The Trend Trader - Nick Radge on Demand

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Nick Radge On Demand The Trend Trader September 2010 by Student2Trader.com

Back by demand, Nick Radge has kind submitted to another interview with Student 2 Trader. This time discussing his trading decisions, risk management, philosophy, entries and exits in more detail. Nick has an impressive history, from starting his own Hedge Fund to being Associate Director at Macquarie Bank. He currently works full-time growing and developing The Chartist and trading. Nick, we’ve just been through a major bear market. What was the strategy you employed to maximise your portfolio? For a stock trader the best strategy is being in cash, and I say this for a number of reasons. It’s been easy to look at these last few years and see clear sustained downtrends, but historically over the last 100 years this type of price action has been extremely rare. When we run the data through the computer it becomes quite clear that up until 2007/08 equity trading on the short side was basically a waste of time. Yes, it was marginally profitable, but the risk adjusted reward makes it a pointless pursuit in my opinion. One would simply be better off sitting in cash and awaiting the next upswing. It could be argued that from now on we stay in a bearish environment and that short side trading will be the only winning strategy moving forward. Possible, but not probable. The second issue is how the rules of the game were changed to suit the big players. Short selling in Australia was banned in September 2008 which basically stuffed any strategy even if it had historically tested well. It’s therefore a risk to employ or rely on such a strategy moving forward because its effectiveness is always going to be questionable.

Short selling is the selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

What are the major risks of viewing declining stock markets as a great time to buy “cheap” stocks fundamentally? The key attribute here is that, in general, trends persist and a stock in motion will tend to stay in motion. Many great traders are trend followers so they’re always buying strength and won’t fall victim to these types of price shocks. Interesting enough price shocks tend to happen in the direction of the prevailing trend rather than against. Its natural human trait to want to buy something at a cheaper price than what it could have been bought for a short time ago, which again is why the natural human will tend to be a long term loser in the market. I would also add, albeit to deaf ears, that the events of 2007/08 clearly prove the notion of fundamental investing has serious flaws. Performance measurements would clearly show that the risk/adjusted rewards being offered by 99.9% of global equity fund managers is disastrous. In simple terms an annualised return equal to or better than the maximum equity drawdown is deemed an excellent record. Most fund managers have maximum drawdown’s nearing 50% now even though their annualised returns are usually single digits. It’s simply unacceptable to me.

Risk/adjusted reward is a concept that refines an investment's return by measuring how much risk is involved in producing that return. Equity drawdown is a percentage decline in equity capital, commonly quoted as a percentage loss on capital. You are often quoted saying “cut your losses, let your profits run”. How does this philosophy work, taking into account expected win rate? There is a direct relationship between the win/loss ratio and the winning percentage. The higher the winning percentage the lower the win/loss ratio. Using the ‘average human’ again we are brought up to be right. That’s how we’re rewarded at school, at university and as we develop our careers. The better performers step further up the ladder. This cultural upbringing makes us believe that in order to be successful at trading that we therefore must have a high winning percentage of trades. Nothing could be further from the truth. The simple fact is that we can’t control our winning rate, or if we can its only be a very small margin beyond random. What we can control is how much we’re willing to lose on a trade, and how far we ride a winner. These are the only two traits we can control which is in essence the win/loss ratio. A successful trader works hard at these and ignores the ‘being right’ part of the equation. From that point it becomes basic maths to create a positive expectancy.

The concept of rising winners and cutting losers is exactly why many of the great traders are trend followers. The edge is easily captured.

Win/loss ratio is the ratio of the total number of winning trades to the number of losing trades. It does not take into account how much was won or lost simply if they were winners or losers. Winning percentage is the average percentage win on winning trades. Positive expectancy is the expected positive outcome from trading. That is, expected net win. It is generally the expected annual return.

Often we hear ‘risk management’ in trading. Do you think many beginning investors overlook the concept? Why? Absolutely and for similar reasons mentioned above. The average person in the street feels that there is some inherent secret to unlocking the markets and profits. Experts must know something they don’t so it becomes the Holy Grail search to seek out that secret. Once a person truly understands the simple maths is behind creating a positive expectancy, they will then look toward staying in the game long enough to allow the law of large numbers generate that expectancy, and to do that you need to keep your risk down to small amounts to allow for deviations of expectancy. What is a simple strategy an investor or trader can use to manage risk? From a trading or active investing perspective you must only risk a very small portion of your capital on any given trade. The textbook rule sprouted is 2% but my experience suggests otherwise. Basically your end goal is to stay in the game, both monetarily and psychologically. If you can’t cope with losing in the near term then you won’t achieve the long term positive expectancy. So by working backward from the angle of, “how much pain can I deal with?” you will be in a better position to move forward. How much capital am I willing to lose? It’s different for everyone. Some people can handle 30% or 40% declines, whilst others can only handle 10% to 15%. The rule of thumb from my 25 years experience is that your estimation of how much pain you can handle is actually well beyond the reality. If you think you can handle 30% drawdown, I say you’ll be very nervous at 15% and probably throw it in at 20%. Therefore, keep your risk even lower than what you think you need until you really start getting the psychological issues intact. For those more mathematically inclined, can you explain how the ‘2% rule’ might work in risk management, and why we might use it? The 2% rule is an anti-martingale equation. In layman’s terms it adheres to the

principle that when doing something right, do more of it, and when doing something wrong, do less of it. In other words as we make money from our positive expectancy system we slowly but surely up the ante because 2% of our increasing capital ensures that each new trade has a slightly higher dollar risk associated with it. It’s natural compounding if you like. Conversely when we’re having a rough patch and our capital is declining we’re ensuring that we’re betting a smaller dollar amount on each new trade. In theory we can never lose our capital, we’d need some 140 consecutive losses to get to the point of being unable to trade. The other important consideration is that each and every trade is equally weighted. We have no favourites. We don’t wake up one morning and decide that today is the day we’re going to be 100% right so we’ll bet the house. Using 2% ensures that every trade is taken with the same bias. Would you describe yourself as a trend follower? Can you explain how this idea works? Yes, I a trend follower and have been since I was 18, although back then I had no idea what I was doing. The concept is simple and the best analogy is like being a hitchhiker. A hitchhiker stands on the side of the road in the direction they intend to travel. They have no idea which car will stop and when a car does stop they have no idea how far that ride will take them. They stay with that ride until it stops. In some cases that hitchhiker may only go 10 kms up the road. On other occasions they may get a ride all the way to their destination. When I jump on a trend I have no idea how far it will take me but I do know that I’ll never make big profits by taking small ones. Once you’ve ridden a massive trend you’ll never look at the markets the same way again. Often we hear that amateur traders fall into the trap of thinking that the more complicated a trading system is, the more likely it is to succeed. Is this the case? This again is an example of thinking that so called experts know something that the average Joe Public doesn’t. What the average Joe needs to understand is the simple maths behind positive expectancy. They need that light bulb to go on before they can start moving forward. Using the analogy of travelling in a car from point-A to point-B. Some people choose a high powered sports car whilst others choose a simple family car and others again choose a bike. They all achieve their respective goal – getting from –A to –B. What is an example of a simple entry and exit technique an investor can use on a longer timeframe? Every trend, up or down, is preceded with momentum. One simply needs to catch that momentum. Think of body surfing. You get in front of the wave, swim ahead of it then allow it to drive you forward. But prior to catching that wave there was already momentum driving it. That’s what we do with riding

trends – await some form of momentum and jump on board. In a very simplistic measure any stock making a new 100-day high can only have momentum. It’s impossible not to have momentum or else it wouldn’t be making a 100-day high?

Nick's article on a simple and effective SMSF investment strategy is worth a look: http://www.thechartist.com.au/articles/self-managed-super-smsf/trend-effective-strategy-smsf/

How would you recommend investors manage their initial stops for their investments? As a rule of thumb, and verified by my own testing, any shorter term traders should use intraday stops, that is stops that are triggered as soon as the level is penetrated. However, longer term active investors are better advised to use ‘stop on close’ orders. What this means is wait for the market to close below your delegated stop price and exit the following day. It’s what I use and it’s highly effective.

Stops loss orders are placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit an investor's loss on a security position.

How about a simple entry and exit technique for a trader on a short timeframe? This would depend on the market type. US equities tend to be more ‘back fill’ markets, that is choppy moving back and forth. The best style in these conditions is to be a buyer of weakness and seller of strength, so more mean reverting rather than trend following. In Australia, a less mature market, we are blessed with great trends so momentum or trend following are best. Short term traders need to be cognizant of commissions as these can drag excessively on accounts and almost create failure regardless of how good the strategy is. How would you recommend traders manage their initial stops for their trades? Short term traders should exit as soon as their stops are hit regardless of the time of day. I set mine to be executed automatically by the broker. What are your thoughts on using breakeven stops? Trailing stops? Both are very important. Breakeven stops are an essential ingredient to success and I diligently use them when swing trading. They can become frustrating, but they serve a purpose and must be adhered to. Trailing stops

are what makes the money. It’s important to not fear giving back open profits. It’s a natural tendency to want to bank the profits, but as I stated above, you’ll never make a big profit taking small ones.

Breakeven stops are when stops are moved up to the entry price at which you bought a security, assuming you are long, designed to stop the investor out at breakeven, minimum. Trailing stops are a stop-loss order set at a percentage level below the market price - for a long position. The trailing stop price is adjusted as the price fluctuates. The trailing stop order can be placed as a trailing stop limit order, or a trailing stop market order.

Should traders employ profit targets? Why, why not? In certain market conditions targets should be used. In choppy range bound markets they can be useful, but in strong periods of time they are the worst kind of tools. Now if we might talk some basic technical analysis. You’re a follower of Elliot Wave Theory, can you give our readers a bit of background to the concept? Elliott Wave Theory is not for everyone, indeed I get a lot of people coming to my site to cause troubles, yet when they see it in action they readily change their minds. We now have a solid following but doubters will always loom. It’s important to understand how we use technical analysis, which is very different from what the academics claim. I do not use technical analysis as a predictive tool. I use it as a comfort tool, that is, simple a way to get involved in a trade that makes me feel okay to manage it. I want repeatable patterns for trade frequency. I want specific right/wrong points of reference so I know when to enter and when to get out. Technical analysis does this, albeit the predictive power of any pattern is about random. This is where we use of basic maths to create the positive expectancy even with a 50% winning rate.

Elliot Wave Theory is named after Ralph Nelson Elliott, who concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves. What are the most important pieces of information for chartists? Volume and its relationship with the closing price are highly important. Volume is very much misunderstood and many common measurements, such as On Balance Volume are erroneous. Gaining an insight into volume traits can be very helpful, especially for discretionary trade setups. That said the only true confirmation tool is price.

Do you use any indicators or oscillators? The only oscillator I use is what I call my Divergence Oscillator which is simply a K% Slow Stochastic. There is nothing special about it and I could use numerous others to do the same job, but it suits me and I have been using it successfully for many years. Can you explain the concept of divergence? Divergence is a point in the trend where underlying weakness is building. In essence we may have price making new highs yet the oscillator is failing to follow and making lower highs. This will tend to lead to a stalling of price or a fast snap back. We use these setups as a trend reversal trade.

Divergence occurs when the price of an asset and an indicator, index or other related asset move in opposite directions. What type of divergence is most reliable? There are three types; A, B and C. I only ever use Type-A which is where price makes higher highs yet the oscillator makes lower highs. It’s acting like a rubber band being stretched to breaking point. What trap do amateur traders fall into when looking at using indicators and oscillators as a trading system? Amateurs are looking for that secret entry technique so it’s natural for them to look into all these oscillators and indicators that look pretty on the page. Until they ‘get it’ they will probably spend the rest of their lives roaming the universe for the Holy Grail indicator. What are your current developments at The Chartist? 2010 is a year of creating a succession plan for the business. Currently it’s solely me. Because many subscribers no rely on us for their SMSF we have to ensure that the business remains viable should something untoward happen to me. It will also allow me more free time to research new strategies and improve current ones. Research is a never ending pursuit. The second development is moving into the FX arena and also adding futures. We’ll be offering trading advice and technical research on global futures and FX in the coming months which expand on our current equities offering. The last development is the establishment of an ‘auto trade’ facility which will be the first one of its type in Australia. Auto trading will allow subscribers to have our recommendations automatically executed on their behalf without any input from themselves. It’s like a midpoint between a managed fund and doing it themselves. They will be able to choose the specific strategy as well as some of

their own parameters. We do the rest. Do you have a future vision for The Chartist? Our vision is to keep The Chartist as Australia’s premier ‘value add’ technical advisory service. There is scope to expand into the US at some stage but there is a lot of scope locally first.