Monday, October 09, 2017

Market Trading Tactics - Part 1

I bought this book titled Market Trading Tactics for ten years ago and left it on the shelf. It stood there ever since, collecting dust. At the back of my mind, I didn’t want to read it. I couldn’t figure out why I bought it in the first place. I am an investor and as an investor, there was no need for trading tactics. In my mind, traders and investors were enemies. We were the Allied Powers and them, the Axis Powers. The markets were our fighting ground. So how can I read a strategy book devised by the enemies?

I was so wrong!

Recently, in order to fulfil my mission to shift all my reading onto Amazon’s Kindle, I decided I have to quickly finish the last of the few hard copy books left on my bookshelf. Market Trading Tactics begged to be unwrapped. Yes, it was still wrapped in plastic which had turned yellow. So I did unwrap it and read it at full speed. I was done in two weeks.

Market Trading Tactics by Daryl Guppy (2000)

To be honest, the bulk of it was not what I was looking for. These were about moving averages, trading indicators, chart reading etc. I maintain my view that if past prices could predict future prices, then the infamous stats would be reversed: 90% of all market participants would make money by trading stocks and a lot of professional traders would be billionaires. Billionaires not just millionaires. Past prices and trading volumes do provide some information useful to long term investors and traders alike but not to the extent that it can help anyone beat the market consistently. I still believe it is much harder to generate long term 8-10% annual return by trading.

The anecdotal evidence was provided by the author Daryl Guppy who wrote about his own trading career including how much he could make by trading. These were really interesting stats. He shared that in one year, he made $60k profits on a base of $100k, making trades every two weeks (i.e. about 30 trades for the year), while adhering to the various rules that he set for himself, including stop losses, limits on capital risked per trade etc. He also shared that his average trade size was about $30k and his win rate was 70%. Of course, if he could replicate this for 30 years, then he would have beaten Warren Buffett. Since his net worth is still much less than that of the Oracle of Omaha or for that matter, many less famous value investors (yes, I am passing judgement here :), we have to assume that this should be one of his best years.

Having said that, I did learn a lot as an investor and some of this knowledge could actually be applied well to what we do. Here’s three nuggets that I found pretty useful:

1. As a market participant, we could only control three variables, out of many, many variables that goes into generating returns.

2. We need to know our styles, are we inherently bullish or bearish and how we should correct for our biases.

3. What is our absolute emotional stop loss?

You have to cut loss! You have to!

Ok, that's Korean drama style, we are not there yet. Let's tackle them one by one.

The first one should have come as common sense but I never really gave too much thought about it until I read the book. The author described it really well. So he said that in most activities that we engage in, we usually have a lot of control. Be it playing tennis, running a business, cooking etc. In running a business, we decide how to launch products, where to launch, at what price, who to hire, where to do promotions, what to do with e-commerce etc. Successful businessmen made lots of good decisions that propelled their businesses forward and beat competition. But as an investor or trader, we can only control three things. Yes, three. Our entry price, exit price and size of the trade (relative to our portfolio). That’s it.

Yes, there are activist investors that nowadays try to influence businesses, getting great outcomes, but for most of us, that’s pretty much the only things we can control. So, how do we win given what we can do is so limited? Hence what really matters is really psychology which impacts how we control the three variables. We should never be taken for a ride by the markets, buying into euphoria and selling in panic. I would say that for long term investors, the priority of importance is probably the sizing, followed by entry price and then exit price.

Sizing is also related to the last point so let’s keep things simple for now. Every position should be big enough to matter but not too big as to jeopardise the whole portfolio. In my experience, it would usually be 2-5% of a portfolio. For really high conviction bets, it could go up to 10% but that’s really risky. If we are wrong then wipe out a lot of our net worth. Next, entry price. There is really nothing much to add. For value investors, this determines almost everything. We buy way below intrinsic value and earn the difference between price and value. If we are right, there isn’t really an exit per se, bcos the value compounds and over time, we see these become 5 or 10 baggers.

On this note, we move on to the second point which is about styles.

Most of us are predisposed to have some sort of biases. We are inherently optimistic or pessimistic, we have formed our world views earlier in life and we act according to these views. For me, I am inherently optimistic and this comes up in my investing style. I tend to bullish and hence tend to buy easily, usually catching the falling knife too early and the stock continues to fall after my purchase. But thankfully, most stocks recover afterwards as I got the long term story right. I also tend to overstay, even in stocks that I believe I should be exiting. The converse is true for bearish people.

In order to correct this, now I know I should always enter a position small. For instance if this stock should ultimately be a 5% position. I would start with 1-1.5%. Then I have 2-3 bullets to add to 4-5% over time. Usually the stock goes down after the first buy, and the second and third buys allow me to catch the bottom. As for selling, I would need to develop better selling techniques, by setting rules such as never have any positions bigger than 8% of the portfolio. Sell a third or half the position after the stock has gone up 100% etc. However, these tips are also very personal i.e. it differs from person to person. So you have to know your own style and develop techniques to better manage and control the three variables well.

In the next post, we talk about the emotional stop loss!
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