easier, they are more profitable overall, because when a trade does not work out your loss is as small as it can reasonably be.

Cutting Losses

Before you enter a position you should know where you are going to get out. This is critical to keeping your trading account intact. When you enter a trade there are only three things that can occur. Your analysis was correct and the trade moves into profit, your analysis was wrong and the trade moves into a loss, or you get lucky and it moves strongly in your favour. We prefer the third outcome and the purpose of our analysis is to identify opportunities where we can get lucky, but more importantly we want to avoid the situation where we get caught with large losses.

Develop the habit of always placing a stop loss order into the market when you enter a trade, to ensure that you control your losses on any trade.

Scaling In

Have you ever entered a trade and realised almost immediately that you did the wrong thing? Most traders have. By entering a part position, you can test the waters and if the trade moves as you expect then you can add to the position. This is known as scaling in. Most traders enter a position in one full parcel and exit the same way. However another tool you could use is adding to a winning position, maximising the returns from a good trade. Starting with a position less than your maximum you can add to the position at preset intervals. Scaling in is one of the most under used techniques by traders. Spend as much time developing
your position sizing model as you spend on looking for good entry techniques.

Holding

The world famous speculator from the early 1900’s, Jessie Livermore, made the following comment in “The Reminiscences of a Stock Operator” written by Edwin LeFevre:

“And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight!”

Jessie Livermore commented that most money in the market is made from sitting, not thinking, referring to the fact that holding positions was a key to his success. It takes time for a trade to play out and having the patience to allow the trade to develop is critical to the success of the trade. This does not mean that a trade that does not work out should be held until it becomes profitable. A stop loss is an efficient way of dealing with these trades, but for profit to grow takes time.

Scaling Out

Scaling out of a position is the reverse of scaling in. You exit part of a position on the first signs that the market may be turning around, then exit more once the turnaround is confirmed. A common strategy employed is to exit 1/3 of a position when the trade has moved in your favour by the amount of your risk, 1/3 of the position to take a profit at twice your risk and the final 1/3 when the trend finally ends.

Scaling out aligns your trading with the trend as it unfolds and increases the probability you will have a successful trade. As a trend develops it is inevitably getting closer and closer to the end of the trend. No trend goes on forever and there comes a time when the odds favour a reversal rather than a continuation of the current trend. It is impossible to consistently pick the top and bottom of a trend and scaling out allows you to capture the most likely part of the trend, but also hold onto gains until the trend ends to maximise your winners.

Taking Profits

When a trend finally ends it is time to take profits. Unfortunately a flag does not go up to signal the trend is over, so as a trader you are looking for clues that alert you to the end of a trend. As we mentioned in the section on holding, it is important to be able to distinguish between a pull back and a change in trend. There are a number of different techniques for taking profits and completely exiting a position. Choose the exits that you find appropriate to your particular style of trading, and you can always use more than one exit, taking the exit that works best for you. More than any other part of your trading, rules are required for exits.

Any exit signal that you use should be based on set criteria. Once you are in the heat of a trade your perception of what is happening is altered. It is often linked to your profit and loss rather than to what the market is doing. You can become emotionally involved with the position and your decision-making criteria can become altered. Exit the trade when your signal occurs. If the trend continues and you are exited too soon you can always re-enter if the market conditions continue to be in your favour.

Re-entry

It can be frustrating to be exited from a trade too early, but exiting from a trade does not mean the opportunity no longer exists. If you are exited too early you can re-enter a trade provided the reasons you got into the trade remain valid.

As part of your trading plan you can determine what has to happen for you to take a re-entry. It is possible to re-enter immediately after being stopped out, but this does come with some risk that the re-entry is too soon. If you have been exited from a long trade, it may be that the market bounces higher only to fall away soon after. A less risky approach is to watch the pull back to see whether the market is going to continue to drop or bounce higher. A re-entry can be taken once you confirm the market is moving higher.

Remember your first entry may not be perfect, but if your reasons for entering the trade remain valid, then a re-entry can add to your success. If at first you do not succeed, try and try again, provided the criteria for the trade remain valid.

Re-entry can be one of the hardest things to learn, because you have exited the trade to take profits, or cut a loss. You then have to adjust your view to confirm whether the original reasons for entering the trade remain valid and decide whether it is appropriate to get back in to the position. This requires you to be flexible and to remain emotionally detached from your trade.

Conclusion

Mastering these core skills will dramatically improve your trading results regardless of the market you are trading. Identify the area where you are weak and work to improve on that area. Master one skill at a time to improve your trading overall.

By Jeff Cartridge
Education Manager

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Which Stocks Are Ready To Pull Back?

Friday, November 18th, 2011

The overall Australian market had a spectacular run in October this year, up a staggering 15 percent from trough to peak on the ASX/S&P 200. In light of this you may wish to ask the experts what stocks are likely to pull back in the new term.

Market Analyser Can Help

You can use the Market Analyser software to identify keys stocks which are indicating that they’re due for a pull back.

Start by using the Watchlist Wizard tool to quickly create a watchlist of stocks from the ASX Top 300. (See below for instructions on using the Watchlist Wizard.)

We can then use the Prealerts scanner available to Market Analyser users to identify stocks that indicate there is “distribution” taking place, as stock is offloaded into the weaker hands.

Set up this scan through the Analyser Wizard, a handy tool within the Market Analyser allowing you to access the Prealerts indicators. For help with this tool check this post.

Market Analyser: Selecting the Analyser Tool

Yesterday’s scan produced the following list:

Market Analyser: Distribution Scan

As you can see there are a number of stocks that are currently undergoing distribution and could offer a potential sell signal. You may want to research these companies further before entering a trade.

The effectiveness of this scan depends on the current trend of the underlying stock, and we have illustrated this in the following three candidates which came up in a recent scan:

1) AWE Limited (AWE)
2) Metcash (MTS)
3) Spotless (SPT)

Note that you can also use volume as a confirmation of the sell signal, as you would be looking for volume to pick up as the share price falls.

AWE Limited (AWE)

AWE (formerly Australian Worldwide Exploration Limited) is engaged in exploration, development and production of oil, gas and condensate primarily in Australia and New Zealand. AWE concentrates on exploration and appraisal-type assets, in regions of proven prospectivity and where there is a high chance of commercial success.

Market Analyser Scan - AWE Limited

You can see that the Prealerts worked fabulously for AWE earlier in the year, giving four winning sell signals when the general trend of the stock was down. Now that the stock price is attempting to recover, the Prealerts offer a good signal of when the stock price is likely to take a pause. AWE is now at a key resistance level, but you would want the stock price to trade below the previous swing to confirm a sell signal.

Metcash (MTS)

Metcash Limited (formerly Metcash Trading) is a wholesale distribution and marketing company specialising in grocery, fresh produce, liquor, hardware and other fast-moving consumer goods. MTS has four business units: IGA Distribution, Campbells Wholesale, Australian Liquor Marketers and Mitre 10.

Market Analyser Scan - Metcash Limited

Metcash has been trading sideways for the past couple of months and the Prealerts signal has given a great signal that the share prices was due for a pull back. If you took this signal you would be up 4.5% in two days and would be watching carefully for price action around the $4.10 level which has been the key support level for the past couple of months.

Spotless Group (SPT)

Spotless Group Limited is engaged in the provision and outsourcing of labour-based services in Australia, NZ and USA. Their Retailer Services division provides hanger systems, labels and packaging to the garment manufacturing and retail industries worldwide. Facility Services provides facilities management and support services like cleaning, food, linen and garment services in Australia and NZ.

Market Analyser Scan - Spotless Group

Again the Prealert scan gave a great signal back in mid-May. There was another signal in early October which pre-empted a sideways move for 3 weeks, but now we have a signal in as the share price finds resistance at multi-year highs, and offers a low risk sell signal. Note that Spotless Group has confirmed it has received a $698 million takeover proposal (at $2.63 per share) from buyout firm Pacific Equity Partners, but says its directors view the bid as too low. The bid from PEP comes six months after Spotless rejected a $657 million offer from US buyout giant Blackstone Group.

Summary

Utilise the Prealerts features in Market Analyser to scan the markets for your specific trade selection criteria. You will save time and identify some likely pullback candidates.

By Michael Hevern
Investment Adviser

For Buy and Sell recommendations on ASX listed companies register for a FREE trial of MDS Financial Research.

Instructions – Using the Watchlist Wizard

1. In Market Analyser, open a watchlist window by selecting Menu > Watchlist
2. Click on the Watchlists item on the top menu bar, and select Watchlist Wizard.
3. In the Watchlist Wizard window click Next, select Australia from the Countries list, then select ASX Top 300 from the Available Watchlists list on the right of the window.
4. Click the Update button. Your new ASX Top 300 watchlist will now be available from your watchlist window.

Disclaimer: The information provided within this article is not an invitation to trade a specific stock, but is intended for educational purposes only.

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How Understanding Volatility Can Improve Your Trading

Friday, November 11th, 2011

The markets have certainly been volatile lately. This is a comment that you may hear on a regular basis and it is often used to describe a share or market when it falls sharply, but what does it really mean? And more importantly, how can we use an understanding of volatility to improve our trading?

Volatility is the fluctuation in share price as measured over a period of time. If one share moves in a range of 20 cents in a week and another share moves in a range of $1.00 in a week, this would be considered a more volatile share. Note that this says nothing about the direction of the movement, just the range of movement. This is one way to measure volatility and there are many other ways to measure it as well.

The average true range (ATR) is a measure of how volatile a share is on a daily basis. The true range is the movement from the high of the day to the low of the day including any gaps that may occur. The average true range is the true range, averaged out over a number of time periods. In Computershare, shown in the chart below, the ATR(10) varies from a low of 10 cents to a high of more than 30 cents. A spike in the ATR has occurred recently following the announcement that Computershare has gained approval to take over a US based share registry. Looking closely at the chart you will see that when the volatility spikes it can be a sign that the share is about to reverse direction as it did in May and August this year, but the reversal was slower coming in January.

Understanding Volatility

Statistically speaking the range can be defined by the standard deviation, which is the range required to contain a certain percentage of price movement. 99% of price movement is contained within 2 standard deviations of the current price, so only in very rare cases will the price move beyond 2 standard deviations. Bollinger Bands display two bands that are 2 standard deviations from the current price as shown on the chart below. When the bands tighten up the volatility is low and when the bands widen out volatility has increased. As you can see in the chart below volatility has increased sharply following the announcement. From a trading perspective, when the share price breaks outside the band then expect a reversal as can be seen in August, September and October and again recently.

Using Bollinger Bands when analysing volatility

While these measures can easily be applied to an individual share there is a more sophisticated way to look at volatility which is more informative than a simple mathematical calculation. The volatility index, known more widely as the VIX, measures the premium that is being paid to purchase options on the S&P 500 index. To correctly price options it is necessary to take into account the volatility of the underlying market. If option prices spike then it is a sign of an increase in volatility in the market. In Market Analyser the volatility index is accessed by the code .VIX and the underlying index is the S&P 500 .INX. Both of these can be displayed on the same chart using the Overlay security function.

The Volatility Index VIX

The VIX is shown in pink on the chart overlayed on the S&P 500. Volatility has certainly been higher during the last 4 months than in the few months preceding it based on the VIX. Note the turning points in the index often coincide with the turning points in the VIX. Once the index reaches an extreme a reversal is imminent. High readings in the VIX correspond with points where the market turns higher and low readings in the VIX can signal sharp drops.

Using these tools you can measure whether the market is volatile right now and also use this knowledge to assist in identifying turning points in the share or market you are following.

By Jeff Cartridge
Education Manager

Test this strategy for yourself! Download a free trial of the Market Analyser software here.

Computershare was recommended as a buy by MDS Research Team at the start of November. You too can get advantage of our buy and sell recommendations on ASX listed companies by registering for a free trial of MDS Financial Research.

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Finding True Performers in the Market

Friday, September 30th, 2011

I was talking to some traders recently who were upset that the companies they held were not doing well. At the same time the markets were lower and the question I was asked was how much the market was influencing the performance of the shares. Fortunately there is a very simple way to answer that question using Market Analyser and the Overlay Security function.

A rising tide is said to lift all boats, so if the market is going up most shares go up and when the market is falling most shares go down. The overlay allows us to pick out the true performers by comparing their performance to the market.

The Overlay Security feature in the Market Analyser software

From the Standard Indicators list, click on Overlay Security, then type in the XCode of the security you want to compare to. .AXJO is the Aussie 200 index which is representative of the Australian market. You are not limited to comparing your shares to the market as a whole, you could compare your shares to the sector, gold or even another share.

Overlay of BHP and the XJO in Market Analyser

In the overlay chart above of BHP versus .AXJO you can see that BHP follows the index very closely. This is hardly surprising given that BHP makes up 15% of the index, so a move in BHP will have a significant impact on the index.

Consider the performance of some other shares that have recently featured in the ASX Company News section of the Trader Dealer blog.

Overlay of Castlemaine Gold and the XJO in Market Analyser

Castlemaine Goldfields (CGT) was certainly outperforming the market strongly through July and August, but currently is falling in line with the market.

Overlay of Sedgman and the XJO in Market Analyser

Sedgman (SDM) fluctuated between strong outperformance in August to underperformance during late September.

Overlay of GoConnect and the XJO in Market Analyser

GoConnect (GCN) is currently outperforming the market quite nicely.

We can compare sectors to the index as well and the two strongest performers at the moment are the Health Care and Consumer Staples sectors. These sectors are considered defensive, with investors buying into these sectors when they fear that the economy is weak, because regardless of how bad things get we all have to eat and when medical attention is required it is not usually a choice.

You can use the Overlay Security tool in Market Analyser to strip away the forest so you can examine the trees that are ripe for harvesting.

By Jeff Cartridge
Education Manager

Try this feature for yourself!

Download a free trial of the Market Analyser today.

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Intra Market Relationships: the S&P/ASX 200, Aussie Dollar and US Treasury Bonds

Friday, September 2nd, 2011

I had a nice trade this week in the Aussie 200, trading contracts for difference. I’ll show you how I made the decisions to enter the trade, but first of all a quick lesson in intra market relationships.

The US Treasury bond is seen as one of the safest places in the world to invest money. It is backed by the US government and despite the recent downgrade in its credit rating, the US has never defaulted on a payment. The market perceives that it is so safe that in the financial crisis of 2008 bonds were pushed up to a level that meant interest rates went negative. This means the US government was being paid to borrow by the investors!

A bond pays interest and the price of the bond changes as the market’s expectations of interest rates rise and fall. If interest rates rise, bonds fall in value and if interest rates fall then bonds rise in value. The higher the price is, the lower the return on the bond.

When investors perceive that the market environment is risky, money flows into bonds. When people are scared by stock market falls, they will buy US Treasury bonds and when people are prepared to take on more risk, they will sell bonds and buy shares. So the normal relationship between Treasury bonds and the stock market is:

• bonds up, stock market down
• bonds down, stock market up

Adding in another independent variable we can follow the relationship between the Aussie dollar and the stock market. If money is flowing into the Aussie dollar then some of it will find its way into the Aussie stock market, and if money is moving out of the Aussie dollar then the Aussie market is likely to fall. The Australian market and dollar are perceived to be more risky than the US markets so when investors are scared they sell Aussie dollars and Aussie shares and when they are prepared to take on risk they become buyers. The normal relationship between the Aussie dollar and stock market is:

• AUD up, stock market up
• AUD down, stock market down

Now back to the trade from Wednesday morning. I was watching the last hour of trading in the US markets and the setup highlighted in the charts below unfolded. The charts are hourly charts of Aussie dollar (AUD=), Treasury Bonds Dec Expiry (ZBZ1) and the S&P/ASX 200 (.AXJO). The highlighted setup occurred. The Treasury bonds fell sharply, and at the same time the Aussie dollar and Aussie 200 both fell away as well. This is not normal behaviour; remember if bonds are falling then Aussie 200 should be going up. The sharp fall in the bond market had me believe that a turnaround in the Aussie 200 was likely.

Trade Setup: ASX 200, AUD, US Bonds

I watched the market closely for signs that the Aussie 200 had stopped falling and made my first entry around 4325 as it began to climb higher. Instead of rocketing to the upside as I would have liked, the market broke to a new low. It was still above my stop loss, but I was losing a small amount at this stage. The bonds were still lower and the AUD now turned up, this gave me the conviction to add to the trade near 4315 once the Aussie market began to climb again. The trade was supported by simple technical analysis with the market bouncing off an up trend line.

Technical Analysis of the XJO

My first exit came about very quickly as the market climbed to the down trend line. There was no guarantee that a breakout would occur so I chose to take some profits early, with a gain of about 15 points on the second entry. The remainder of the position was exited just below 4350 with a limit order set to take me out when my objective had been reached. This was a gain of about 25 points on the second entry and happened to coincide with the market rolling over and falling away from this level. This was more likely good luck than good management.

By combing the view of different markets and understanding the intra market relationships I was able to make a nice profit on this trade.

By Jeff Cartridge
Education Manager

Charts from Market Analyser: download a free Market Analyser trial and test this trade setup for yourself.

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Mind the Gap: Trading Risk with Options Versus CFDs

Friday, August 26th, 2011

In this article we examine two types of leveraged instruments, CFDs and Exchange Traded Options, and look at the risk profiles for a simple long strategy. Warren Buffet called derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”.

Except for the dark days of the GFC, the recent market volatility has been unprecedented, as is illustrated by the VIX chart below. The VIX is the CBOE Volatility index, which is a measure of fear in the market. It is clear that we have not seen this level of fear since the uncertain times when Japan was hit by the earthquake disaster back in March.

VIX Index
FIGURE 2: CBOE Volatility Index (VIX)

It’s often said that the only thing that an investor can control in trading is their risk, and this is particularly important when dealing with leveraged trading instruments.

When traders think of trading with leverage Options and Contracts for Difference (CFDs) quickly come to mind. The recent market volatility has decimated many CFD trading accounts, while those who have been trading with defined risk through the use of Options are in a better position.

Sample Trade: David Jones

David Jones Chart
FIGURE 2: David Jones at 8th July – looked to be consolidating above $3.90.

A recent trade which caught traders out was in David Jones (DJS). Back in early July David Jones was trading at a two-year low and had retraced 32% from its two-year highs. But some traders may have been tempted by the fact that it was trading on a PE of 11 and a dividend yield of 8.2%, fully franked.

On the 8th of July it managed to break to a monthly high and was closing near its high for the session. Had you taken a long position with a view to trade DJS for a 10% move, you would have opened the position around $4.00 and looked to place your stop around $3.84 (or 4%). We have calculated the profit and loss (P&L) for the trades using options and CFDs and this highlights some of the risks and benefits associated with using leveraged trading instruments, particularly when you are hit by a nasty surprise.

The CFD Trade

Had the trade performed as expected the P&L would have looked like this:
P&L for a CFD Trade in David Jones
FIGURE 3: Profit & Loss in a David Jones CFD Trade

If the trade had performed as planned those who purchased the stock would have a return on investment of 9%, but if you used CFDs your return on investment would have ballooned out to over 300%. Not bad.

Reality Check

David Jones Price Plunge on July 14
FIGURE 4: David Jones shares price plunges after profit downgrade on July 14th – Ouch!!

As anyone who held DJS shares on the 14th of July would know, the company came out and reported a profit downgrade and the shares plunged over 15% on the open. The P&L calculations are detailed below:
P&L Calculations for David Jones CFD Trade

This “nasty surprise” was a shock to the bank account as you can see: the stock holder would have lost 17%, but the CFD holder would have lost a whopping 540% overnight.

The Options Trade
One way to avoid the prospect of a nasty surprise is to position yourself in the trade using Options. On the 8th of July DJS 400 AUG11 Calls were trading at 14 cents per contract, so you could have bought the right to buy the stock at $4.00 for 14 cents per share, and the P&L calculations are shown below:
Options Trade on David Jones

Your maximum risk is $1,480 (or 100% loss) and as the trade unfolded you would have lost that amount. However the trade has been a success, in that you have defined your risk and have not lost any additional money due to the release of the DJS profit downgrade. This compares to the $3,710 loss (or a ROI of -17% loss) on the share position or the $6,874 loss (or ROI of -543% loss) on the CFD position as outlined above.

Conclusion

Mind the gaps and beware of WMDs of the financial variety.

When a stock’s share price gaps, particularly on market open, you can face extraordinary losses, particularly when you are trading using leverage instruments like CFDs, as illustrated in this David Jones example.

Options can be used in order to reduce your risk, while still participating in potential profits from a move in the underlying stock price using a limited risk strategy.

We have highlighted the David Jones trade as our example, but there have been any number of similar examples in recent times due to the elevated market volatility, including Billabong, BlueScope Steel, QBE, Qantas, Macquarie Bank and Woodside, all of which have fallen 15% to 20% within a few trading days and in most cases gapping on open.

Use Options to define your risk, particularly in volatile market conditions such as we’re experiencing at the moment. In future articles we will talk about the High Yield Covered Put strategy and the Stock Repair strategy, which are particularly relevant to this market.

Utilise the features in the Market Analyser software to plan your trades for the particular Options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk. Sign up for a free 14-day software trial here.

By Michael Hevern
Head of Research

See also:
Options Trading for All Types of Market Environments (Part 1): The Protective Put
Options Trading for All Types of Market Environments (Part 2): The Covered Call
Options Trading for All Types of Market Environments (Part 3): The Covered Call Collar

For buy and sell recommendations on ASX listed companies register for a free trial of MDS Financial Research.

MDS Financial Advisory Services offers general advice on trading Options to generate consistent steady income on your investment portfolio. Call 1300 610 024 for further information.

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Low Risk Entry Opportunities

Friday, August 19th, 2011

As a market watcher and active trader I have observed that there are times when I am certain the market will move higher and other times when I am sure it will move lower – though most of the time I have no idea what is going to happen next. Markets are trading around the clock and there are many opportunities to profit, but it becomes absolutely necessary as a trader to specialise and narrow your focus. It is important to let half-rate opportunities pass you by and act only when the signals all line up and scream out buy. Chasing the half rate opportunities eats into both your account balance and your confidence.

Every time you enter a trade you are choosing to place some of your capital at risk. I’m sure by now you’re aware that it is critical to know how much capital you have at risk on each trade, so I won’t repeat those rules again today. The whole purpose of placing your capital at risk is to gain a reward. And if you’re a successful trader then you have learnt to balance risk against reward. And this is where things get interesting.

Your aim when trading is to minimise your risk and maximise your rewards. This is illustrated in a random entry strategy that buys any share and then sells it three days later. If you keep repeating this process, you can say you are a trader. But the net results are likely to be very poor. If the market is bullish you might make money with this approach, but if the market is bearish there is an excellent chance you will lose. Some shares you buy will go up a little, some more and some a lot, while some shares will go down a little, some more and some a lot. Overall this tends to cancel out, but what if you cut out your large losing trades. All of a sudden your results are skewed to the upside. Small losses and big wins can lead to very profitable trading. At this point it becomes tempting to place tight stop losses to cut off your losing trades, but too many losing trades and you are also going backwards quickly.

Let’s consider another way to balance the risk reward equation by refining your entry technique. Wait for the right trade to come along before ever placing an order. While you may have to wait forever for the perfect trade to arrive, the best trades all have one common characteristic. Whether the trade wins or loses is unknown when you enter the trade, but the risk you are taking is clear. A low risk entry opportunity will always outperform in the long term, because you are only taking on a small risk with a chance of making a reward. What does a low risk entry point look like in the wild? Oops! I mean, The Bourse.

A low risk entry point is one that you will quickly tell you if you got it wrong or not. It’s extremely difficult to pick the exact turning point in any market, but the price movement after your entry will confirm very quickly if you are right or wrong. As an example an entry near a trend line is a low risk entry point. If the price moves below the trend line then you know very quickly you are wrong and can exit safely with minimal risk. In a similar way if you enter as a share bounces off support or resistance, you know you are wrong if it breaks through that level soon after. And when the share you are trading reaches an extreme and turns around this is another low risk entry point as you will quickly be proven wrong by a move to a new low.

Entry Opportunities in Commonwealth Bank

In the chart of Commonwealth Bank (CBA) the first line marks the peak in the Money Flow Index shown at the bottom of the chart. This is an extreme that occurred in April and a small pullback from this level began to develop. It would be possible to short sell CBA, using options, warrants or CFDs, but it did not go as planned and CBA moved higher and this trade would have been exited for a small loss, unless you exited quickly.

The next time the Money Flow index reached an extreme was in May and the trade worked out better as this pullback developed some strength. The top trend line could now be drawn. The Money Flow Index then peaked again and coincided with hitting the downwards trendline. This is an excellent trading opportunity as two low risk entry opportunities line up. However it took two months for this opportunity to arise in July. Would you wait for two months for a trade? Remember good things are worth waiting for. And one last opportunity appears in mid July – this time for the buyers which could have resulted in a quick gain for short term traders who exit quickly.

Right now we are in no man’s land, and there are no low risk entry opportunities in CBA. The Money Flow index is sitting in the middle of the road and a significant move could occur in either direction. Be patient and wait for the next low risk entry opportunity to arise. And for the impatient there are other shares to follow, but stick to the same rules.

By Jeff Cartridge
Education Manager

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The Covered Call Collar – Part 3 of Options Trading for All Types of Market Environments

Friday, August 12th, 2011

Part 3: The Covered Call Collar

The Covered Call Collar is an options trading strategy that traders can use to protect an existing position that has recently surged into a key resistance level. Rather than simply taking profits on the share position and potentially missing out on future upside, the trader enters into a Covered Call Collar. This options trading strategy seeks to protect your existing share position while still participating in some of the upside for a minimal or no outlay.

The Covered Call Collar allows you to participate in some of the future gains up to the sold strike price, while being protected by the put position.

Covered Call Collar: ideal for participating in future gains, while being protected on the downside.

If you are of the opinion that the stock is likely to sell-off with little chance of breaking the key resistance level, but you still want to hold on to it, you could use a Covered Call Collar options strategy. The Covered Call Collar strategy is similar to the protective put options strategy in that you also buy put options as protection. The difference is that you will now finance the purchase of those put options with the proceeds from writing an equal number of out of the money call options.

The position will still protect you from losses below the strike price of the put options at minimal to no cost to yourself, but it will also stop the position from profiting beyond the strike price of the short call options should the stock stage a rally. That is, you would miss out on a strong rally in exchange for putting on the protection of the put options for next to no cost (apart from commissions, of course).

Use a Covered Call Collar when you expect the share price to move modestly higher or pull back significantly from current levels.

Recent Trade: Newcrest Mining (NCM)

A recent trade which is yet to pay off was Newcrest Mining. We initially entered the share position when the stock price broke above its 50 and 200 day moving averages, around $38.50. It shot up soon after we entered the trade and has now been trading sideways for the past few weeks. We considered a covered collar was appropriate for this position. Based on technical analysis you can see from the chart that the $42.50 resistance level has held for over a year.

So we bought protection at $39.00 by buying 3900 SEP11 Put for $0.645 and then wrote the $42.50 SEP11 Calls for $0.775. We received a credit for this trade and the position remains open. We are protected until September expiry down to $39.00 and profits will be capped at $42.50.

Newcrest Mining - Covered Call Collar Trade
Chart 1: Newcrest Mining Covered Call Collar Trade

Derivative Profiler in Market Analyser

You can plan and analyse your trade as shown above, using the Derivative Profiler option in the Market Analyser software.

MarketAnalyser also provides a payoff diagram for further trade analysis as follows:
Payoff Diagram in Market Analyser
Chart 2: The payoff diagram for the Newcrest Covered Call Collar trade.

Trade Note

Newcrest (NCM) is still trading between the $39.00 and $42.50 option strike levels and only time will tell whether the share price will end up at expiry, but we are protected until September expiry down to $39.00 and profits will be capped at $42.50.

The Trade

Options can be used in order to reduce your risk while still participating in potential profits from a modest move in the underlying stock. Here we’ve explained the Covered Call Collar strategy which allows you to participate in some of the future gains up to the sold strike price, while being protected by the put position.

In future articles we will talk about the High Yield Covered Call strategy and the Stock Repair strategy which is particularly relevant to this market.

Utilise the features in the Market Analyser software to plan your trades for the particular options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk. Sign up for a free 14-day software trial here.

By Michael Hevern
Head of Research

See Also:
Options Trading for All Types of Market Environments (Part 1): The Protective Put
Options Trading for All Types of Market Environments (Part 2): The Covered Call

For buy and sell recommendations on ASX listed companies register for a free trial of MDS Financial Research.

MDS Financial Advisory Services offers general advice on trading options to generate consistent steady income on your investment portfolio. Call 1300 610 024 for further information.

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Commodity Prices and the Australian Stock Market

Friday, July 29th, 2011

Historically, the relationship between stocks and commodities has been that when commodities prices increase, stock prices decrease and vice-versa. The primary reason for this is that inflation tends to drive commodities prices higher and stock prices lower.

Contrary to most global markets however, the Australian market tends to do better when commodities are on the rise.

SP/ASX 200 vs CRB Index
S&P/ASX 200 (.AXJO – blue) overlaid with CRB Index (.CRB – red)

In the chart above we can see a positive correlation between the Australian market and commodities prices. The reason behind this correlation is that a large part of the Australian stock market is related to commodities exports, in particular raw metals and energy-related commodities. In the S&P/ASX 200 (which equates to 78% of the stock market) material and energy stocks account for 28.7% and 7.4% respectively. In other words, commodities-exporting stocks account for over a third of the top 200 companies listed on the ASX.

Sectors

Logically, if commodities prices rise, domestic companies that export commodities would receive a higher value for the same quantity sold. Therefore stocks related to commodities exports will increase in value as their earnings increase.

On the opposite side of the trade, as commodities become more expensive, overseas consumers will pay more for the same quantity. This leads to demand for the Australian dollar increasing, which strengthens our domestic currency.

Australian dollar vs. US dollar: (AUD – blue) overlaid with CRB Index (.CRB – red) which is a measure of performance of a basket of commodities (19 worldwide commodity prices).

In the chart above, we can see the correlation between the Australian dollar and the CRB index. We also know that a strengthening Australian dollar coupled with a bullish stock market will attract risk-taking investors from overseas to invest in the domestic stock market.

When overseas investments increase, the demand for the Australian dollar will also increase, thus completing a virtuous circle. A virtuous circle is a complex of events that reinforces itself through a feedback loop and has favourable results.

In the meantime, more overseas investments in the Australian stock market would naturally boost it, leading to another completion of a virtuous circle.

Below we can see the relationship between commodities prices, the Australian stock market, the Australian dollar and overseas investors.

Virtuous Circle

The reason behind movement in commodities prices

Commodities prices follow the simple rule of supply vs. demand. If supply stays the same and demand increases the goods will become rarer, and consequently more expensive.

As most commodities are priced in US dollars, we need to extract the strength of the US dollar from our data in order to study the movement resulting from the supply vs. demand law more accurately.

USD vs CRB Index

In this chart the US Dollar index (USD – blue) measures the performance of the US Dollar against a basket of currencies, overlaid with the CRB index (.CRB – red).

The CRB index mirrors the movement of the USD index. The commodities price increases whilst the US dollar becomes weaker, and vice-versa. The CRB index is negatively correlated to the US index.

To neutralise the impact of the US dollar’s strength, we can weight the commodities price with the US dollar index value following this simple formula: CRB * US index / 100.

CRB Index Adjusted by USD Index
Source: Reuters

As we can see on the weekly chart, from the end of the Global Financial Crisis up until January 2011, commodities prices rose steadily within a channel.

Within the global economy, demand for commodities is rising as developing countries, such as China and India, are increasing their consumption of raw metals or oil derivative products. However, supply is not rising accordingly. For example, petroleum-exporting countries registered with OPEC have agreed on exporting quotas, which will limit supply in order to increase their benefits.

We now understand that on a long-term basis global market demand is greater than supply, and following the supply vs. demand law commodities prices are increasing. Even though a long-term view of commodities shows prices rising, in the medium term the increase is not always achieved at a steady pace. External factors such as natural disasters or war can disturb the fragile balance between demand and supply. For example, if a war in a petroleum-exporting country arises, it will impact on the supply curve, which will lead to a rapid increase in the price of this commodity.

From October 2010 to January 2011 the US dollar-adjusted price of the CRB traded above its natural steadily rising channel. Unfortunately if the rise is sudden the demand will not adjust accordingly in the medium term, as importing countries are forced to pay more for the same quantity demanded. The demand will then lower until the price comes back to its equilibrium where it is globally affordable. In the chart above, we can see the decrease in prices at the end of April 2011.

Implication of a spike in commodities prices for the Australian stock market.

In the same way that an increase in commodities prices will benefit the Australian stock market, a significant decrease will cause it to plunge.

Vicious Circle

When commodities prices stop rising, the Australian dollar will follow the trend. Overseas investors will find that their earnings have decreased and will start to withdraw their assets, putting the stock market under bearish rules. As we now understand, the reverse for these patterns is also true.

S&P 200 vs CRB Index vs AUDUSD

S&P/ASX 200 (.AXJO – blue) overlaid with: CRB Index (.CRB – red), and Australian dollars vs. US dollars (AUD= – green).

The chart above shows that when the Australian dollar and CRB Index stabilised earlier this year, the Australian stock market plunged instead of stabilising too. Since commodities prices started to gradually increase at the end of June, the Australian dollar and the share market have tended to follow the trend.

Conclusion

After looking into the relationship between commodities prices and the Australian stock market, we can identify that while a globally sustainable steady rise in commodities prices will benefit the domestic share market, a quick upward shift in commodities prices, above the steady rising channel, will inevitably be corrected with a corresponding decrease. This decrease is certain to trigger big losses in the Australian share market.

There are no guarantees when trading, but investors could take a sudden upward shift of commodities prices as a signal to sell commodities-related stocks, as we now realise that the shift will not be sustainable.

By Bryce Dupuy

The information provided within this blog is general advice only and you should consult the services of a financial professional in order to ascertain whether the information is applicable to your investment strategies and risk profile.

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