Tuesday, October 17, 2017

Market Trading Tactics - Part 2

This is a continuation of the previous post.

In the last post, we discussed how lessons learnt from traders apply to investors. As market participants, we really have very little control over our destinies unlike most other activities. A tennis player can always decide whether to be aggressive or defensive, to target opponents’ weak backhand or serve to kill. A businessman, likewise, can also do a lot, such as using discount pricing or scale to squash opponents or headhunt the best talent in the market to run his business. But for investors and traders alike, we are in a game where we control only one lever. We pull it to buy, release to sell, and the length of our pull determines our bet size.

Maria, still the most beautiful tennis player.

In other words, as market participants, we can only determine our entry price, our exit price and the size of our trade. This game is really quite restrictive. Hence the lessons from the last post would hopefully serve to remind everyone that in this game, we are our own worst enemies. The crux of success boils down to superior analysis and managing our psychology. I would think that psychology is more important than superior analysis.

Previously, we discussed the first two points about control and style. Today’s final point is about our own emotions. Particularly how our emotions would create what Daryl Guppy (the author of the book Market Trading Tactics) called an emotional stop loss.

In my years of investing, I have not really thought too much about this. Luckily or unluckily, I believe I never hit this stop loss. An emotional stop loss is the amount of money that we cannot afford to lose emotionally. It could be $10,000 or it could be 10% of the portfolio. If we were hit by this magnitude of loss, we feel really bad emotionally and we start to break down. We cannot think rationally and make stupid decisions. We are very likely to just sell out everything, hence cutting loss at the worst time possible, only to see that things recover after that. Obviously, this is different for everyone but we must recognised it’s there.

To make things more vivid, let’s put in some no.s. Imagine that we have a $100k portfolio and our emotional stop loss is $20k. But we did not know this. We put $25k into a pharmaceutical stock hoping to make 20% since our analysis showed everything was great and a new drug would be launch soon. Lo and behold, the company announced the new drug failed and it goes down by 80% in a week. So we lost $20k in a week. This is 20% of the portfolio. We just lost a couple of years of overseas trips at a click of the mouse button and we needed that for the downpayment of a new car. We panicked and sell out, shared the bad news with our spouse and faced the music, only to see the stock recover in the months after.

This is the emotional stop loss.

It is very much similar to a nervous breakdown or a snap. Our psychology makeup somehow works like a rubber band, if we are over-stressed, or over-stretched, we will snap and when that happens, it's very hard to recover. We sometimes see this even in friendships. People who are good friends for years but time after time tension built up and one incident (like a friend refusing to just put a Facebook Like when requested perhaps) can ultimately bring about some kind of a crunch that could simply bring the other to conclude, the friendship bond is broken. It could be repaired but it will not be the same.

Can we accept these friends?

So to make sure this never happens, we need to size really well. We need to think in terms of both absolute dollars as well as percentage of the whole portfolio. We would also need contingencies. For me, the rule of thumb would be never putting more than 10% of the portfolio in any single name. In fact, I would try not to get close to 10%. If the stock rises that much, then it’s best to sell out a portion of it. Of course, starting a position small definitely helps. Starting a new position at 1% and then look to build up as we learn more seems like a good strategy.

Our relationship with money is unique and the way we handle it is also unique in the history of mankind. From the caveman era till modern society, humans always dealt with physical possessions and very seldom the concept of virtual wealth as we do today when trading with screens and computers. Human activities in the stock market only started recently and hence its impact is not well understood. It is famous or perhaps infamous that Sir Isaac Newton lost a fortune in the early British stock market. For a genius like him to lose a fortune, what are our chances if we don't try hard to understand what we are up against?

"I can calculate the motion of heavenly bodies, but not the madness of people." - Sir Isaac Newton

It is said that every trade should be more akin to the decision process we make when we buy houses or for some entrepreneurs, buying and selling businesses. When we are looking to buy our matrimony homes, or a future nest, we really do serious stuff. We go for multiple viewings, we study maps, understand localities, we interview neighbours, we research markets. Well, at least I believe most of us do some of these when deciding to put hundreds of thousands. Yes, while each stock position will be just a fraction of homes or businesses, the due diligence should not be proportionately less. Even for trading, we need to do a lot more work than we think for each trade. I would say that the checklist should be at least 7-8 steps as I have depicted previously. But it's not easy. It takes effort. This is why so few ever succeeded in making huge sums from the markets.

This two part series on Market Trading Tactics hopefully gives us another tool to get there. To summarize:

1. In investing, we control only three variables: the entry price, the exit price and the size. Of these sizing is the most important, followed by the entry price. We get these rights by doing deep-dive analyses, understanding the intrinsic values well and buying way below them. It also means patience. Sizing comes with experience and it's important not to size it too small that it doesn't move the needle. Or size it too big such that it hits our emotional stop loss.

2. We have to know our styles. Some of us are bulls and other bears. Bulls tend to get in too early and bears too late. We have to adjust how we then enter markets. Bulls should enter small and build up. Bears have to enter big and/or try to be a bit earlier but with a smaller stake.

3. We must never hit our emotional stop loss because we cease to function at the high mental capacity to invest or trade. We need to do better analyses and know our own psychological makeups better in order to beat the market!

Hope this helps! Huat Ah!

Happy Deepavali to all!

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