Trading Explained

The TRADING section of your report acts exactly as the name suggests; as an area to help generate opportunities. The ideas will have a technical bent, but be supported by fundamentals. For example, we might run a filter for stocks that are showing price momentum and then look at each of the names which qualify to see which is looking the best fundamentally. 

The ideas that we select will be written up and presented as Trades, and then tracked using the Trade Table. We will monitor the positions in real-time, and provide guidance on when to exit. We will also keep a list of the 10 most recently closed trades.

Whilst we encourage members to consider the Trading Ideas and other content within the section, it should be noted that we are not managing the Trades as a portfolio in the same way that we manage the MT portfolios, which have very specific instructions and are performance tracked.

The Trades are just that, a collection of trades that are all considered equal, as opposed to stocks in the portfolios which are weighted and tracked for performance. Aside from the 10 most recently closed positions, we will not be tracking the long-term performance of the Trades. It is up to any individual who wants to use the ideas to come up with their own performance record, factoring in fees, commissions, slippage, trade frequency and anything else which might affect performance. 

Trading Strategies

In order to identify opportunities, we have created a strategy template to filter stocks. The current strategy is 3MA Buy and Sell Signals. It is a trend and momentum strategy. Below is an explanation of the strategy 3MA. 

3MA Trend Following Strategy

3MA is a simple, easy-to-understand trend following template designed to highlight stocks that are trending across multiple timeframes. Trend alignment is the key. The strategy will identify short- to medium-term timeframe opportunities (i.e. day/weeks to weeks/months).

As the name suggests, the template uses 3 EMA’s (exponential moving averages) which need to be in a certain configuration for a stock to pass the ‘test’. That configuration is as follows;

• The shorter-term EMAs are crossed higher; the 8-period EMA (red) is crossed above the 21-period EMA (blue).
• Both the shorter-term EMAs are above the longer-term, 125-period EMA filter (green), which is also pointing higher.
• The price action sits above all of the EMAs.

Below is an example of 3MA in action. We see in November that the price action moves above the green, longer-term, 125-period EMA filter. That green EMA is sloped higher. In January, the red, 8-period EMA crosses above the blue, 21-period EMA – creating our first BUY signal. The price action proceeds to run from just below 1100c, up to 1250c before the red crosses back below the blue. More recently, in May, the red has crossed back above the blue once again, creating our second buy signal. Whilst this is a textbook example, the crossing of the EMAs would have allowed a trader to capture the bulk of the move higher, simply by buying once the red crosses above the blue, and then selling once the red crosses back below the blue.

Of course, real-world examples aren’t always this clean, but 3MA will filter out all the stocks which meet the criteria outlined above and provide us with plenty of trading ideas. We will present these ideas in the signals section each day.

To summarise:  

• 3MA is a trend following screening tool
• Trend alignment, across multiple timeframes, is the key
• Short- to medium-term opportunities
• Rules are simple and easy to apply (you really just need to set up a chart template)

3MA is designed to measure all elements of a trend, across multiple timeframes. The moving averages tell us four important things about the trend;

• Direction
• Strength
• Confidence
• Sustainability

ELEMENTS

Elements combines the 3MA template and adds a couple more elements (hence the name), to provide for a more complete (and hopefully robust) entry signal.

All told, the strategy combines three elements and they are outlined with examples provided below.

• Trend: as identified by the 3MA Signals
• Level: Is there an important support/resistance/technical level in play?
• Signal: Is there a price action signal to warrant an entry?

The ‘trend’ part of Elements we have already discussed and the ‘level’ part is fairly obvious, whilst the ‘signal’ part is a little more subjective and can take a few different forms. Let us have a look at an example;

On the chart above we can see that the 3MA trend is in place; red EMA above blue EMA; both above the green EMA.

In the blue box on the left, we see a candle which spikes up to about the 740c region. In the blue box on the right, we see the red candle which spikes below this level but ultimately closes back above it – see close up below;

The combination of these two candles has created a ‘level’ around 740c. This was the swing high from late April and the latest swing low and retest level in the current uptrend.

Looking back at the original chart, we can see the price action rally off the 650c level, push through 740c (prior swing high) with ease, and then come back and retest that level. It’s the retest and confirmation of this price point which makes it significant and, in the process, creates a new support level.

All we need now is a price action signal. My personal favourite is a three-bar reversal. In the textbooks it looks like this;

The reversal bar/candle (the middle candle in the graphic above) often comes at the bottom of a downtrend and shows the bears pushing the price lower before the bulls recover into the close. That movement is what creates the long tail or ‘wick’ on the bottom of the candle. That alone does not constitute a signal. The signal is only complete once a bullish confirmation candle follows.

Of course, things in the real world don’t always look like they do in the textbook but our real-life example is pretty close;

Each of those confirmation candles provides an opportunity to be a buyer and, as we can see below, the price action continued to run away;

The cross above highlights the last candle you see in the chart pointing out the confirmation candles. For those playing along at home, the stock is IPH.

There you have it team, ELEMENTS in action. A strong trend, a significant level, and a price action signal. We will refer to this strategy template in future analysis.  

EXIT STRATEGIES

June 2019

Having removed stop losses from our Trading Ideas, a number of members have been asking questions about how to manage trades. It’s a fair question but it is a question to which there is no single, ultimate, final answer.

What risk management strategy a person chooses to employ will depend on how much time they have, how strict they want to be, their level of market understanding, their level of technical understanding, and their individual risk profile. There is no ‘one size fits all’.

A strategy might simply be to set the stop-loss 10% below the entry price and a target 10% above the entry price and let the price action do what it will. That might be regarded as a ‘crude’ strategy but it is a strategy nonetheless. And it is important to note that an exit strategy or ‘risk management’ is more than just exiting losing positions. It should also govern how and when you exit winning positions.

In my time as a younger man, I did a lot of backtesting, looking for the holy grail of exit strategies. After about a year of this the conclusion that I came to is that there is not one strategy which is perfect. In fact, most strategies that I tested were, individually, about as good as each other. It was only when combining elements did the strategies improve – and not by that much. And finally, the biggest conclusion that I came to was that stops losses can potentially do more harm than good.

Let me elaborate. The backtesting I ran was over 30 years of data (so including big events like the GFC and the ’87 crash – yes, I did this testing quite some time ago) which also accounted for survivorship bias – i.e. acquisitions, bankruptcies, de-listings, dead assets etc. As far as I could manage it, it was a clean data set. I tested basic exit strategies (ATRs, percentage moves, moving average crosses, RSI signals, time in trade, pivot points, Fibonacci levels, support and resistance, etc) and found that all of them would have underperformed no exit strategy at all. Let me say that again. Every strategy tested would have underperformed having no exit strategy at all.

Now, I am not claiming that the strategies that I tested were the most elaborate, or effective, or efficient – or that there aren’t exit strategies out there that disprove this finding. The strategies I tested were just the basic stuff. But it did highlight that tinkering can do more harm than good. By setting stops in any basic way, the harm that the hitting of those stops did by taking me out of longer-term trends and potential profits, was greater than the benefit derived from exiting losing positions that went on to continue being losers.

This is why I am reluctant to use ‘hard’ stops today. A hard stop is a stop that is pre-programmed into a trading platform, which will simply execute once the price level is triggered in the market. My preference is to use ‘soft’ stops. I.e. to have an idea at what price I would like to exit a position and then monitor the price action as it moves towards this level. I can do this because I sit in front of the screens all day, watching the charts and seeing how things move. For someone who can’t (or doesn’t want to) do this then hard stops fulfil a valuable purpose.

All that being said, here are the combined factors I will consider when determining a ‘soft’ stop.

• I will use the Average True Range (ATR) of a stock to see what the price range is 3-4x ATR away from the entry price.

E.g. If a stock is priced at 100c, and the ATR is 4c, then I would look at a range 12-16c away from the entry price.

• I will then look for significant support/resistance levels, major candles, consolidation points, round numbers, etc

E.g. If there is a support level 18c away from the 100c price, then I would look to put the stop loss below that level (which would be 80c). Given that 80c is a round number, I would then probably adjust again, and put the stop loss down at 78c.

In the example above, I have made two adjustments that simply looking only at an ATR, or a round number, or a support level, or a percentage amount would not have caused me to make. I have taken into consideration more ‘factors’ and this is where the improvement comes from. Using a combination of factors is better than using just one element.

The final consideration – and this is a big one – is completely subjective and essentially unable to be quantified or codified. I’m sorry to say, it only comes from watching markets for 15 years. All the textbooks will tell you not to use gut feel. To be cold and calculated and mathematical, and stick unwaveringly to your hard stop strategy. I say there is a place for gut feel and I hope the following example highlights it.

Using our example above, let’s say we have bought a stock at 100c, with a hard stop at 78c. There is an announcement before the market opens one morning with an update about our stock which is negative. The stock is looking to open 25% lower, at 75c. It does, in fact, open at that price and the hard stop is triggered at the first available price, 75c. The loss is 25%. Not great.

How often have us market watchers seen a stock open on its low for the session after a bad announcement, and then rally at some point throughout the session? Or perhaps even rally all day? It happens often. Here is why. On the open, you have everyone rushing for the exit. Everyone who wants out is falling all over themselves to dump stock. There are also no buyers at that point. So the book gets smashed with sellers when there are few buyers, and the price gets hammered. After that initial puke, some semblance of sanity kicks in. People see a stock down 25% and whether they are bargain hunters, hardcore value guys or pure gamblers (the reason is irrelevant) they start buying. And they start buying at a time when a lot of the sellers are washed out of the system. That’s why we often see big bounces off the initial plunge. That 25% loss could easily turn into a 15% loss or a 10% with a little market nous and experience.

But how do you write an exit strategy based on something so subjective? There are smart people out there who have no doubt come up with some rules and done the backtesting to codify such outcomes but, alas, it is beyond me. For me, it stays in the camp of ‘gut feel’.

As mentioned, the scenario above is just one example of how experience and repetition can get a better result than just mechanical stops – and this is why I leave room for it in my approach to managing positions.

For those who don’t have the experience, or do not have the time or inclination to watch the market, using hard stops is the way to go. I would suggest using a combination of factors, like those which I have outlined, as a good starting point for anyone looking to create their own approach.

Cheers,

Chris.