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Archive for August, 2010

High Frequency Trading

07 Aug

Let’s face it. We little guys are at a significant disadvantage compared to those institutions that are paying millions of dollars to put powerful computers on the trading floor. Milliseconds of time saved translates into billions of dollars in profits for Goldman Sachs and other High Frequency Trading (HFT) companies.

Now what would Bruce Lee do? According to Bruce, relying on a weapon in combat, any weapon, is a limitation. It is a limitation because it prevents you from using other techniques that may be more effective in downing your opponent. Likewise, HFTs using computers are limited. They are limited to pre-programmed algorithms that are only as good as the programmer. These HFTs also deal with large amounts of capital, much more than us little guys are handling. The limitations of HFTs became readily apparent with the recent Flash Crash where some select stocks were going for pennies on the dollar.

So how can the little guy capitalize on HFTs? Well, I recently discovered one phenomenon that may help. Late in the day (after 3:15) is my favorite time of day – this is when major swings often occur. This is particularly the case during extermely volatile times (such as now). Often when there is a significant gap down at the opening bell it translates into a major sell-off late in the day. I suspect this is due to mutual fund redemptions. People panic and sell their mutual funds. The adjustments are made by the mutual fund company at the end of the day. They can’t avoid it.

By studying late-in-the-day trading I found a very simple market characteristic that I would like to share with my readers. It is quite simple and powerful – all you have to do is watch the last 15 minutes of trading prior to market close, from 3:15 to 3:30 PM.

Some simple rules that vastly improve the odds of success for day trading. Here are the rules:

First lets define the parameter %DeltaIndex which is the index percent change over the last 15 minutes of the day.

%DeltaIndex = 100 * (Index at 3:30 – Index at 3:15) / Index at 3:15

In English, the rules would be as follows:
(1) if %DeltaIndex is small (i.e. less than +/- 0.33%) then continue with the trend established in the last 15 minutes.
(2) if %DeltaIndex is large (i.e. greater than +/- 0.33%) then reverse the trend established in the last 15 minutes.

Mathematically the rules are written below:

(1) If %DeltaIndex > 0% AND %DeltaIndex < 0.33% Then Go Long
(2) If %DeltaIndex >= 0.33% Then Go Short
(3) If %DeltaIndex < 0% AND %DeltaIndex > -0.33% Then Go Short
(4) If %DeltaIndex <= -0.33% Then Go Long

Stay tuned and be happy. Don’t let the markets get you down.

ProfitGyan

 

The 2% Rule..!!

01 Aug

There is a concept in risk management that you’ll here about, the 2% rule, although each person may have a slightly different set of standards. I think risk management is the most important thing for investors and traders to be up to speed on. Unfortunately, often traders are great with technical analysis or fundamental analysis and are totally lacking in risk management principles and discipline. You can be the best stock picker in the world and be knocked out of the game in 1 or 2 bad positions without risk management and discipline. So I present for your entertainment and hopefully financial well being, the 2% rule.

Basically what we have is a concept in which no one position should represent more than 2% risk to our entire portfolio should things go badly. This starts with planning and risk assessment before, not after the trade. All too often we are quick to say I like this stock here or there, but have no real plan for dealing with risk. When I look at a trade, a large portion of my time spent is identifying risk. I want to know at what point, if this trade goes against me, am I going to cry “uncle”. In other words, I’m identifying the risk associated with the trade. So don’t just look at the stock in terms of how much can I make, look at it in terms of how much can I lose. Once you have identified your risk, assuming the risk/reward ratio makes sense, you must quantify how much 2 % risk represents in your portfolio. Example: $10k portfolio x 2%risk=$200 risk. So now I know how much ($200) risk I can afford.

I now look at how much risk I have identified in the position. Example: buy xyz stock @ $11 with a stop(uncle point) @ $10=$1.00 risk. Now take $200.00 portfolio risk and divide it by $1.00 position risk and you come out with 200 if my calculations are correct ;) This means, so long as it doesn’t violate any other risk principles I apply, I can safely purchase 200 shares of XYZ @ $11 with a stop @ $10 and if my stop gets hit, my overall portfolio risk will be no more than 2%. This means I can afford to make a few mistakes in looking for that big winner.

There are sometimes things that may happen like gaps that’ll mess up the equation and expose you to more than 2% risk, but we can’t control everything, but everything we can control, we must. Taken the previous example (XYZ @ $11), obviously if we can buy closer to out stop ($10), we can afford to add more shares and thus increase our potential reward profile. Example: wait for a pullback in XYZ and buy @ 10.25 with the same stop @ 10=.25 risk—$200/.25=800 shares.

This has certainly changed our risk/reward ratio and has introduced another problem-do you want the majority of your portfolio tied up in 1 stock? I don’t and have my own rules for those situations; however it is clearly more profitable to buy closer to your stop thus decreasing your risk.

 

Rules for Investing Discipline

01 Aug

Many people think that the best way to invest is to fill it, shut it and forget it – and they are reinforced by the dramatic successes of people who found Reliance shares in their grandfather’s trunk or bought L&T in the last bull run and held on for dear life.

That’s all survivor bias. You hear only the good stories. Who tells you stories like – I found 25,000 shares of Global Trust Bank but they are worth nothing. It’s not good conversation at parties. So you hear of a few good stories and do not hear of the bad ones, so you assume this is the perfect way to invest.

It’s not. Buy and hold has been successful in the past only because stock markets have trended upwards. From 1982 to 2000, the US markets went only one way: up. In India, we saw a big boom in 1992 to Sensex 4K or so, a bust and then back up to 6,000 in Year 2k, after which there was a bust again, adn then back up to 21,000 before we’ve stopped here at 15K.

This is still higher highs and higher lows. We have not seen a period of stagnancy. The US meanwhile has sorta stagnated – from 2000 to now it’s barely moved in real terms (counting inflation). But in 1966 to 1982, the index had only moved downwards. Meaning, a 16 year period where the high of 1966 was only regained in 1982.

Current situations are quite like that too, we may have another long period of nothingness. What if it’s another 16 years? Buy and hold may have worked in the last 16, but will it work in the next 16? So what if it has worked over most of the last decade – if this next 16 years will be bad, it impacts you. It impacts your retirement, your children’s fund.

So learn a few basic discipline rules:

• Cut your losses: put a stop point to how much money you can lose in a stock. And when you reach that point, get the hell out. How much? Well, for some people it’s 2% per trade. For others it’s 30% absolute on each investment. That’s for you to figure out.

• Don’t buy when there’s nothing to buy: If you go to a market for tomatoes and you find only rotten bananas, will you buy them? Some people feel that when they have decided that money must go in equities they have to buy some shares right now. That is stupid. Find opportunities. It may take some time, and they may not be visible (who has the time to track everything) – but only invest when it’s a no-brainer.

• Ride your profits: When something’s going well, stick with it. It’s always tempting to take your profits when they’re on the table. But the best profits are on a long term trend.

• Don’t act on what you hear: Too many people feel the need to talk. They come on TV and the internet and spit out random theories on where you should invest and what you should do. Don’t just listen to them ; do your own research. I am one of these characters – so don’t listen to me, do your own research.

But why do such people, including me, feel the need to educate you, or to tell you what to do? Because it satisfies their need to feel like a hero. And some of them earn their living that way – when you think they are a hero you will buy their random recommendations. For others it is a way to reinforce their own trading decisions – i.e. when they want to sell, they need to have people to buy, so they “recommend” the stock. Whichever way you look at it, it does not serve YOUR needs. In all probability you don’t know what your needs are, but you might be right for thinking it’s to profit on your investment.

• Set a goal, and get bored: investing without a goal is like driving without a destination. It’s thrilling to know that you can drive. And you feel like you’re exploring something, learning something new. But once you realize that you have to drive everyday, it gets more and more boring until all you do when you drive is curse the traffic and long for the destination.

Investing is like that; you set yourself a goal – a house, a car, a trip to Interlaken in Switzerland, that 6 month sabbatical to train for a mountain climb. Whatever. And invest so you get there. Because investing is boring, and it deserves to be boring. The thrill is really in decorating that house, or climbing that mountain. The ride is going to be choppy so you have to curse the market, cut your losses, find those opportunities, curse some more etc.

Btw, investment does not mean buying shares. It could mean spending time getting a part time degree so you get more pay and reach your goal. Or it could mean schmoozing with the top managers so you climb the ladder faster. Anything, that helps you reach a goal that you don’t have the money for.

(So what then, are my goals? I want to write a book, get fit, drive across the country, learn a musical instrument and travel like crazy. Somehow all of them are linked to a certain quantum of money I must have. And somehow I’m too lazy to even start any of them, even if I had the time or the money. I’m a hypocrite. But working on it.)

Lastly, my free advice. Don’t take free advice. It’s never worth the money you don’t pay.

 

Advanced Trailing Stop Loss Methods

01 Aug

In this article we will look at taking this one step further and using stop losses not just to limit risk and lock in profits but also to enable you to produce even more profit but increasing the level of risk you are in the trade at the appropriate time. This does not mean that you trade at a more risky level – remember this is a cardinal sin for traders. It does mean, however, that you take on more risk at a time in a trade that is already in profit. This way, you can be assured that the trade will never lose you money but you will be able to give it more freedom to develop without being stopped out too early!

Non-fixed Average True Range (ATR) Based Stop Losses

The average true range is an indicator that takes into account the volatility of a stock. The more volatile a stock, the more room is required for a stop to prevent the trade from being stopped out too early intraday. ATR takes into account the volatility of a stock unlike other more basic forms of stop loss such as a trailing percentage or point stop loss. For a more detailed discussion of ATR (and other indicators), please visit Technical Analysis from A-Z available at www.equis.com/customer/resources.

As an example, it is possible for you to set your initial stop loss to 2*ATR below the low of the day and then increase the stop loss to, for example, 3*ATR once the stock is in profit. This will allow your trade a little more room to breathe with very little chance of losing any money.

The chart below demonstrates this principle:

The red line is the stop loss that is not based on the traditional approach of trailing behind a fixed ATR while the blue line is a stop loss that is based on a fixed ATR. The trade was entered on the 19th September and it can be seen that, in this case, the blue stop loss is activated much quicker than the red stop loss. In other words, in this case, a non-fixed ATR produced much more profit than the fixed ATR based stop loss.

Mixed Stop Loss Methods

It is also perfectly possible for you to mix the initial stop loss method with a totally different method of stop loss calculation later on. For example, the initial stop loss can be based on a 2*ATR and then be trailed based on the low of the past “X” number of days. So, if we take X to be 40 days, then as soon as the low of the past 40 days is greater than the initial stop loss, the stop loss is trailed to the newly calculated method and so on.

Summary

The above state two methods of advanced stop loss calculation. There are a number of different other methods and you will need to find a method that is suitable for you. Remember, there is no method that is ideal in all situations and you may find that one method may be better in one stock and not another. It is therefore important that you back test your method on different stocks to ensure that the method, in general, works. Above all, keep it simple and manageable. Without sounding too harsh remember the following pneumonic – KISS – Keep It Simple Stupid!