Part I: Modern trading world
Chapter 1: Different sea — same sharks
The 2008 Global Financial Crisis was a wake-up call for those who thought the sharks were friendly and the financial waters welcoming. Now it is much easier for the sharks to get into our pool and savage our savings. Easy access to the internet and modern technology have broken down the barriers between private traders and the large institutions, but some things never change. Now more than ever it’s survival of the smartest.
This book is about the changes wrought by modern markets, and we look at the Guppy trading methods that have stood the test of time. We introduce modifications and new methods designed to prosper in markets irrevocably changed by the Global Financial Crisis. This is the modern world and some things have changed forever. Before we are overwhelmed with change we revisit some of the foundations, which have not changed.
Trading is tough, but traders who work with smaller amounts of capital have an advantage over traders who must work with larger amounts of capital. This size advantage allows the smaller trader to outperform the market. It is an important trading edge and a foundation of the Guppy trading methods.
Everybody who trades or invests in the market looks for a trading edge. Most times they look in the wrong places and it may take many years and a lot of cash before they discover their mistake. A trading edge is an approach, a tool or a technique providing you with an advantage in understanding how the price of your stock is most likely to behave. There are four stages in developing a market edge, and the last is the most important because it gives part-time and private traders a gift to make their edge super sharp.
The first stage is the most simplistic edge based on a variation of insider trading. This relies on finding out information before others do. Insider trading is illegal, but the search for secret information is not. Understanding the price activity shown in figure 1.1 may provide clues to the insider information used by others. This clearly looks illegal, although it’s rarely enough to trigger a query from market regulators. One popular market approach is based on the idea that hidden somewhere in the company accounts and the details of the business is a fact or interpretation undiscovered by the rest of the market. This is not considered a suspect activity and this search method forms a foundation of the investment industry. These gems do exist but they are rare.
‘Find good companies that are undervalued’ appeals to our sense of the simple, but it rarely provides an investment edge for anyone other than the most skilled professionals. Knowing what is happening is important, but it usually does not provide the edge needed for success.
Some people try to use charting and technical analysis in the same way to find early information. Good chart analysis identifies developing patterns that may be created by traders with more information than the general public. These patterns are discussed in chapter 26, Patterns of informed trading.
The least harmful aspect of this is the search for leading indicators. These are technical analysis approaches claiming to provide advance information of trend changes, of exact market turning points, and at times they claim to tell the future. These are the least harmful because they usually only involve wasted time.
The most harmful development of this idea is found in very expensive trading programs, secret systems and other trading schemes sold to customers desperate for a trading edge. These promoters play on the belief there is a ‘secret’ to the market, and that exclusive information is required for success.
Figure 1.1: possible insider selling
The second stage of developing a market edge comes with our understanding of personal trading techniques. Not only are there multiple markets to choose from, but there are also multiple useful trading and investment techniques. We could choose to trade only stocks, or banking stocks, or work in the derivatives market. Depending on the market or market segment we select, there is a specific range of techniques that work well. Our task is to find the techniques, or combinations of techniques, we can use successfully.
Our market edge is sharpened when we understand there is no single magic trading approach. Each of us is different, and our personality influences the way we see the market, the way we identify opportunity and the techniques we prefer to use. We sharpen the trading edge by specialising in a single market, or a small group of trading techniques.
The third stage comes when traders apply money management to every trade. Losing is an inevitable part of winning and cannot be separated from our trading activities. This hungry, unwanted partner often consumes all our trading profits and much of our trading capital. We control these devastating impacts by using a risk management rule based on the 2% rule. The chart in figure 1.2 shows how these calculations and discipline protect the trader from devastating losses. It is tamed by techniques to safely grow our trading capital and protect trading profits. The exact combination depends on the market you select and the trading techniques you prefer.
To the novice, this solution seems a long way from the real business of buying and selling shares. The successful trader builds her success on close attention to the details of these techniques. They provide the most important aspect of her trading edge. The professional, full-time trader develops an edge from knowing her selected market, honing her technique and applying disciplined, accurate money management. In this book we discuss the combinations necessary to provide our trading edge.
The fourth stage is perhaps the most important of all and contributes to superior returns. The part-time trader has one additional edge that allows her to outperform her professional counterparts because it gives her a super-sharp edge. It comes in two parts. The full-time professional trader has to trade every day. The part-time trader does not. She simply waits for the absolutely best opportunity to develop, and then trades it.
Our small size, trading in thousands of dollars rather than hundreds of thousands of dollars, is also an advantage. We can trade smaller stocks and enjoy the advantages of price leverage. Using price leverage, the Australian stock IVA in figure 1.3 offered a 378% return over eight weeks. This low-volume stock turns a $10 000 position into $37 872 profit. The trading volume is large enough for the part-time trader, but too small for the professionals.
Figure 1.2: protection from large losses
Time and small size are gifts given to part-time traders. Many foolishly squander these gifts with impatience and by taking good, but not excellent, trades. Use the gifts of time and size to make careful selections suitable for your preferred trading style. This is the super-sharp trading edge we use. Used correctly it gives an additional 20% to 30% on top of the underlying market performance. Traders who do not acknowledge their small size or use it incorrectly will deliver returns at about the same level as those delivered by the funds, which are constrained by their large size.
Figure 1.3: opportunity for the part-time trader
Stay in touch with reality
The financial markets are like an ocean full of sharks where large financial institutions, mutual funds, savvy institutional traders and brokerages prowl for profits. The survival rate for the small fish, the private trader — the minnow, or the guppy[1] — is very low.
We are all part of a financial food chain, but the guppy does not have to provide a protein feast for the shark. The ocean is big enough for both of us. Let them eat someone else. As a small fish, I need to survive in order to grow into a bigger fish. You, as a private trader, need to learn and master those strategies most suitable for your size.
We need to consider survival strategies suited to the guppy of the markets. This is not to disparage the skills of professional traders, nor to underestimate the importance of the institutions and funds in providing liquidity. The purpose is to understand we are not them and their rules cannot be ours.
The private trader has a tremendous capacity for self-delusion. Many beginners assume they ought to follow and imitate large professional traders. They believe and hope that Warren Buffett’s investment objectives can also be theirs. We really do not understand Berkshire Hathaway’s objectives, but we know they consistently make money over a long period and we want to do the same. Warren Buffett attracts perhaps more than his fair share of myths. They include:
• long-term investing is for dividends — but his company Berkshire Hathaway does not pay divi...