Six Steps to Trading Like a Pro
“In the fields of observation, chance favours only the prepared mind.” Louis Pasteur (1822 –1895) Chemist and Microbiologist
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By The Same Author Share Analysis and Company Forecasting The Business Plan: A Manual for South African Entrepreneurs The Millionaire Portfolio Jungle Tactics: Global Research, Investment & Portfolio Strategies A Guide to AltX: Listing on SA’s Alternative Stock Exchange Become Your Own Stockbroker The Corporate Mechanic: The Analytical Strategist’s Guide Richer Than Buffett: Day Trading to Ultra-Wealth The Millionaire Portfolio: New Edition The Guerrilla Principle: Winning Tactics for Global Project Managers Women & Wealth: Footsteps to Financial Freedom Lore of the Global Trader: Strategies to Master International Markets
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Contents BY THE SAME AUTHOR DEDICATION NOTE FROM THE AUTHOR Searching for Perfection Intelligence does not always equate to success PREFACE: HOW THE BOOK WORKS
Not Like Other Technical Books Designing a Trading System o The Three Fundament Steps o The Three Technical Steps
PART ONE: RULES OF THE GAME CHAPTER 1: INTRODUCTION
Your Trading Business Plan o Private Issues o Establish A Routine
Trading Plan Sections
CHAPTER 2: ARE YOU CRAZY?
A Story to Offend Predictable Habits of Traders o Still Crazy – The Following Is For The Uninitiated o What are shares? o Is it risky to buy shares?
CHAPTER 3: RULES TO GET STARTED
35 Essential Rules o General Trading Rules o Rules To Consider Before You Trade o Rules That Are Trading Specific o Rules That Relate To Actual Trading o Rules For After You Have Placed Your Trade
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CHAPTER 4: FORMS OF ANALYSIS
A Day In A Newsroom o Analytical Method 1: Fundamental Analysis o Analytical Method 2: Technical Analysis
CHAPTER 5: SOME MARKET FUNDAMENTALS
Where Do You Start o Economic Growth o Capital Flows o Interest Rates o Trade: Flows & Balances o Monetary Policy o Consensus Forecasts
Using Economics To Improve Trading Strategies
CHAPTER 6: GRASPING THE CONCEPT OF TECHNICALS
Why Technical Analysis? o What Is Technical Analysis? o Technical Analysis Versus Fundamental Analysis
Contrary To Popular Belief - Technical Analysis Does Fail
CHAPTER 7: MAKING BOTH ANALYTICAL METHODS WORK FOR YOU
What Are You?
Both Systems Have Advantages o The Fundamental Perspective o The Technical Biases Basic Recommendation For Novice Traders o Checklist For Novice Traders
Have You Made Up Your Mind: Which Is Best? o Where Do Your Go From Here?
PART TWO: GETTING READY CHAPTER 8: STEP 1 - PORTFOLIO STRATEGY
Lessons From The Past
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CHAPTER 9: THE THREE PORTFOLIOS OF BILLIONAIRE TRADERS
First – An Outline Of Basic Portfolio Types o Common Portfolio Types
Aggressive Portfolios The Defensive Portfolio The Income Portfolio Speculative Portfolio The Hybrid Portfolio
Trader’s Asset Allocation
The Three Portfolios Of Billionaire Traders \ o Portfolio 1: The Foundation Of Wealth o Portfolio 2: Taking Advantage Of Market Anomalies o Portfolio 3: The Day Traders’ War Chest
PART THREE: FUNDAMENTAL PERSPECTIVE (WHAT TO BUY) CHAPTER 10: STEP 2 - CHOOSING COMPANIES TO TRADE
A Time To Forget The True Issue – Be Prepared
Phase 1: Find Growth Sectors o Volume Based Technical Analysis o Indices – Three Identifying Trend Indicators Indicator 1: The Advance-Decline Line Indicator 2: Upside-Downside Volume Ratio
Phase 2: Reducing Share Filter o Step 1: Market Cap o Step 2: Share Price o Step 3: Liquidity/Tradeability o Step 4: Earnings Growth o Step 5: Strength Of Financials – Ratio Analysis\ Solvency Check Liquidity Ratios Profitability Ratios Efficiency Ratios Gearing Ratios Investment Performance Ratios
Testing For Market Volatility
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CHAPTER 11: STEP 3 – ESTABLISHING A PRICE RANGE
Phase 1: Understanding Cycles o Using The 4 Phases Elliot Wave Fibonacci o Prepare For The Trading Week
Phase 2: Correlation Analysis o Concept Of Correlation o Market To Global Leading Vs. Lagging Indicators More Information: Leading Indicators More Information: Lagging Indicators o The Magliolo Expense Ratio Company PE To Sector Averages The Single Company Company PE Vs Competitor PE
Phase 3: Share Price Analysis
PART FOUR: TECHNICAL TRADING CONFIRMATION (WHEN TO BUY) CHAPTER 12: ESSENTIAL SIGNALS
Good Place To Start: Essential Signals o Line Charts o Bar Charts
CHAPTER 13: STEP 4 – PHASE 1: IDENTIFYING TRENDS
Phase 1: Methods To Identifying Trading Trends o Step 1: Candles o Step 2: Is There A Trend? How Do You Draw Trend Lines? o Step 3: What Are The Support & Resistance Levels? The Bounce The Break Through o Step 4: Draw The Channels o Step 5: Superimpose Moving Averages Simple Moving Averages Exponential Moving Average Sma Vs. Ema Moving Average Crossover Trading o Step 6: Volume Is The Final Variable Is Volume Really Important? Page 8 of 192
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o Three Sets Of Volume Sentiment CHAPTER 14 : STEP 4 – PHASE 2: IDENTIFYING PATTERNS
Phase 2: Detecting Trading Patterns o Step 1: Head & Shoulders o Step 2: Double Tops & Bottoms o Step 3: Triangles & Rectangles o Step 4: Wedges o Step 5: Pennants o How Traders Use Chart Patterns o Take A Glance From Magliolo’s Detection Strategies
CHAPTER 15: STEP 5 - FINDING MOMENTUM & STRENGTH
Phase 1: Looking For Momentum o Step 1: The MACD o Step 2: On Balance Volume
Phase 2: Finding Strength o Step 1: Relative Strength Index (RSI)
Other RSI Indicators
o Step 2: OB/OS
PART FIVE: POINT OF DECISION CHAPTER 16: SENTIMENT ANALYSIS
Financial Modelling o Negative Aspects of Financial Models o Positive Aspects of Financial Models.
Basic Trading Systems o o o o o o o
The Cost Averaging System The Du Pont Model Factors That Influence ROI The Modified Du Pont Formula The Constant Rand System A Word of Warning The Constant Ratio System Page 9 of 192
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Stock Splits Reverse Stock Split or Share Consolidation Share Dividend O The Free Cash Flow Method O Calculating An Investor’s Total Return
Market Sentiment
Everyone Influences Markets o Sentiment-Based System o The Global Market Sentiment o South African Market Sentiment
CHAPTER 17: STEP 6 - TIMING
Three Steps To Timing o Step 1: Determine Strength Of A Share o Step 2: Determine The Share’s Trend o Step 3: Determine The Potential Future Price Strength Of The Share
Entry & Exit Points o The 3-2-1 Method o Exit Strategies
PART SIX: ADVANTAGED TRADING CHAPTER 18: THE IPO – NO TRADING HISTORY
New Public Issues The Magliolo Indicative Valuation Method o Phase 1: Peer Analysis & Gross Value
The Indicative Valuation Methodology Example o Phase 2: Three Discounts Discount 1: Industry Cash Flow Discount 2: Industry Tradeability & Liquidity Discount 3: Company Specific Analysis
Looking At Prospectuses
CHAPTER 19: VALUABLE INVESTMENT TOOLS
Too Many Indicators Equates To Failure o The Watch List Avoid Mixing Your Trading Signals o Avoid Market Madness o Don’t Listen To Doomsayers Page 10 of 192
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o Ability To Measuring Liquidity o Cash Flow Per Share: The New Bottom-Line Filter o Patience
CHAPTER 20: CUTTING-EDGE DAY TRADING
Combining Averages o Step 1: Determine Whether To Trade Or Invest o Step 2: Establish Substance
CHAPTER 21: CONCLUSION & FINAL WORD
Conclusion Final Word
APPENDICES REFERENCES GLOSSARY
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Note from the Author This is my second financial book for The Penguin Group, but my 12 th published manuscript on stockbroking, trading and related fields. For me, however, the importance of writing Six Steps to Trading Like A Pro has been nothing short of knowledge which I have gained from clients as a consequence of all the workshops, seminars and personal mentorship programmes provided since 1995. The contents of this book have become a standard methodology for those interested in coming to grips with the countless facets of investment and, more specifically, trading the vast array of financial instruments available round the world. Yet, despite its title there is no doubt that anyone who has completely mastered the art of trading successfully in a hostile and ruthless global environment, will dispute that there are only six steps to moving from a complete novice to trading like a professional. I do not dispute such allegations. The mere fact that this is my 12th book on finance acknowledges that investment and its intricacies do not stand still and that these will continuously adjust as new instruments are developed and introduced into a world economy that moves to new demand and supply variables. What I can stress, though, is that too many experts complicate the route to understanding the basics of trading and populate books with complicated economic, taxation and stock broking rules and regulations. I am not advocating that such regulations are unimportant; simply, these are secondary to trading like a professional. Interestingly, each of my new books have introduced such complexities, but usually in small bite sizes – so that the growing army of private investors around the world can improve their personal knowledge while improving their trading strategies. Bear witness to the following: In 1694, when the Bank of England was formed it was already dealing with over 50 companies. The National Debt in that year was less than UK£415 million, while today the UK’s National Debt is over UK£900 billion. Despite this debt, London Stock Exchange (LSE) has become the most important in Europe and, in fact, one of the largest in the world. There are over 3,000 companies listed on the LSE, with 350 of these coming from 50 different countries. About 1,800 of the LSE's company listings trade on the Main Market, and the total value of such companies is over UK£3.5 trillion. In the US, the advent of mutual funds led directly to investors’ buying shares. In the UK, the 1968-69 boom in unit trusts led to investors buying shares. How does the above help private investors to better their trading skills? Other than the knowledge that the UK and US markets are large and stable, the information only helps to confuse investors with too much economic and market information. There really is no need
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to know what the national debt is, or that unit trusts helped investors’ to shift their interest to ordinary shares. There seems to be an unbelievable compulsion by many financial writers to give in to popular trends and fashionable thinking during specific economic circumstances, such as highlighting trends in boom or bust markets. This book is not driven by a compulsion to provide you with yet another book on popular trading methodologies. Rather, it happened as a consequence of a culmination of a number of very specific events. Three of these events are as follows:
The first happened in 2008, was when a client asked me the following question: “Is it possible to break up the complexities of trading into a few very pertinent steps?
The second event took place in Durban in 2009, during a share trading workshop. I had just explained to the group that trading is a logical process, determined and ruled by strategy and market emotion, when an attendee asked: “Doesn’t market sentiment ultimately kill any logic?”
The third event took place when the massive Japanese earthquake happened in 2011. I was hosting a conference for Chinese entrepreneurs when the news of the devastation broke. Instead of sympathetic comments, one entrepreneur simply stood up and said: “I have to get back to Shanghai. There is market share to be gained”
These started to make me think:
Is it possible to break down trading into a simple set of basic rules?
How can one take illogical market sentiment into the equation?
How do we do this in a ruthless global environment?
From such simple questions, Six Steps to Trading Like A Pro was born; the above influencing events will become clearer as you read this book. In fact, its composition comes from the mere fact that the raw material gathered from workshops during these past three years stemmed from many questions asked by intelligent men and women anxious to broaden their knowledge of trading and, eventually, investment as a whole. Ultimately, if increasing trading logic helps to create successful and more sophisticated online investors, then increased tradability should result in a better economic environment that, in turn, promotes a climate in which companies can prosper; bringing benefits to a wider scale than many people suspect. This book thus builds upon the knowledge gained from working with novice traders and professional stockbrokers since I started my career in stockbroking in 1990. Through them, I have gained a deeper and more pertinent understanding of the role of sentiment in markets and, as such, my analysis has become more succinct and accurate. The purpose of this book is to give beginners and more experienced traders a fresh look at the principles and applications of using charting signals in conjunction with fundamental analysis. These methods are important, because when a trader applies them with precision, they provide him or her with a deeper understanding of the strength of their chosen investment, taking into account market sentiment as well as current trends.
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I hope that this book will engender debate on how many steps it really takes to get from novice to experienced trader. Recently, I read an article that stated: “Only 140 steps to trading perfection!” My first thought was that, by the time you get to step 15, you will have lost the advantage of any profitable trade. If nothing else, I hope that the new trader will find an enhanced ability to detect and act upon changes in prices and to benefit from such action. The use of fundamental analysis provides you with better understanding of what you have to do before you buy shares, while technical analysis is used to determine investor interest in the share before you time such trades. I have also noted from lengthy discussions with professional traders that only a handful of their clients are happy with their personal trading strategies. As one said: “Few traders are perfect, and most can certainly improve their performances,” adding, “the aim is to be more consistent in trading, before trying to make big profits.”
Searching for Perfection The search for easy answers to trading is usually equated to using new signals and complicated techniques. This all-consuming and encompassing search is, in fact, not necessary. Rather, the novice trader should first understand what his or her true trading ability is as the skill to improve trading does not rest on new techniques, but actually centres on the trader’s own personality, behaviour, discipline, personally developed strategies and what his or her trading aims are. Since the publication of my first book, Share Analysis & Company Forecasting (1995), I have trained hundreds of traders and found a simple truism: traders start out well as they following their own rules, but quickly become inconsistent and then trading losses surpass profits. While there are many reasons for sources of trading errors, this book focuses on reducing complexities of using a combination of fundamental and technical analysis to trade in a rapidly shifting global environment. The question arises: What is different about Six Steps to Trading Like a Pro? The book does discuss, as do many other books, how technical signals work, including candlesticks, MacD, Bollinger Bands and Moving Averages. This is where similarities end. This book uses both fundamental variables and technical signals to assess, choose and buy shares in a simple to understand methodology. Instead of identifying a host of fundamental variables that could affect shares, and then throw a ton of technical signals at you, I have limited the all these issues in steps that can be easily and - more importantly – quickly implemented to enable you to buy any form of stock exchange security. AND TO DO THIS TAKING INTO ACCOUNT INVESTOR SENTIMENT AND TIMING. Why now? Aren’t popular technical signals enough? Surely, candlesticks have become the accepted form and shape to analyse any market or individual share? I am sure that experts have told you that using the MacD and RSI are enough to determine buy and sell signals and, therefore, investor sentiment? Do we really need alternative chart signals to improve trend forecasts? The short answer is that markets are no longer independent. Global factors radically influence market sentiment to the extent that candlesticks cannot alone efficiently represent a definite trend. Essentially, as global markets become more inter-connected, fundamental analysis will play an increasingly more important role; lagging/leading indicators between markets need to be better understood to become more efficient in trading. As such, the ability of traders to understand these variables forms the basis of all trades before technical signals can be used to identify potentially profitable trends. Under current globalised market conditions, where world economies have been influenced by earthquakes, ballooning national debt levels and civil upheaval, the trader’s ability to compare one Page 14 of 192
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market to another can significantly impair his or her ability to make consistent profits. Hence, the ability to apply charting signals in conjunction with pertinent fundamentals will enable the trader to understand a share’s price data, possible changes in that data and enable him or her to project key trading ranges. The aim is to establish areas of resistance or support before implementing technical signals. By using these alternative methods to forecast key price ranges, the trader actually gains skills and enhanced confidence to shape his or her long-, medium and short-term strategies and tactics. The result is improve decision making and thus profitable trades. The Six Steps to Trading Like A Pro should provide enhanced confirmation and better understanding about trends and related direction and strength. When used correctly, the Six Steps should also reduce traders’ reliance on subjective opinion, whether from media, corporate or Investor Relation news and releases. In fact, too much technical analysis without a foundation of sound fundamentals will hamper correct trading decisions. Consequently, I hope that the proposed approaches set out in this book help you to evaluate trends in an easier and quicker manner. It is also my hope that this book will promote new research into fundamental analysis and how to use these factors with technical signals. Charts should track global market cycles, differences between world major economies and political systems. Currently, they do not. Charting analysis usually focuses on price and price history. The norm is thus to ignore all outside influences and forces that could move prices. I have heard technical analysts say: “You don’t have to understand anything other than technical signals, as everything is already included and accounted in the securities’ price.” What about new company listings? These do not a price history, so should we ignore all of IPOs? How can you tell that an earthquake will happen? Is the potential of a future disaster already taken into account in a securities’ price? Least of all, politicians often make capricious statements which move markets in unpredictable ways. Technical analysis on its own ignores such influencing events. There is thus a very urgent need to assess world trends and patterns in a simple format and then to relate these variables to a set of technical signals and guidelines. Once such combined fundamental and technical variables have been assessed, a final decision to trade must be based on a filter that incorporates sentiment analysis and timing. While all this may sound too time consuming and complex, relax - all these factors are amalgamated in this book in a simple set of guidelines.
Intelligence does not always equate to success I have met many professionals, who have read a number of my books and quickly made the decision to become professional traders. Surely, you can easily change careers and become a trader? Other people do it, so why can’t you? I am in no way discouraging you to change your career to that of trader. I am merely pointing out that stockbroking is a profession that takes many years to achieve a reasonable level of success. Image a dentist changing to trader. That seems reasonable. Now imagine a trader changing to dentist. Also reasonable, if the trader is willing to go back to university to study dentistry. Now, why is it any easier for the dentist to assume that – without study – he or she can become a successful and profitable trader? It takes years of hard work, gaining experience and knowledge to become really successful. On an optimistic note, I have trained new traders to achieve a solid level of trading accomplishment. Page 15 of 192
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Trading is not a Get-Rich-Quick scheme. New traders will encounter obstacles and major problems that must be immediately resolved. Trading is thus not for the faint hearted. I believe that day trading necessitates complete and in-depth knowledge of industry and markets and the ability to rapidly assess the tsunami of contradictory information that will engulf you if you let it. Build a character of discipline and patience to endure boring routines and you will have a starting point to changing your career. To many professionals, who have approached me to change their careers to that of trader, the idea of trading means long lunches, spending more days at the seaside than in front of their computers and a life of luxury. It takes time, patience and diligence to achieve a life of uncompromised wealth. The good news is that all this is possible! If you want achieve unbelievable wealth, contact me on
[email protected] and I will assist you to effortlessly move from your current career to that of trader. So, come with me on this journey and let’s set simple rules to trade effectively. As always, enjoy and contact me personally if you have any question, whether theoretical or practical.
Jacques Magliolo
[email protected] www.magliolo.com 2011
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Preface: How the Book Works Not Like Other Technical Books From the outset, I must stress that this is not a book about the advantages of any one trading system over another, whether technical or fundamental, nor is it a preference treatment of free market ideologies over socialism. It is also not a book about globalisation, or the promotion of emerging markets over first world trading systems. I have no desire to compare, promote, criticise or lament one financial system to another or – for that matter – to shout loudly that my recommendations are the only worthy ones in the world of trading. The ultimate message is simple – to succeed in the business of trading and investing, as in all aspects of political and economic life, it is crucial to note that the world is rapidly changing on all environmental fronts. Therefore, while the objective is to set out trading methods for both shareholders and traders, it does so with the knowledge that under a globalised world it is financial suicide to ignore forces that are literally changing everything; from the way a company operates in the global environment to the manner of political governance. Without a mindset to embrace global forces, the politician cannot budget for changing world supply and demand factors, the entrepreneur becomes vulnerable to international competition and the risk profile of a trader’s strategy increases and thus becomes more inefficiencies and less profitable. Six Steps to Trading Like a Pro is a book about reducing complexities of the myriad of fundamental factors that dominate the corporate world and to take the intricate mathematics out of technical analysis. It is a book that suggests that – from my experience in stockbroking since 1987 – both the systems of fundamentals and technicals can cohabitate to the ultimate benefit of traders. Here is a blatantly obvious statement: Many policy mistakes and its consequences to world exchanges by Western governments come from a misunderstanding of globalisation. Stephen D. King, chief economist of HSBC said in a recent interview: “In the 1990s and 2000s, they (western politicians) patted themselves on the back for ‘achieving’ low rates of consumer inflation, which in reality was driven by cheap exports from places like China. As a result of their erroneous thinking, they left interest rates too low and allowed a gigantic asset bubble to swell, culminating in the spectacular collapse of the 2008 global financial crisis.” After the financial meltdown, some western politicians have targeted globalisation as the bad boy of business, who has caused unemployment, many losing their homes and eroding the real wages of workers. Their aim: clamp down on globalisation and punish export-driven emerging market countries. What nonsense, I hear you say. “And, besides, how can that really affect my trading?” I concur about globalisation being a bad boy is nonsense, but do argue that trading will be influenced by such thinking. Image a major country deciding to place heavy import duties on some
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product; or even prevent the importing of any such goods to protect their own workers. What do you think will ultimately happen to the country, its workers and the product itself? Even more pertinent: What will happen to those listed companies producing or selling this product? This book looks at how these unbelievably complex fundamentals can be simplified to produce a set of conclusions that will help traders to make better choices. As such, the principles, theories and ideas presented in Six Steps to Trading Like a Pro calls for novice and professional traders and investors to think and understand what it takes to achieve success in an increasingly growing global elite that operates on ruthless free market ideals. Therefore, there is a need to stress that, without an understanding of factors that affect overall markets, business and share movements, investors and traders alike cannot make informed decisions for the short or the long term. Among the many factors assessed, this book can be explained in a two- fold structure: The first looks at three steps that explain fundamental analysis and the second looks at three steps in the technical analysis area. Of course, there has to be chapters dedicated to setting the scene and some to conclude and explain the various chapters. Back to the globalisation debate: if free trade across the world does force companies to be more efficient and provides all nations with the ability to gain wealth, then all this simply means is that stock markets around the world will see new ones open and proposer; a global trader’s dream to be able to diversify across new global exchanges. From this book’s perspective, globalisation is merely one variable to successful trading. However, more specifically, the fundamentals outlined in this book account for correlations between various exchanges, so that the trader is able to achieve his or her desired trading targets. So far, globalisation has created millionaire traders around the proven We have seen Western traders become ultra-wealthy individuals, with many using their knowledge of global economics and business trends to make profitable informed trading decisions. Alternatively, I have seen traders who have become obsessed with technical systems. These socalled “Systems Junkie” or “Techies” believe that they can become ultra-wealthy by only using a few well-placed technical signals. When markets become volatile, like in the 2008 financial crises, many simply become bankrupt and disappear from the trading scene. The main reason is that they were focused on one system, while the other was ignored, to their financial detriment. Quietly, they leave trading and their voices are no longer heard. The problem is that many novice traders don’t take the time to build skills, experience, knowledge, discipline and control. Those who do, even pure technical traders, do become wealthy. So, Six Steps to Trading Like a Pro may mention the psychology of trading, but not in great depth. It is, however, a book, whose lessons are simple and easy to understand and implement. The idea – after all – is to get you in front of a trading desk quickly, but not before you have learnt the seriousness of becoming a trader. If you are really serious about trading, I strongly recommend that you spend as much time with drafting logical trading strategies as you do with looking at technical indicators and charts.
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THE SIX STEPS TO TRADING LIKE A PRO STEPS
THE FUNDAMENTAL PERSPECTIVE (WHAT TO BUY)
1
SETTING UP A PORTFOLIO STRATEGY
2
CHOOSING COMPANIES TO TRADE
3
ESTABLISHING A PRICE RANGE
TECHNICAL TRADING CONFIRMATION (WHEN TO BUY)
4
IDENTIFYING TRENDS & PATTERNS
5
FINDING MOMENTUM & STRENGTH
6
TIMING (BUY & SELLING STRATEGIES)
DECISION TIME
FINAL DECISION MATRIX IMPLEMENTED
Designing a Trading System
Two parts – six steps: unlike many books on trading, the aim of this book is to use an equal and evenly based system, with unbiased emphasis on fundaments and technicals. o
Fundaments assesses what you should be looking at before you buy.
o
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THE THREE FUNDAMENT STEPS o
Step 1: Setting up a portfolio strategy must include an ability to build wealth for the long term, while taking advantages of short-term market mishaps and anomalies.
o
Step 2: once your three portfolios have been designed and set up, you need a system to choose companies to trade. There are literally thousands of companies around the world to choose from, so how do you go about finding investment and trading opportunities?
o
Step 3: Once companies have been chosen (Step 2), these have to be investigated and understood in great depth. Among the list of required information is an understanding of the company’s share price. How has the company price moved during the past 12 months? How does this relate to the company’s net asset value?
THE THREE TECHNICAL STEPS o
Step 4: In the first three steps, the trader has identified – through fundamental strategy – a list of shares that offers potentially solid investment and trading opportunities. These companies’ shares have been investigated. Now, the trader needs to assess what patterns and trends are dominant.
o
Step 5: The list of shares have been filtered down to ones with strong trends and investment patterns. The strategy now is to look at these stocks and to identify which have strength and momentum. It is pointless buying a share that has a strong trend, but the momentum of that trend is weak.
o
Step 6: all issues and strategies have been implemented and the trader is ready to buy his selection. This final Step sets out buying and selling levels to enable the trader to optimise returns.
Each of the above steps should be applied as follows:
Establish a fair and reasonable time frame: o
For share section, identification, fundamental and technical analysis.
o
Type of trader you are: In Lore of the Global Trader the various forms of trading are set out.
The issue here is that you need to decide what kind of trader you want to be. Do you want to trade every day, weekly, monthly? This influences the amount of time you need to research stocks and also the amount of time you need to assess trading patterns.
Define Your Risk: When developing your system (or trading style), it is crucial to define how much you are willing to lose on each trade. This is a personal matter and only you can determine that amount. A general rule of thumb is that you should never commit more than 2% of your total capital on any single trade.
There are many systems that do work, but many traders simply lack enough discipline to follow their own set of designed rules. Consequently, many end up losing serious money. In essence, a trading system should attempt to:
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Enable you to identify trends quickly. Enable you to confirm the above trends. Enable you to confirm when a trend has started to die
If your trading is profitable, but you use only some of the above steps, then you have done well. Once you've tested your trading system for at least 2 months (as a demo account) and you are still profitable, you are then ready to trade on the exchange. However, you must always remember to stick to your rules. Opportunities will always arise from improved knowledge. How can the shareholder or trader position himself or herself for future growth if they do not have an understanding of how current worldwide trends could affect their business? In addition, how can they position their trading business without a fair prediction of how current trends could change in the future. So, this is a book of investment and trading strategies. I need to stress that the only way a strategy can work is if it is used in a logical manner. Therefore, don’t ignore one system of the other. Use these to your benefit and to improve your trading; especially with world economic forces continually moving and changing investment techniques. What and where will you be as a trader in future if you don’t understand global macro-economic and political trends?
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Chapter 1: Introduction “The four most dangerous words in investing are, It’s different this time.” Sir John Templeton (1912 - 2008) US-born British stock investor, businessman and philanthropist
Sir, sir , sir…. I looked around. No-one else was walking along the long austere corridor of the Johannesburg Stock Exchange in 1990. This young women was waving at me. Who was she? She came up to me, breathless from the long run. “Sir, sir, sir…” she repeated. “Catch your breath,” I said, adding, “aren’t you a dealer for Sid?” Sid was the name of the owner and managing director of one of the largest stockbroking firms in South Africa. I had just been appointed as junior industrial analyst. “…and stop calling me sir! After all, you must be less than two years younger than me.” “Ah, but you are an analyst,” she said, with a heavy tone of sarcasm, “and I’m just a dealer.” That made no sense. I knew that most dealers earned more than twice what analysts made in those days, and I was late for a meeting …... So, not wanting to debate the issue, I asked: “was there something specific you needed?” “Your last company report was absolutely accurate and I was wondering whether you have updated that report? The share hit the 120 cent mark as forecast. What can we expect in the next couple of weeks?” Being accurate wasn’t a compliment; just confirmation that she had made a commission on one or more successful trades.” Now she wanted to know what was next for the company, so that she could make yet another commission.” “Aren’t you supposed to be conducting technical analysis on analysts’ recommendations?” “Caught out,” she said, and turned away, walking back towards the trading room. “Thanks anyway, sir. I’ll wait for your next report to be published.” The easy route to trading is to accept what market experts say, follow rumour and conjecture. The more accurate way is to do the work yourself and follow your own analysis; waiting for someone else to complete a report is a waste of time and trading opportunities. This is obviously more difficult and time consuming, but ultimately will be the single most differentiating factor between traders who are ultra-successful and those who trade as a hobby.
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Now, there are libraries full of books on how to set up personal trading strategies. I have written many articles about trading journals, how to establish strategies and how to trade world markets, from local and global securities. This book cannot cover all these issues in great depth, but can start by telling you what the pertinent facts are to establish yourself as a serious trader. The first step in any serious venture is to conduct your own analysis of the market or business you are about to enter. I don’t know of any real business that is free, so I am assuming that you intend to spend hard earned cash to start a trading business. Trading, like any business, takes patience, time and funds to establish. There is no point in saying that all you need is the funds to invest in securities and “everything else you will learn as you go along!” That is the easiest recipe to financial ruin. I have written many business plans in the past decade, some complex and running into several hundred pages; covering issues relating to corporate profiles, shareholder structures, strategies, financials and growth plans. A trading business plan is important, but should cover two main issues, namely those relating to personal daily routines and, secondly, issues relating to the trading business itself. These two topics are set out in the following text.
Your Trading Business Plan Definition: A business plan is a formal statement of a set of business objectives, reasons why you believe these can be achievable and a set of strategies to reach such goals. It usually contains data pertinent to capital providers, such as (among other) background information about the organisation, directors and financials.
PRIVATE ISSUES You are about to enter a complex financial world where greed, panic and hope are the order of the day and often takes place at the blink of an eye. I have told the story before: a colleague spent 12 hours watching markets – nothing happened. He decided to take a 10 minute break. Guess what happened? In those 10 minutes, the market he had invested in had fallen by a staggering 20% as the World Trade Towers fell in 2001. In 10 minutes, he had lost an unbelievable R7.3 million. To make matters worse, his portfolio was not diversified and the shares that fell represented 60% of his portfolio, so he lost - in that 10 amazing minutes – 50% of his entire wealth. Not to put a finer point on the issue, I asked him if he had a business plan to set out how and when he should trade. He just glared at me, which in itself was an answer. He seemed to have ignored the premise that trading is a business where people lie, cheat and create rumours just to influence share prices. In addition, professional traders can today trade for clients and simultaneously for their own book. Many market observers say that this is a conflict of interest and often creates unrealistic share movements in favour of brokers and thus to the detriment of private clients. Maintaining a positive attitude during such trying times is in fact extremely vital for success, and negativity is one of the greatest challenges a trader must overcome; especially when massive earthquakes render the world’s third largest economy useless. In addition, I have seeing successful traders doubt themselves at crucial times and that loss of confidence – no matter how brief – renders traders useless. Page 24 of 192
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You cannot expect to succeed in the long-term if you cannot see trades in an objective and unemotional manner. If you lack confidence and skill to take logical trading steps without hesitation, then I suggest that you look for a less tense career. The answer is to start your trading career slowly, to enable you to build confidence while assessing your risk profile. You do this by first establishing a long-term share portfolio, which concentrates on blue chip stocks. The three portfolio of billionaire traders is outlined in Chapter XXX. What I can reiterate in this section is that the first goal is to look at why you are negative in aspects of trading. As a trader, you need to be positive, but always have a healthy and realistic respect for the market. Some experts suggest that you only have to stop reading negative media stories to build a positive attitude. I believe that this is – in a world where you can make money in a bull or bear market – insufficient and actually sets a dangerous precedent. The aim is to actually see negative events as a positive trading opportunity. Look at the various needs around the world and ask yourself: “who will benefit from such an event?” The answer is usually: those who will rebuild that which has been devastated. Look again, and ask: “which listed companies will benefit from such rebuilding?” While many of the older professional traders will see the above as a complete waste of time, newer market players in the field of futures will tell you that trading equities does help you to improve your trading results. Don’t try to trade Futures without skill, knowledge, trading savvy and, of course, the ability to trade with confidence and positive thoughts. Yet another obvious statement to make is to stay away from people who are trading as a hobby. You want to associate with professional traders. After all, it is through such associations that you will develop necessary skills to build confidence and trading skills. I have a wide cycle of colleagues in the market, who exchange trading ideas and debate new issues. As an analyst and trader, therefore, I am constantly on the lookout for trading ideas that will make me think and possibly rethink my strategies. There are many groups in South Africa that enable you to discuss market and company related issues. Apart from chat rooms on the internet, look for professional business associations. These will be made up of analysts and traders who are making a living from these professions.
ESTABLISH A ROUTINE
Start the day with a lengthy fast walk; at least 30 minutes. Remember that you will be sitting in front of a computer for hours a day – so start the day with an exercise that will keep you strong.
Spend at least the first hour of the working day with administrative tasks. Get these out of the way as they become a distraction during the crucial trading hours.
Have a designated strategy for the day.
Set entry and exit points before the market opens.
Research the financials of companies you wish to invest in.
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Check the profile of world market indices for the past 24 hours.
Determine the financial commitment you wish to make in each trade.
Determine how much time you intend to invest in your trading day. o
For some traders this might be a few hours a day or even a week.
It is important to keep a record of all trading transactions in a journal.
Trading Plan Sections A solid trading plan should have well defined plans and strategies:
Trading Objectives and goals: What is your trading objective for the day and how does this apply to the overall trading strategy? For instance, how many trades do you intend to do each day and how much will you spend on each trade?
Trading programme: Do you have a tactic to improve your trading ratio of profits over losses.
Defined Trading Plan: A professional trader will always clearly define the point at which he or she will buy a security and also the point at which he or she will sell that security. o
Entry method: based on market conditions, such an entry point may be on the down or upside.
o
Examples: if ABC Limited’s share falls by 15% off its current high, I will buy R10,000 worth of stock.
If ABC Limited’s share breaks the Resistance level twice, I enter the position if the moving average confirms the buy.
I will always only buy if the position is supported by significant volume.
Exit method: Always choose a trailing stop loss and clearly define the sell point. There must not be an ambiguity to the statement.
Examples: I will sell my entire position when the share has climbed by more than 30%.
I will sell my entire position if the share falls below the second stop loss.
The exit will always be just under the support of the first hour range.
If a trader is making continuous losses, there is something wrong with his or her strategy. Continuing to trade under such conditions is suicidal. Stop trading and review your strategies before you resume any form of trading.
Examples: o
If you make three losses in a row, stop trading. Page 26 of 192
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o
Stop trading immediately if losses account for 50% of your portfolio value.
If the above happens, many traders decide to stop trading for at least a week, while they re-evaluate their strategies and trading techniques. In addition, check out and conduct more analysis on the market and trading conditions and risk management. Finally, what about you? If trading is a business, then you have to have a section of the business plan that covers salaries. Ask yourself: what do you need to cover your expenses? If trading doesn’t meet your expectations, maybe you should review your trading objectives or stay in your current career.
CHAPTER SUMMARY This chapter stresses that homework has to be done before the real business of trading can commence. Novice traders need to be prepared to spend time laying down a serious foundation of knowledge, before they can expect real success and also real returns from trading. IN THE NEXT CHAPTER In Chapter 2, beginners are frightened by jargon, level of work and sheer technical and fundamental expectations.
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Chapter 2: Are You Crazy? “Rule No 1: Never Lose Money. Rule No 2. Never Forget Rule No 1.” Warren Buffett (1930 - ) US Billionaire Investor, Industrialist & Philanthropist
A Story to Offend I apologise if the following story offends you: And so it has been said in ancient script that …. ….. one day, Odin - chief of all Gods and the ruler of the universe – came down to Earth on his great white steed. He roared over the clouds, bringing thunder and rain to a small South African town. The steed swept past vast landscapes filled with flowers and shrubs. He finally came to a standstill on a quite beach and dismounted, rubbing his one good eye. He surveyed the world he had won when he had overthrown the primeval giant Ymir and fashioned the world from his remains. He shook his head: “I left my home in Asgard (near Valhalla), where I feasted with the spirits of slain warriors, to come to this? He said, with sadness. He threw his spear into the soil and – again – rubbed his good eyed, having exchanged his other eye for wisdom millennium ago. “If I really had wisdom,” he thought, “I would have slayed Frey, so-called God of Peace and Prosperity eons ago.” Odin stood tall and thought of Thor, his son and also Gold of Thunder. “Now, if I had combined the God of Prosperity with Thunder, maybe I would be back home in Valhalla.” He waited patiently, knowing that the person he sought would soon be walking his way. The most beautiful mansion in Asgard, where the heroes slain in battle feasted each night would have to wait for Odin, for more urgent matters needed his attention. Trader Jack – for that was what Odin would call him – came walking rapidly and Odin smiled. That was what he liked - warriors gathering accurate information. “You. Come here.” Odin had never quite understood the meaning of politeness. But it was Trader Jack’s turn to smile. He too didn’t know the meaning of politeness. After a brief introduction, Trader Jack waited no time to answer Odin’s question. He said: “Odin – there is a fundamental contradiction in your setup.” Odin listened. “After natural disasters, like the one in Japan in 2011, two things seem to happen almost simultaneously. The first is that religious zealots immediately claim that it’s retribution for some misguided policy, such as Aids in Africa after famine or not been a Christian after floods in India.
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“The second is that economists and analysts will claim that natural disasters are good for economies and companies.” Trader Jack added: “If the above is true, then you cannot have a God of BOTH Peace and Prosperity. Death and destruction thus leads to wealth as rebuilding starts. It is therefore not peace that results in wealth.” Trader Jack continued …. pure destruction results in significant construction (often paid for by world economies through charities) which, in turn results in jobs being created for the poor. More people become more wealthy. GDP and GDFI are boosted as labourers spend wages that stimulate all facets of their economy. “Japan must surely be better off after its earthquake and tsunamis?” asked Trader Jack. Odin looked at Trader Jack: “For that matter, then what is the difference between Wealth and Prosperity?” The truth is that the wealthy can more easily overcome disasters thrown at them by Mother Nature. Prosperity, on the other hand, is derived from the Latin word for “hope” and confuses the goals of attaining prosperity with the means of achieving such targets. Trader Jack finished by saying: ”In essence, during peaceful times wealth can be attained, but money flows stronger during disasters that affect people.” “So you don’t really care that peace is good to attain?” Odin said. “I am a trader. My job is to look for short term market anomalies which will make me wealthy. I know that if I continue to do this, that over time, I will become prosperous – whether there is peace or not. In the longer term, disasters are obviously not good for world economies, as these divert much needed funds away from important projects to life saving ones. Those important projects still have to be done – but often at higher costs.” “And let Peace be left to the Gods.” Odin roared with laughter. “You, “said Odin, “ will be my next God of Wealth.” And with that Odin was gone - back to Thor and Freya, his son and Goddess of Beauty and Love.
There were three reasons for the above near-blasphemous story:
If you are offended by a mere story – stay out the market.
If the thought of taking advantage of the weak in society appals you – stay out of the market; if you don’t, others will.
Remember, you are competing against other traders. Disasters are resolved by world politicians, organisations and banks – it is not your responsibility.
Predictable Habits of Traders The stance of many professional traders is that traders ultimately only trade against each other in a competitive pursuit for profits at the exclusion of all other variables. Therefore, if you – as a trader – understands how other traders think, you will have a definite advantage no matter what is happening in the economy; disasters included.
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The heading for this chapter is Are You Crazy? The full heading should actually be Are You Crazy To Be Entering This Industry With So Many Unpredictable Variables? One minute you are making so much money that you are stunned and living the life of a millionaire, the very next minute you are losing it all, facing the Sheriffs-of-the Court and having repossession orders lodged against you. Yet another trader will be making trades based on solid fundamentals and lose his or her capital, while a complete novice (without experience or skill) will pick the right stocks and become instantly wealthy. Do you really want to be part of such an industry? Years ago, I started looking at the habits of traders (novice to professionals) and noticed a number of common threads among their behaviours. In fact, there are surprisingly few threads that should enable you to become more perceptive before we plough through serious fundamental and technical analytical theories in later chapters. The answer is quiet simple: Yes, you have to be a little crazy to be a trader, but it is fun and certainly beats working for a boss. And, again – yes, you can make serous money if you are professional about trading. There will always be the lucky and inexperienced trader who will make serious money – you can take comfort that they usually lose it all in the end. Of course, depending on how markets behave, trader’s perception also change. Trader habits can be narrowed down to a number of market-linked reactions. Imagine that you could determine how other traders will react when a set of economic statistics is released. If such data is negative, will they sell or buy? Knowing such information would enable you to place your securities in a better and more profitable position before data or environmental events take place.. The key is thus to know what the relationship is between trader and market. The first thread (or common behaviour) is that of traders who simply react to events without analysis. They sell on negative news and buy on positive. They wait for the market to react before they take a position. The norm is that they make little money and often not enough to cover their costs. These are, what I call, the Market Sheep. Another common behaviour is that of traders who buy based only on long-term trends, called an Investor – as opposed to A Trader.. They also do not really affect short term traders, other than to provide a sense where the long term trend is. I am more interested in the next two types of trader habits. The first is that of the professional trader who sticks to his or her belief no matter what happens to the market. The second is that of traders who speculate. In the first, someone who believes that the market will always be in an uptrend ignores that markets do fall (The Ultra-Bull or Ultra-Bear), while the second is merely following rumours and innuendo, called The Speculator. the To take the above habits into account, I have also developed a set of personal habits; as follows:
Never let a trade fall or rise to a point where you start to worry. Remember that Market Sheep will continue to trade until overall sentiment changes, then you will be on the wrong side of the trend.
Anxiety, hope or greed should never be part of a trading habit. Ultra-bulls or Ultra-Bears will be there to take up your sale or buy orders, but waiting too long makes you susceptible to loses.
Concentrate on realities and analytical forecasts instead of probabilities and rumours. Speculators have already taken up most of profits on short term rumours. Stay with trading market anomalies on strong long term trends.
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Remember, equities will always outperform banks’ interest rates – so, getting into the stock market is not really crazy. A simple look at the JSE All Share Index over a 10 year period confirms this.
Still Crazy – The Following Is For The Uninitiated While this book is really for those who have some understanding of how markets work, the following is a simplistic overview as a precursor to the more complex issues outlined in further chapters.
What are shares? Imagine you are an entrepreneur, who owns a fishing boat. Now, over time you have managed to build your business into a fleet of six vessels. You know that your private company has reached its zenith. Without additional capital, you cannot buy more boats, or maybe expand into related businesses, eg. Have a fish restaurant. You start off with a plan to go to the bank and raise some funds to build a restaurant. The bank insists on seeing a business plan, three months bank statements and so on. After some assessment, the Bank agrees to provide you with a loan of R5 million at an interest rate of prime +2%. You go home – elated – that you can now build the restaurant, and maybe buy an additional two vessels. After a few years, you realise that – in fact – your restaurant wasn’t as successful as you first envisaged, because advertising costs are too high and your boats are too small to go further out to sea. And a whole lot of other issues …. So, you are prepared to sell part of your business to private partners. That may be easy – or extremely difficult, depending on your type of business, cyclical nature of profits etc. A common problems is placing a value on the company. Now, imagine that the above business went to the stock market to list instead of trying to find a private investor. The stockbroker (called a Sponsor for a JSE Main Board listing or a Designated Advisor for a JSE Alternative Exchange listing). The broker would split the ownership of your company into millions of shares. These shares would be offered to investors through the stock market trading facility. If these investors believe in your company, they would buy these shares and you would have effectively raised capital by selling a portion of your business to a mass of private investors. These investors are now part owners in your business and are called Shareholders. This gives them the right to, among other, share in the growth and profits of your company. There are several different types of shares, but the most common type is called 'an ordinary' share. The reason investors buy shares, therefore, is not to help you, but because they believe that your company will do well in future and the share price will rise. A higher share price is called capital growth, while payment to shareholders of a Dividend can be described as an interest paid to shareholders. A dividend payment is not always undertaken by the company. Most economically developed countries around the world have one or more stock markets, either run as an Open Outcry system or an Electronically-based one.
Is it risky to buy shares?
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There is an stock market saying that the higher the risk, the higher the potential reward. This means that if you buy a share that is risky in the sense that the company is small, has not made great profitable strides, then the potential reward – if the company does perform well – is high. For instance, some years ago io was analysing the coal-related market and came across a share trading at one cents. The company had only one contract, had not made profits in years, but it did have unique technology. Further analysis indicated that this technology was highly sort after in the US. It does not take a genius to see that the company must, surely, be in discussions with potential buyers. I recommended the share as a High Risk - High Gain speculative stock. As expected, the company soon announced that it had plans to “join a foreign partner in developing new markets.” The share rose from one cent to 300 cents in a matter of two weeks. The alternative is that the company could have continued to perform badly and even be delisted; shareholders would have lost all their investments. The less risky shares tend to be the bigger companies, which make up the Indices. These multi-nationals are called Blue Chips and tend to have strong finances, a long history and are far less risky than small, recently-formed companies. Such companies are unlikely to go bust, but the safety aspect tends to give you less capital growth than the higher risk ones.
Chapter 2: Are You Crazy? CHAPTER SUMMARY Basic concepts were discussed to provide a basis for novice traders to start composing their trading plan. A story was told to offend the uninitiated in the typically ruthless nature of stockbroking. If you were unaffected by the story, read on; if not, trading may not be for you. IN THE NEXT CHAPTER In Chapter 3, the work starts with a set of crucial rules to help you to trade both effectively and efficiently. Know these intimately, before moving onto more complex issues.
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Chapter 3: Rules to get Started “Markets can remain irrational longer than you can remain solvent.” John Maynard Keynes (1883 – 1946) UK economist who influenced theory and practice of modern macroeconomics
35 Essential Rules Here is a truism: people hate losing money. I am no exception. They will go to the extent that they will deny having made a loss in the market! They will blame market conditions, or slow and inefficient computer software before they will stand up and take responsibility for their actions? Personally, I hate admitting that I am wrong even more than making a trading loss. How do these relate? Well, if you follow your own set of rules, then you should achieve more profits than losses. However, if you deviate from your own rules, and make a loss – whose fault is it? If you do ignore your own rules, either change these or admit that you made a mistake and say that you have learnt from the loss. In this manner, you can move on to becoming a better trader. The focus of trading is not to never make a loss! That will simply not happen. The goal is actually to have more profitable than losing trades. With this in mind, the following general rules should provide you with some helpful hints for you to start building a solid foundation for your trading career. Remember that a very small percentage of all new traders around the world are successful within the first year of trading. Yet, some traders do accumulate immense wealth very quickly. What do these successful traders do that is so different to enable them to benefit from intimidating world markets? Searching for the answer to this question is what started the process of gathering the raw material for Six Steps to Trading Like a Pro. Some of the following rules are very basic and obvious, but many have been used often by millionaire traders. As such, it offers you a basic start to the more complex rules that are set out in this book. The following are some of the more important rules that were generated from the many workshops carried during the past decade.
GENERAL TRADING RULES Rule 1: Ask the question – who are you? In my book on global trading, called Lore of the Global Trader (Penguin 2011), I set out a list of basic questions to enable you to determine what your level of trading knowledge is; the list is available on request, so send a query to
[email protected]. The interesting aspect of the list is that many wannabe traders return to tell me the obvious: they are not ready to actually trade. The following questions can be used as a precursor to the mentioned list:
Do you have an objective temperament, in a subjective environment? Do you have an ability to control your emotions even when the market is crashing?
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Can you make a position and sleep at night?
Can you focus enough not to drown in the massive amount of market information (often contradictory) continuously made available on the internet?
Rule 2: Can you afford to lose? There is a rule which suggests that you should never trade with funds which you need to live on. In other words, don’t use money to buy shares if you need that money for groceries. Then, there is a school of thought which says that people get mortgages to buy vehicles and homes, so why not do the same to buy shares? After all, if you have a well-defined trading plan, shouldn’t your risk profile be minimal? The reason that many pundits suggest that you do not use funds needed elsewhere, is that such funds will affect and influence your trading decisions. Often, the emotional aspect of trading is much more severe for beginners than for the more skilled trader. When you are staring out, there is a greater likelihood that emotions will influence trading decisions, compared to the more experienced trader. Consequently, trading funds should always be viewed as money you can afford to lose. One of the keys to reducing emotions in the trading sphere is emotional independence between private wealth and your trading account. Rule 3: Personal wealth and trading funds should be separate. Following on the previous rule, a trader should not be in a position whereby he or she “hopes” that their trade will be profitable. The successful trader must always be able to remove personal from trading emotion. When you find that you are “hoping” that a purchase will be favourable, usually it isn’t. Rule 4: Preserve your trading capital. Without wishing to sound like a pessimist, there will be times when you will encounter losses even if you follow the above two rules. The answer is to ensure that each trade doesn’t influence the entire portfolio. this is achieved by having a diversified and balanced portfolio. these terms are explained in Chapter XXXX. Rule 5: Don’t be a sheep. Successful traders are not influenced by current or fashionable trends. When everyone concentrates on long positions, they tend to be contrarian and go short. The theory is that, if 85% of buyers are bullish, then the market is overbought. Conversely, if less than 25% are bullish, the market is oversold. Only sheep follow. Successful traders use this theory to buy when everyone else is selling and vice versa.
RULES TO CONSIDER BEFORE YOU TRADE Rule 6: Always review overall market news. The skilled trader does the following: he or she will assess local general and corporate news and then compare that to global news. Then look at sector indices and how these have reacted to such news items. Follow that up with specific assessment of shares and related news issues. These will act as an alarm, warning you of potential shifts in the market and, of course, specific shares. Rule 7: Do you know what markets you want to trade? Start with the above rule to determine which sectors are interesting ones, i.e. which are in an upswing. Know what your trade limitation is and then buy within that limit. Rule 8: Set trading boundaries. To complete the above rule with a rule: keep three to five times the money in your trading account than is needed for any acquisition. You may have to reduce your position to comply and also avoid trading decisions based on the amount of money in your account. There will be times when a “hot” tip will convince you to buy a share out of your limits – don’t. you will simply be risking your whole portfolio if you do.
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RULES THAT ARE TRADING SPECIFIC Rule 9: Assess five possible shares to buy and select three for further analysis. I usually select five shares to assess based on fundamentals and then eliminate two based solely on global trends. The remaining three are placed through the Six Steps as set out in this book. For instance, if five shares include two gold companies and the gold price has started falling, then drop these two shares immediately; this reduces time wastage. Rule 10: Confirm one-out-of three trade. Of the three trades, as set out in the above rule, I recommend that you choose only one. Remember that the more stocks you have in your portfolio, the more time it takes to assess, reassess and trade such stocks. Rule 11: Start relatively small. I have said this on many occasions: start by making virtual trades, before you enter the real world of stockbroking. Then begin to trade in small amounts, such as R10,000 per share and get five shares. Rule 12: Define clear BUY and SELL points. This rule is easy to say and every trader has the intention to keep to this rule, but many fail to do so. Here is the problem: a trader stats that he will sell a share if it falls by 10%. When the share does fall by 10%, the trader hesitates and keeps the share, hoping that the share will turnaround. Rule 13: Do you really have to trade today? Stated differently, if you are not comfortable or your rules don’t line up for a trade, then I suggest that you stay out of the market. Another way of stating this rule, you do not have to trade every day, or even hold a position every day. The novice trader often feels that he or she must have an open position every day – this is not true. There are times when the market is completely dead or too volatile. Use these times to complete research and market analysis. Successful traders tend to have patience and strict discipline, enabling them to effortlessly wait for an opportunity before they acquire securities. Rule 14: Patience is a virtue. Strangely, not every trade will be a profitable one. An obvious statement to make is that markets do go up, but also fall. my strongest recommendation is to stick to your strategy and to keep within your predetermined chosen markets. Ultimately, you will also learn to wait before acting on a selected Buy or Sell strategy. Rule 15: Emotion can kill you. Experts always say the same thing: never chase a share or market, even if you intended to acquire a share, but failed to execute your trade on time or at the predetermined price. Remember that there will always be other opportunities. To remove emotion, always have a stop loss and an exit strategy. If the market suddenly moves in the opposite direction of your trade, you need to know that your stop will be executed. As such, there is absolutely no reason to panic. Rule 16: Averaging down or up is a skill. The rule to averaging is not to add more to a position than you already have. For instance, if you have 100 shares in ABC Limited, don’t buy an additional 100 shares in the share price falls. An ideal situation is to pyramid by 50% of the shares, then 25% , followed by 10%. This is conditional on the market showing promising signs of a turnaround. It is also recommended that beginners avoid the "inverted pyramid" type of averaging. This is when you add more than your original position with every new averaging down. This is dangerous, as any market reversal can render you bankrupt. Rule 17: Do you have to trade specific markets? It is always recommended that beginner traders develop an understanding of local bourses before they move to trading global exchanges. This does not, however, mean that they negate the importance of trading outside their country. There are times when you should ignore local trends in favour of foreign ones. Page 35 of 192
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RULES THAT RELATE TO ACTUAL TRADING Rule 18: Stay out of the market for the first 30 minutes of trading. This rule helps beginners to be patient and to be more careful about the trades before entries are made. Admittedly, this rule means that you will miss some opportunities, but it is better to miss entries than to make bad ones. Rule 19: Avoid market orders. Placing an order at the current market price is purely a lazy way of trading. The skilled trader will determine liquidity and tradeability before putting in an offer (See Chapter XXX). To avoid violating this rule, place specific price limit orders, using the 3-2-1 rule, as set out in Chapter XXX. Rule 20: Stagger pricing. If you want to get the best price possible for a number of shares, you may want to do it in four instalments. This enables the beginner to see if the market is moving in his or her direction before becoming totally committed. Successful traders use both fundamentals and technical signals to guide their trading and to determine pricing. Rule 21: Cut losses. When a share falls to your stop loss – sell immediately. If you get into the habit of keeping to your rules, you will ultimately find that trading is less stressful and more analytical. The rule is simple: admit that you made a trading mistake and move onto the next trade. Strangely, you can be a successful trader by being right on less than 50% of your trades. The condition is that you keep to your stop losses, but let your profits run (see next rule). Rule 22: Let profits run. There is an old saying that a share can only fall by 100%, but can continue to rise infinitely. So, why would you cut profits short? The reason is that young traders tend to panic when shares rise or fall too quickly. Admittedly, there is no problem in taking profits, but why not let your profits increase to higher levels? Many experts traders concur that you should never take a profit simply for the sake of a profit. You should have a reason to close out a profitable position. Rule 23: Sometimes, losses and profits make no sense. During a conference in 2009, I used an example of a trader who saw shares rise on poor financial results, while the same trader saw a share fall on another company’s good results. The poor novice was so confused that he decided that being an architect was easier. The reason for the above is that a share could fall on good results, if those results were not as good as the market forecast and, conversely, a share could rise if poor results were not as bad as the market expected. Rule 24: What is your stop loss? This rule is easy to understand and to implement. The only difficulty is in choosing a stop. I recommend a 15% initial stop on a trailing basis. Reduce that to 10% when the share rises by 10% and then to 8% when the share has risen by 15%. In this way, you lock in profits, while not being too tight – which could see you being kicked out of your position too quickly. It is always recommended that you immediately get into the habit of always setting a stop loss. Never trade without one. Rule 25: Never ever ignore your stops. Once placed, your stop loss stays in. keep to this strategy, as you cannot guess which way the market is going. If you try, and ignore stops, you will without doubt regret your decision. Rule 26: Never add to a losing position. If a share is falling, there will be a temptation to try and rescue the share by averaging down. Remember that this strategy is very specific and linked to numerous filters. It is not a guessing game as many novice traders believe, to their regret as they merely compound ultimate losses. Page 36 of 192
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Rule 27: Can you judge potential profits before you trade? My personal trading mentor – back some 15 years ago – told me to have a plan in place to sell your security even before you enter a trade. Essentially, it goes like this: if a stock rises by 15%, place on a watch list. If the stock rises by another 10%, sell enough shares to recoup your original cost. I have added the following to my mentor’s strategy: when you recoup your original cost, remove the share from your portfolio. have a second “Free Share” portfolio, which you keep for the long term. Have a stop loss of 15%. Rule 28: Place stops immediately. This is merely a rule to stress the importance of stops. Never break this rule, under any circumstance as it is the best way to protect your capital.
RULES FOR AFTER YOU HAVE PLACED YOUR TRADE Rule 29: Continuously monitor trades. There is no point in monitoring long term trades every day and, conversely, it is plain stupid to monitor short term trades only every month. In the first instance you are wasting your time, while in the second instance you could end up with a stock falling to nothing. The important point is that you should use short-term technical signals for short-term positions, which includes strategic and pertinent monitoring of your stocks. Rule 30: Can you change stops as needed? The simple answer is that you can. For instance, if a position rises really fast, it is recommended that you tighten your stop to lock in profits. Sometimes this change in stop enables the trader to take profit beyond his or her original profit target. Rule 31: Always be flexible, but don’t forget to take profits. The strategy is to know your own timetable. For instance, if you know that you have to be in conference for two days, then sell short positions which you will not be able to monitor. Rule 32: Take regular breaks. Trading every day does eventually get boring. And boring gets to hamper your judgement. It is suggested that traders take a complete trading break every six weeks. If you are successful, go on holiday for a week, but if you made a loss, spend the next week researching and analysing markets. A break from the trading desk helps you to reassess your strategies and see the market in a fresh manner. Rule 33: Believe in yourself. Once a strategy has been established, don't let colleagues or rumours deter you from trading to your plan. Decisions made during the trading day based upon short term shifting trends or news items are often disastrous. It is better to formulate a strategy based on logic before the market opens, then enter the market at a predetermined price range. Rule 34: Stay the course. Remember that you have to be strong willed and disciplined to succeed in the market. Stick to your strategy and you will dramatically increase the probability of trading profits over losses. Rule 35: Analyse every trade. Every time I trade, I write down the time, date and price of the trade. I also provide a reason for the trade. Every week, look at the successes and failures of your trades and critically assess why you bought and sold the stocks. Over time, you will develop an eye for profitable situations and a logic for selling. Personally, I analyse every trade, even after a decade of active trading. COMMENT: The above trading rules are important and will take time for novice traders to start implementing them. Somehow, novice traders often find it difficult to incorporate these rules into their daily trading plans. As such, I have no doubt that it will take time for you to so, but be warned: the longer it takes you to start using these rules, the quicker you are headed for losses.
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CHAPTER SUMMARY Some of the most important and crucial concepts (stated as rules) in the world of trading were outlined to provide some ground rules for novice traders. Guidelines outlined in the chapter covered issues prior to, during and after trades have been placed. IN THE NEXT CHAPTER In Chapter 4, the concepts of fundamental and technical analysis – the basis for this book – are set out.
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Chapter 4: Forms of Analysis “It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person's ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making.” Alan Greenspan (1926 - ) US economist and former Chairman of the US Federal Reserve
A Day in a Newsroom THE JSE ALL SHARE INDEX
One day in October 1987, I was sitting in the newsroom of the Business Times, the financial insert of South Africa’s most successful weekly newspaper, The Sunday Times. I had been appointed as a junior financial journalist and the following discussion with one of the senior editors needs to be repeated; as follows: Editor: “So, what form of analysis do you subscribe to?” JM: “Well, Ed, I believe that – as a graduate of economics – fundamental variables will always rule the day. Technical signals are visually more agreeable, but I don’t really believe that they take all factors into account.”
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Editor: “Oh, really?” It was his face that really told me how he felt about my comment. I quickly realised that I had just made a major blunder. Here I was, a junior, telling this senior editor that I was a graduate (I found out later that he had been trying forever to graduate) of finance and that I didn’t truly believe in a technical analysis. My comment may have come across as knowing better than him! I tried to repair the tramped toes: “Ed, what do you see as being the major current technical signals?” Ed: “Resistance levels are solid, and shares still have some upward momentum.” The date was the 19th of October 1987 and the JSE All Share Index was at 2804. He had barely uttered these words when a senior writer entered the newsroom and practically shouted: “the market is crashing!” Within two weeks the JSE All Share Index had fallen by 40% to a level of 1682. Let me reiterate: I am not advocating any analytical system over another. All systems have merit if they can help a trader make a decision on what to trade and at what price. There are effectively two main systems, namely technical analysis that assess share movement and price and fundamental analysis that assesses the company and the environment within which it operates. Recently, another form of analysis had started to become more prominent. Sentiment analysis is used in Six Steps to Trading Like a Pro as the final filter to decision making (See Chapter XXX).
ANALYTICAL METHOD 1: FUNDAMENTAL ANALYSIS For as long as stockbrokers have tried to automate decision making, there has been debate as to which analysis is better, but let’s set aside debate in this book and consider both forms as equally important. Remember that three of the six steps are based in fundamentals and the other three in technicals. Fundamental analysis is usually equated with in-depth analysis of economic variables, including statistics, qualitative and quantitative analysis. We can go further and say that this form of analysis requires some accounting knowledge as you have to assess companies’ financial statements. Without doubt, the above cover a vast array of information, including environmental and corporate reports, new legal and statutory regulations, and stockbroking schedules. Fundamental analysis is therefore the study and use of the four environmental factors of economics, politics, business and technology to assess and forecast influencing variables which will affect future price movements. In fact, you have to take the above stated environmental factors and apply them to global markets, regional areas and country-specific sectors. Then, in addition to geographic analysis, you have to apply that analysis to macro-economic (GDP, inflation, unemployment etc.) and micro-economic levels (company analysis). To relate the above to a trader’s specific needs, fundamental analysis provides him or her with knowledge on how general market conditions could influence price action. The importance of fundamental analysis is thus the ability of the trader to understand how certain issues influence others, such leading and lagging indicators in both economic and stockbroking spheres (See Chapter XXX). Remember that all news (good or bad) renders a reaction from investors and speculators alike. Then there are the strange reactions by speculators to news not being released:
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no specific report has been released, but the anticipation of such a report is so great that speculators move markets. One of the most used and spoken about economic indicators is that of supply and demand. This can be used as an indicator of where price could be headed with the following basic guidelines:
Supply: when there are less buyers than sellers of a share, supply exceeds demand and the price should fall.
Demand: when there are more buyers than sellers of a share, demand exceeds supply and the price should rise.
Price: this is influences by quantity of shares in the market and the ability of traders to buy and sell, i.e. liquidity and tradability.
The single most important fact to remember about fundamental analysis is that it is an assessment of stock markets (companies) relative to economics. In essence, the stock market is the leading indicator of economic growth and, therefore, if a country's future economic outlook is good, then companies should improve todasy, or –stated differently – the current performance of the stock market is indicative of future economic growth. This means that the JSE is the leading indicator of economic growth. This is one of a number of crucial issues that has to be understood if you want to be a successful trader. If you don’t understand this concept, then every trade you make will be based on incorrect assumptions. Can you image how successful your trades will be if that is what you ewnd up doing? From a global perspective, if your county’s economy is solid, the more foreign businesses and investors will invest in your country and stocks will ultimately rise. So, ass the economy gets improves, interest rates are raised to control growth and inflation, which makes securities more attractive. In order to get their hands on these assets, traders and investors have to buy which results in the value of the shares increasing.
ANALYTICAL METHOD 2: TECHNICAL ANALYSIS Technical analysis is defined as the use of price and price history to identify current and potential trends in securities and general markets. The theory is that a trader can look at the price graph of a share and – using common historical patterns – identify trends caused by buyer and seller behaviour. These behaviour patterns enable traders to forecast potential price movements on the basis that all market information is reflected in a share’s price. For instance, if a share’s price traded within a defined support and resistance level in the recent past, traders can assume that historical price levels will hold true in future. Consequently, the use of technical analysis assumes that historic patterns will hold true in future. Another way of looking at this statement is to say that investors tend to react in similar ways to specific events. In the following graph, two simple resistance and support levels are highlighted; as follows:
SUPPORT: LINES: CD AND GH RESISTANCE LINES: AB AND EF
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The assumption is that a share will bounce between AB and CD (or EF and GH). I believe that the real lure of technical analysis is the instant graphic appeal, enabling traders to easily visualize trends and thus trading opportunities. The important thing is that novice traders understand technical concepts before they try to implement them. They use weird and wonderful terms like Fibonacci, Elliot Wave and MACD forms part of the appeal for novice traders
CHAPTER SUMMARY The way the world works: you have those who believe solely in technical analysis (at the exclusion of all other variables) and then you get those who believe that fundamental analysis is the only viable form of share selection. Seldom do you get traders who believe that both systems can work together. This chapter set out the beginnings of a concept on fundamental-technical analysis cohabitation. IN THE NEXT CHAPTER In Chapter 5, Fundamental analysis concepts are explained in greater detail.
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Chapter 5: Some Market Fundamentals “In Stock Markets, you can be right for the wrong reasons or wrong for the right reasons.” John Allen Paulos (1945 - ) US mathematics professor at Temple University
Where Do You Start There are many fundamentals that shape long-term strength or weakness of securities around the world and certainly too many to set out in this book. However. before leaping into the global arena you do need to understand some pertinent concepts. There is a starting point for those that want to be part of global growth and its inherent dangers. You need to make a conscious and absolute decision to seriously want to achieve a portfolio that is well managed, efficient and competitive against the forces of global traders. The following is a brief set of basic, need-to-know terms and concepts:
ECONOMIC GROWTH There are two basic forms of economics pertinent to traders. The first is called Macro-Economics and deals with the overall market, while Micro-Economics deals with the company and related issues. As a trader, the importance of macro-economics is that, the wealthier consumers are within a political environment, the happier and safer they feel, which in turns leads to more spending. The more these consumers spend, the more money flows into company coffers and the higher their projected profits become. Higher profits mean higher share prices and – once again – happier investors. Companies that sell more product tend to expand, which creates higher demand for funds from shareholders and banks and, not forgetting, higher tax revenue for government. Government in turn spend more money on infrastructure and so on. A strong economy benefits everyone. Alternatively, weak economies are usually accompanied by little spending and, ultimately, businesses stagnate, profits dwindle and investors stop buying shares. The latter is a recipe for a declining trend in share prices.
CAPITAL FLOWS In Lore of the Global Trader I set out how easy it is for traders to buy various forms of securities anywhere in the world and on any exchange. When economists and the media speak about the flow of funds do they means the amount of shares bought and sold around the world?
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Definition: The flow of funds is the movement of foreign exchange from one country to another and can be viewed as including loans, loan repayments, bond issues, foreign direct investment and portfolio investment such as stocks, bonds and derivatives. So, the more money flows into your country’s stock market, the higher share prices will move. Traders need to look at Capital Flow Balances. Capital Flows
Net Balances
Negative Flows
A negative net balance means that more capital (investments) are leaving the country for another destination than are entering the country.
Positive Flows
Foreign investments coming into the country are greater than investments leaving the country.
Influence on Securities Excess supply of currency over demand leads to a weakening of the currency. This makes imports more expensive and often devalues shares. Excess demand over supply for that country's currency causes the currency to increase in value. Imports get cheaper and shares often rise in price.
Traders need to be aware that foreign investors love moving their funds around the world, looking for:
High interest rates Reasonable to strong economic growth Strong and growing financial market
INTEREST RATES Simply put, banks borrow funds from the State Lending Bank, often called The Reserve Bank – or Federal Reserve, to enable them to lend money to consumers, such as businesses. The banks lend this money from Reserve Bank at an interest rate called the Prime Rate. They in turn lend money to consumers at above the prime rate. The explanation is simple. If many entrepreneurs need money to expand, the borrow money in increasing numbers. This money is used to buy goods. Ultimately, too much cash is chasing too few goods and prices increase. This is inflation. A higher prime rate is then used as a State tool to reduce inflation; higher interest rates are a disincentive to borrow and thus less cash is chasing goods, and the cycle of falling inflation is resumed. Examples of Global State Banks: Australia Reserve Bank of Australia (RBA) Canada Bank of Canada (BOC) European Union European Central Bank (ECB) Japan Bank of Japan (BOJ) South African Reserve Bank (SARB) Switzerland Swiss National Bank (SNB) United Kingdom Bank of England (BOE) United States Federal Reserve (Fed)
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The importance for traders of the State keeping inflation at reasonable levels, is the fact that companies need to grow with minimal influences on their profits. Take note: the higher interest rates are, the worse the effect is on profitability. For instance, if Company A has a net debt level of R100 million and interest rates are at 10%, the company will have (simplistically calculated) a debt repayment of R10 million. If interest rates rise to 12%, then his debt repayment rises to R12 million. Without a comparable rise in earnings, the company’s profits fall, which is usually met with a declining share price. The reverse is also true. When interest rates are falling, businesses tend to borrow more, pushing up retail and capital spending, thus earnings rise.
TRADE: FLOWS & BALANCES Ina globalised world, companies are increasingly selling goods across borders in a rush to find and secure new markets. So, selling from one country to another is called exporting your goods, while buying from another country is called importing goods. This basic concept can have extreme results on traders’ perceptions of trends. Every time goods are imported, they have to be paid for in the currency of that country. This buying and selling is therefore accompanied by the exchange of money, which in turn changes the flow of currency into and out of a country. A country’s Trade Balance is thus the monitory value of - or balance of - net imports over exports. This ratio of exports to imports demonstrates a country's demand for goods and services, and ultimately signifies how economically well a country (and thus companies) is going. If exports are higher than imports, a trade surplus exists and the trade balance is positive. If imports are higher than exports, a trade deficit exists, and the trade balance is negative.
Exports > Imports = Trade Surplus = Positive (+) Trade Balance Imports > Exports = Trade Deficit = Negative (-) Trade Balance
MONETARY POLICY In well run countries, fiscal and monitory policies are designed and implemented by national governments and corresponding central banking authorities to achieve desired economic objectives.
Monetary Policy: This is the process and established policies a State and Central Bank of a country uses to control the supply of money to the public through the determination of a rate to achieve a set of objectives relating to growth and stability of the economy.
Fiscal Policy: This is the State’s strategies and implementation policies and decisions relating to how, on what and how much money is spent and collected (tax) and the balance between to achieving high employment rates and controlled inflationary economy.
Knowing that inflation targets exist will help traders to better plan their entry and exit strategies.
CONSENSUS FORECASTS A consensus forecast is sometimes just called a consensus. This is a general agreement by a group of experts, whether analysts or economists, as to upcoming economic or corporate events or media releases.
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Corporate Forecasts: This is the pooling of analysts’ expectation of listed companies’ financial results. However, with new legislation in South Africa relating to corporate governance and insider trading, it has become difficult to find such consensus corporate forecasts. It is thus recommended that traders find specific website that offer such services.
In essence, the benefit of these consensuses, is that it removes inaccuracies in the ultimate release of information via novice traders simply following the pooled advice. For instance, assume that Company A’s consensus profit is expected to be down by 30%. When the consensus hits the media, the share is bound to fall on such negative news. Assume that your analysis shows that profits will fall by only 2%. What does that mean to the astute trader? Large degrees of consensus inaccuracies lead to a reversal of the major stock movement caused (in the first place) by the consensus.so, in the above example, astute traders would buy the stock as it fell, wait for the bounce and then sell. Without doubt, a lot can happen before a report is released, so it is always prudent to keep vigilant as market sentiment can quickly change just before a release. The essence is that pooled expectations can be wrong – so the answer is not to invest all your funds on someone else’s forecasts.
Using Economics To Improve Trading Strategies For traders, the perfect starting point in using the above economic fundamentals is to determine what a company’s core product is, which could encompass different variables. For instance, the chief executive officer of a major newspaper/magazine retailer in South Africa told me that their core product was “any good that could increase the number of people walking through their stores.” Another chairman said they saw their core product as “anything that could be retailed,” while yet another director told me that core product meant “a focus on the item that contributed the majority of sales.” If you know that 80% of Company A’s profits are derived from goods bought in the US, then exchange rates play an important part in analysis of profits and thus price and co-existing trends. If, however, 80% of a company’s profits are directly related to the interest rate (such as large retailers, who sell their products for cash and hold that cash for 90 days), then interest rates are important. The more directors tell the investing public of their plans and the better such plans are outlined in the media, the better traders can read their potential share movements and the company thus avoids irrational share movements. EXAMPLE: Take, for instance, the example of an engineering company that is about to undertake a major restructuring of all its divisions. Once the board of directors have made the decision, the next step is to make an announcement to the public. However, instead of making an outright statement in the press, stating that they are about to undertake a restructuring and then to provide details, the company issues a “cautionary announcement, warning shareholders that the company could be making an announcement that could affect the share price and that shareholders should trade with caution.” They are warning shareholders that they are about to make an announcement? A week later, they release details of the announcement. For traders, there is a process here that needs to be explained. First, the announcement is just that – an announcement, yet the share price often moves upwards. Nothing has been done or even commenced. No restructuring has taken place, but the share has risen on the back of a positive announcement.
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As the company undertakes its restructuring, expenses and possible problems are incurred. In addition, a major restructuring most often takes more than 12 months to complete, which means that investor interest diminishes, as the company often does not meet financial expectations. During this phase investors should buy the share as it declines. The next step is for the company to consolidate its restructuring and the financial start to benefit from the restructuring, which filters down to earnings per share. The share rises as shareholders and other investors scramble for more shares. It is then time to sell.
The above can be summarised in a number of basic rules pertaining to economics SCARCITY: The world’s economic pie is limited. As there is only so many products to go around and everyone wants more than they have, what one person gets, another cannot have. That means virtually every good produced, every action taken has an opportunity cost. SUBJECTIVITY: Value and price are subjective issues. This subjectivity means that the public’s likes and dislikes are different and, as value and price are subjective conditions, the trading public is thus willing to pay different prices for what they buy. From the seller’s side, prices are determined by demand for goods and production costs, which depend on the subjective value of the resources. INEQUALITY: No one said that life has to be fair. Differences in natural abilities, acquired skills, individual effort, political influence and parental wealth mean that some have more income, wealth and control over resources than others.
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COMPETITION: Competition is good and, ultimately, a competitive market is an efficient market. Competition among buyers and sellers brings out the best in them and in the economy. Less competition among sellers creates higher prices for buyers (and vice versa). IMPERFECTION: Nothing is perfect and never will be. While some problems can be fixed, many cannot. Markets have deficiencies that can be corrected only by government action, but government has many flaws, which often prevents corrective actions and even worsen the economic condition. IGNORANCE: No one knows everything. Information is a scarce commodity. Acquiring information, like producing any good, entails the opportunity cost of limited resources. Those with more resources can secure more information. Sellers, who have a good, usually have more relevant information than buyers who want it. COMPLEXITY: There is always more than meets the eye. Every action has many effects, some intended and obvious, others unintended and more subtle. Any action that is good for one person is likely to be bad for another. One person's expense can be another's income.
CHAPTER SUMMARY Crucial economic concepts were briefly outlined. The focus of the chapter was to get novice traders to understand that wider macro-economic conditions have major influences on markets and all related businesses. If you are serious about trading as a business, these concepts must become part of your daily routine. IN THE NEXT CHAPTER In Chapter 6, the basis for using technical analysis is explained.
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Chapter 6: Grasping the Concept of Technicals “The object of knowledge is what exists and its function to know about! Plato (380BC) Classical Greek philosopher and mathematician
Why Technical Analysis? Let’s start by frightening you. Look at the following statement and ask yourself if any of it makes any sense …... …… there are many categories of technical studies, including trend-following, fading and oscillators and include signals such as moving averages, convergence, divergence, directional movement Indices, stochastic, commodity channel indices and Put-Call ratios. Now ignore the above and let’s bring a semblance of order in the process of analysis and technical signals by keeping variables simple and logical. Technical studies are without doubt essential to trading, but used independently of fundamental analysis limits the scope of a trader’s understanding of the current price at the expense of a more general market and economic overview. For example, take Company A’s RSI Reading:
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The value of the RSI is always a number between 0 and 100.
A low number indicates a more oversold market A high value indicates a more overbought market.
So, when Company A’s RSI hits the Oversold Position, the share rises, but when it hits the Overbought Position, it falls. It would be wonderful if that always happened. Yet, the information is useful, but would be more so if could help the trader to answer these questions:
Are the indicated trends new or not? Are the trends temporary or longer termed? Are the uptrends sustainable, i.e how far will it go? Are the downtrends sustainable, i.e how far will the fall be?
If used independently of fundamental analysis, most technical studies simply don’t reveal pertinent and crucial trading information, such as length of a trend and a definable price target.
WHAT IS TECHNICAL ANALYSIS? Quite simply, technical analysis is the study of combined investor and trader sentiment and behaviour and its effect on the current price of securities. The information to conduct technical analysis is derived from price histories of financial instruments, together with time and volume data. These variables enable technical systems to form graphs which traders use to forecast trends and price action. Technical Analysis versus Fundamental Analysis Fundamentalists believe that the value of securities is best assessed by investigating complex financial statements, quality of directors and key management and specially earnings and growth rates. They follow a intricate patterns of analysis to make forecasts on securities in line with global markets and often relative to economic cycles. Today, many analysts concentrate on company fundamentals, monitoring company trends and assessing how these could influence investors’ and traders’ perception of current and future share prices. This behaviour is collectively called market or investor sentiment. Six Steps to Trading Like a Pro asserts that investor sentiment is the final filter to buying a security. Example: In the late 1990s while working at stockbrokers Global Capital Securities as Head of Research, I found my analysis on a motor-based company peculiar and I started to doubt myself. This company’s turnover had increased from R1 billion to R3 billion within a three year period and profits had more than doubled. Yet the share price stayed at the 300 cent level during this entire period. How could that happen? Further and more in-depth analysis highlighted that investors simply did not trust management or the figures in the financials. Market sentiment was negative and a higher share price was not going to happen.
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Therefore, while fundamental analysis highlights crucial corporate trends and technical analysis identifies trend patterns, investor sentiment holds the key to whether prices will actually move. This book adopts the stance that fundamental and technical analysis are mutually inclusive. In fact, they these two systems can be used in reverse. Traders can use technical analysis to identify securities with potential positive trends and then use fundamental analysis to filter out those that do not meet your predetermined strategies. If more traders used both systems to determine what and when to buy or sell securities, many would be more successful. Basic fundamental analytical concepts were covered in the previous chapter. Now, let’s do the same for technicals, which can be applied as follows: Tools: A filter tool to identify potential investments.
A timing tool to determine more accurate tune entry and exit points.
Questions: When did this trend last change? What are the major support and resistance levels? Where is the stock positioned relative to these major support and resistance levels? Could the overall market assist or hinder specific stock trends? Have there been any important reversal patterns? Where is the price relative to its moving averages? Is the stock in a strong sector relative to the market? Are momentum indicators positive or negative and do they confirm the stock’s current movement? Has there been strong volume activity? Did such activity coincide with a likely trend change or help confirm an area of support or resistance? By answering the above questions, traders will eliminate securities that are weak, so that they can concentrate on those that offer potential.
Contrary to popular belief - Technical Analysis does Fail At a glance, traders seem to be able to assess, analyse and determine entry and exit strategies at the blink of an eye. There is this vast and incredible amount of complex price and prices movement information that they use effortlessly to trade world markets. Can it really be that easy? Below are some ways in which technical analysis simple fails. I have witnessed such events and can attest that such financial disasters could have been avoided if fundamentals had been part of the mix. Stated differently: Unpredictable events cause securities to move in unpredictable ways. The following are some basic reasons to support the combined use of technicals and fundamentals.
Political events: Any political event can move markets. News that former president Mandela was ill in 1995 created havoc in South Africa, while Iran’s declaration that they had intensified their nuclear program fuelled the fall of the US$ in 2007.
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Economic data: Some of the most sort after economic reports include employment data, GDP reports, manufacturing surveys and major budget speeches.
Natural disasters: disaster that are perceived to influence production supply can move markets contrary to any technical forecast.
Terrorism: Any act of terrorism can affect securities, in unpredictable ways. Notably, the US Towers attack in 2001 and the London train bombing in 2005.
War: Any conflict can affect securities, especially if deemed to negatively influence supplies, such as the Northern African conflicts in 2011; disruptions of oil production saw oil prices rocket to above US$120/bl.
CHAPTER SUMMARY The aim of the chapter was to warn that, while technical analysis does form a major part of trading, it is also dangerous to use signals without sound and in-depth understanding of implications of using such triggers in isolation. IN THE NEXT CHAPTER In Chapter 7, the previous two chapters are summarised by showing you how to combine both the concept of technical and fundamental analysis to gain better and improved understanding of markets and what makes (and how) them move.
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Chapter 7: Making Both Analytical Methods Work for You “The more things are forbidden, the more popular they become.” Mark Twain (1835-1910) US Writer and Lecturer
What are You? I have been involved in innumerable debates about the advantages of using fundamental analysis or technical signals and indicators to determine which securities to buy or sell. The debate is always lively and tends to deteriorate into shouting matches. At the last workshop I held in 2010, I asked the group of attendees the question: “What are you? Are you technically biased or are you more fundamentally focused in hour analysis to determine what to buy in the market?” As expected, the room suddenly became divided into two. However, before the workshop became so rowdy that the conference organizers asked us to leave – I intervened and ask another question: “Why do you feel so strongly that you have to be one form of analyst or the other?” The room became quiet. They were simply not sure what the question meant. Surely, I said, we can use both systems and get the best of both worlds in our pursuit of becoming professional traders. The answer was not well accepted and the reason became obvious after some discussion: Those who are eager to trade without undertaking the lengthy and boring administrative time it takes to set up strategies tend to want to use technical analysis, while those who are more disciplined and academic tend to be more analytical and thus believe in fundamentals of industry and companies. Strangely, the first group tended to be engineers, while the second group were made up of economists and bankers. Fundamental research tends to focus on identifying and analysing the variables and environmental factors that influence securities, while technical analysis is completely focused with assessing price and price trends as dictated by market behaviour. In addition, the latter believes that all environmental factors are already dicsoiu8nted in the price of a security. Therefore, there is no need to understand why events take place. Given the sharp differences, it is easy to understand why traders tend to favourite one form of analysis over the other.
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Both Systems Have Advantages THE FUNDAMENTAL PERSPECTIVE The primary purpose of fundamental analysis is to correctly understand and provide logical reasons for buying or selling a share. In fact, fundamentals provide traders with the analytical tools to understand the underlying value of securities and to determine whether such securities are under- or over-valued. Image selling a share when it hit a technical indicator SELL point, only to discover that the company is about to merger with a multi-national and the share price quadruples? Fundamental analysis should be applied to all investments, whether in the equity market, gilts or derivatives. There is always a need to apply analysis to wider markets through economic and business analysis and investment strategy. Simply stated, look at political, economic, business and technological variables to conclude whether a company or specific security will be influenced or not and whether, I fact, it is worth buying at all. An example would be to assess the Coal Industry, and to determine that the world price was about to collapse. Would you buy Coal-related securities under such conditions?
THE TECHNICAL BIASES Technical analysts is the sole use of price and index data to form graphs that can be applied to determine trends; whether up, down or sideways. Analysts then take this further and conclude whether trends have strength and momentum to continue along its forecast trajectory or not. This is without doubt an important tool for traders and investors, especially in determining when trends can change. In particular, traders are serious users of technical analysis. The main reason for this is that technical indicators and signals can be applied to either intra-day or longer period trading. Like fundamental analysis, technical analysis also works across different types of instruments, from equities to Futures to commodity markets. The technical analysis industry is globally represented by The International Federation of Technical Analysts (IFTA). In the US, the industry is represented by two national organisations:
The Market Technicians Association (MTA) The American Association of Professional Technical Analysts (AAPTA).
In the old days, technical analysis was called Charting, which is actually a better name as the Trader doesn’t really have to do anything technical as it is simply a method of determining if a stock or the overall market is worth buying or selling. I understand the argument that some indicators are technical and seriously complex, but it doesn’t have to be. Charts or graphs can certainly signify patterns and trends and they can even highlight strengths and weaknesses in specific securities or markets, but the problem is that it doesn’t always work. Technical proponents counter the argument by saying that fundamental analysis also doesn’t always work either. That is a fair statement to make. So, technical analysis does give us a clear picture of past performance and all its related trends. Simultaneously, fundamental analysis gives us deeper understanding of the variables that will ultimately influence price. At this point, It is important to note that fundamental analysis and technical analysis can give traders different results. For example, a stock may have a strong technical signal, indicating an overvalued situation, while the fundamentals are screaming that the share is undervalued. When both Page 54 of 192
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fundamentals and technicals line up, investors can buy with confidence, but my contention is that when they do not line up, the combination of the two systems provides the trader with awareness of the risks in investing in such stocks.
Basic Recommendation for Novice Traders A starting point for novice traders:
Use technical analysis only for liquid stocks.
Depending on the exchange that you are using to trade this number will differ, but as a rule of thumb – only trade stocks that have a volume of more than 400,000 shares per day.
Keep the Overall Index on your screen to keep a watch on the broader market or industry.
Determine the power of the share’s trend. o o o
Technical signals: volume and momentum. Moving averages. Find nearby support and resistance levels
Determine the strength of that power: Assess how much power is behind a trend o MACD o Stochastic o Volume
If the stock passes all these tests, we have a possible security for purchase.
CHECKLIST FOR NOVICE TRADERS
Trends: This is the easiest technical indicator and is a line drawn on a share graph that touches meets at least three points. If prices are generally rising, then the general trend is up.
Support and Resistance: If you draw two lines on a graph, the first touching thee points at the bottom of the graph and the second touching three points at the top of the graph – you end up with an upper and lower price levels that shows the trader where buyers (lower line) come into the market and where sellers (upper line) exit the market.
Moving Averages: Also called simply price averages, these are average prices over a defined period of time. The norm is to use two averages in a graph, such as 50 days and 200 days (longer term averages) or nine and 21 days (shorter term averages). They help us determine if a trend is turning as prices move above or below the averages.
Volume and Momentum: These two indicators confirm the health of a trend and identify if the days when prices rise outnumber the days when prices fall (momentum). If either volume or momentum starts to decline, traders can surmise that the trend is weakening.
Relative Performance: This is used to identify whether a stock is stronger than another stock. The Relative performance chart is drawn by dividing the price of a stock by a relevant market index or another company. If the ratio is going up, then the stock is outperforming the market or company. The alternative is if the ratio is going down, then stock is weakening relative to its competitor or market.
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Have You Made Up Your Mind: Which Is Best? Ultimately, traders should make up their own minds as to how to trade, what sort of analysis makes them comfortable. During my research phase for Lore of the Global trader, I spent much time discussing such issues with professional global traders, who recommend the following: “All historical prices, company information and economic figures are easily and readily available – so why not use them? In order to become a true master trader you will need to know how to effectively use all types of analysis.”
WHERE DO YOUR GO FROM HERE? Novice traders can take comfort from the very essence that many others have started before you and many have, in fact succeeded in changing their careers to that of trader. The following is a basic guideline which was given to me over a decade ago. It is still relevant today and is split I to three basic steps: Steps
1
Rules
Rules to Success
Take Cognisance Plan everything Buy Value Diversify according to skill. o Start with equities o Move to Futures o Start an Intra-day portfolio Understand volatility Carefully select our sources of information The above applies to local markets, then regional exchanges and finally global bourses
2
Three Crucial Questions
3
Trading Plan vs Business Plan
Which is the leading indicator: JSE or the Economy What is the current stage of the JSE cycle Do you know what investor sentiment is This is your business, so be serious about it Have a strategy Have realistic expectations Check costs Assess risk-to-reward ratios Take total responsibility for your trades Have a trading journal BELIEVE IN YOURSELF &NEVER HESITATE
My recommendation is not to rely on just one method of analysis. Use them all in a balanced and logical strategy.
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CHAPTER SUMMARY The essence of the debate between pro-fundamentalists and pro-technical analysts is set out and discussed. In addition, a basic set of recommendations is laid out for novice traders and the question – have you made up your mind which is best? – was asked. Think carefully about the question before you answer it, because your answer will directly tell you what your biases trading is. IN THE NEXT CHAPTER In Chapter 8, the first step in the Six Step conversion process for novice traders to professional status is started.
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Chapter 8: Step 1 - Portfolio Strategy “Markets are designed to allow individuals to look after their private needs and to pursue profit. It's really a great invention and I wouldn't under-estimate the value of that, but they're not designed to take care of social needs.” George Soros (1930 -) Chairman of the Soros Fund Management and the Open Society Institute
AIM OF STEP 1: TO ESTABLISH YOUR VARIOUS PORTFOLIOS BEFORE YOU START TO TRADE
Lessons From The Past Harry Markowitz received the Nobel prize for economics for his theories of modern portfolio tactics, which highlight new and better methods of controlling risk. In his Modern Portfolio Theory (MPT) he starts out by assuming all investors are risk averse and defines risk as a standard deviation of expected returns. I studied Markowitz’s theories in great depth back in the early 2000s and came to the conclusion that the difference between his thinking and previous other portfolio theories is that he believed that, instead of measuring risk for a specific share, risk should be measured at the portfolio level. Therefore, each individual investment should not be examined on the basis of its individual risk, but on the contribution it makes to the entire portfolio. Markowitz also believed it is important to assess how investments can be expected to move together or, said differently, how investments correlate to one another. Today, many portfolio managers use his portfolio techniques for asset classes instead of individual stocks; thus constructing globally diversified portfolios. At the risk of sounding presumptuous, I believe that traders need to take that theory and enhance it by one additional step. Traders should assess both individual shares and the portfolio as a whole. In essence, if a single position falls to below a stop loss, do you sell that stock if the overall portfolio is still substantially up? Keep this in mind as we draft the three portfolios of billionaire traders (Chapter 9).
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Over the past 30 years, research techniques and portfolio management systems have changed drastically. If traders are to survive in a globalised and electronic world, it is important to understand the influence of globalisation on portfolios and also a few basic concepts from the past. Six Steps to Trading Like a Pro is not as book on the many facets of globalisation, but certain pertinent factors were uncovered during my research for Lore of the Global Trader. A quick note on some key globalisation points influencing traders: Capitalism is the greatest wealth-creating mechanism ever devised and markets with stock markets tend to adopt a free-market stance to economics.
As entrepreneurs and traders go about serving their own interests, the value of the world's economy increases.
The markets, which are an integral part of capitalism, rise to reflect the increase in the world's economy.
This trend is expected to continue.
Markets offer all investors and traders the best opportunity to participate in the growth of the global economy.
Risk should not be avoided, because it offers an investor the opportunity for higher returns.
Equities offer investors the highest real returns over time.
Most investors and traders cannot expect to meet their reasonable goals without accepting some level of market risk.
The impact of market timing and individual security selection pale by comparison to asset allocation and strategy.
The greatest share of the investment process should be devoted to the asset allocation decision (see Chapter 9).
Risk can be actively managed.
Diversification is the primary protection for traders and investors alike.
Asset allocation between shares, gilts, cash and derivatives allow investors and traders to tailor portfolios to meet their risk tolerance.
MPT offers investors and traders the chance to obtain efficient portfolios that maximise their returns for each level of risk they might be able to bear.
Investors must accept and expect reasonably regular market declines, which are natural. At worst, downturns have negligible affected long-term investors; at best they may represent buying opportunities.
It is vital traders maintain a long-term perspective and exercise discipline with every trade they make.
Markets are efficient and attempts to time the market have not been effective or reliable methods of enhancing returns or reducing risk.
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Active management cannot demonstrate sufficient value added to offset their increased costs.
The world economy is expanding, but the world's stock markets will continue to be an efficient mechanism to capture this growth in securities’ value.
Past performance of investment managers is not a reliable indicator of expected future performance.
Cost is a major controllable variable in investment management. Low cost is strongly correlated to higher investment returns. Management fees, transaction costs and taxes all serve to reduce investor return. Costs must be rigidly controlled.
Lesson 1 - The economist’s staple phase: traders operate in a world that is continually changing and traders must accept that few variables are under their control of they are to succeed. Economists often precede forecasts with “all things being equal,” which means their forecasts are based on variables not changing in the near future. Traders have to adopt the opposite stance using a phrase like “having taken numerous possible risks into account etc.” Changing variables does not mean we cannot build a sound, long-term strategy. In essence, a sound strategy is one that attempts to maximise returns for the risks investors are willing to take. Over time, learn from mistakes and systematically whittle down risks and costs of being wrong. When you start a portfolio, you will be "wrong" a great deal of the time. Lesson 2 - Equities have provided sound investments around the globe: In South Africa, investors and traders can today invest directly in foreign shares. Yet many traders have not changed the “Asset Allocation” to a “Strategic Global Asset Allocation." This is a long-term strategy in which traders divide their available wealth among the world's desirable asset classes. The first task is to decide on which assets to include or exclude. The last 20 years have been good to equities globally, but political risk has played a major role in converting many traders into speculators. During this period, there was low inflation, high inflation, booms, recessions and depressions, high and low interest rates. Currencies around the world were weak, then strong and stock markets around the world boomed and crashed several times during the last two decades. In short, traders had plenty to worry about when going through those times, but also plenty of opportunities to trade securities. The past 20 years has seen portfolios change and today’s investment structures are designed with the leading edge of financial research. However, variables change and the trader should continually assess new and possibly better investment and portfolio tactics. As new tools are developed, these will usually first be available to large institutions and investment advisors, but it is only a matter of time before these tools are available at local retailers. One means of keeping up to date with latest analytical tools is to ask investment advisors about their computer programmes. Often the speed at which these filter down to the retail level is purely a function of demand. The Internet can help in providing such advice. In particular, look for academic research from the economics and finance departments of the major universities that now maintain sites on the Web. Lesson 3 - Beware of numbers: Over the past two decades, investors have been conditioned to think of market timing, stock selection and portfolio performance as the fundamental keys to success. These beliefs are deeply ingrained in South Africa, so even superior investment strategies like Strategic Global Asset Allocation will take some time to get used to.
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In fact, some analysts consider the global arena too risky and unknown for South Africans. However, globalisation necessitates a radical change in the way portfolio managers and traders operate. For instance, investment advisors are expected to have an opinion on where the market is going and, therefore, investors and traders look to these “experts” for advice. The problem is that the market is saturated with financial “experts.” Through the media, investors are exposed daily to countless different opinions about the market, trends and recommendations. They tell investors to retreat to the "safety" of cash, which allows these experts to look responsible, conservative and even caring. In addition, often the first question people will ask is: "What was your performance last year?" Those numbers become the chief yardstick to determine whether the advisor is good or bad. Very seldom will the trader ask: "What's the best trading allocation?" or, "How much risk do I need to take to meet my goals?" In a global market, traders can diversify between countries and not only sectors. The following example highlights the problem of using growth rates as the chief yardstick:
Mr M. Brown has R1 million invested in a newly listed company on the JSE, called Zextra Electronic Ltd. At a price of R1 a share, Brown owns one million shares in Zextra. In the first year of operation, the company landed a multi-billion rand contract with neighbouring states to set up satellite stations. By the end of the first year, the company’s share has moved to R2.20 a share and Brown has achieved a return of 120% on his investment.
Mrs. J. Dawson had R1 million invested in the Far East and shifted her funds to First World markets just before the 1997 stock market crash. Her portfolio looks exceptionally bright, showing a 40% return on a share that climbed from R100 a share to R140 a share.
Both shares show phenomenal returns. Yet both sets of figures distort the true nature of the return on these investments. Brown’s investment return is off a low base and the longer he holds the share the worse his investment return (in percentage terms) will become. For instance, if the share rises by another 120 cents in the next year, the share will have climbed to R3.40, which is an increase of 54%. Another 120 cents in year three will mean a share price of R4.60, which is an increase of 35%. To use percentage increases as a yardstick brings its own problems. That is, off a low base the company has to continually increase earnings to achieve the same rate of capital return. This is an impossible task in the short term, but if the investor had bought the share for the long term then he could see the share rise to R6, which means he would have achieved a 500% rate of return. Dawson’s investment is off a high base and a 40% return is substantial. However, she will be hard pressed to find another investment that will offer a 40% return in the next year. If the investor is told by a portfolio manager that a company’s attributable profit has climbed by 30%, the investor must insist on the base that this percentage is made. For instance, if the company had a profit of R1 million in Y1 and R1.3 million in Y2, this is very different to a company that has a 30% growth rate of a base of R1 billion in Y1. If the number is in the low figures (thousands or low millions) then it can be said “the company achieved a 30% growth off a low base of R1 million.” If the amount is in the high millions or in billions then it can be said that “the company achieved a 30% growth off a high base of R1 billion.” Comment: It is more prudent to concentrate on a portfolio’s long-term potential than on short-term gains. This does not mean traders should miss out on market aberrations. Remember that traders need to have long-term wealth as well as short term profits.
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Without tools to evaluate risk or choose between alternative strategies, investors often feel they are left with just one number to compare performance; year-to-date or last year's performance figures are the only criteria for measurement. If investors believe those figures alone determined a successful investment plan, they should buy the previous year’s top-performing unit trust and ignore market signals. Unfortunately, this approach is often the worst way to form a strategy. Lesson 4 - Change is the only constant: Building a successful investment plan to meet globalisation head on will require a fundamental change in the way traders think about strategy and performance objectives. The word strategy implies a conscious effort to achieve stated goals. Their concern should be to at least meet their minimum acceptable return levels without taking excessive risk. The way an asset-allocation is designed will determine returns for short and long-term periods. In addition, risk and returns will be driven more by the investor’s asset allocation than by individual share selection or market timing. Any asset class can and will have extended periods of significant under-performance from its long-term trend. Similarly, there will be periods when the portfolio will outperform the market trend. Of course, investors can play it safe and stay with mutual funds or unit trusts, or they can have some risky assets in their portfolios. Why have risk related shares? Lesson 5 - Risk can be your friend: The reason is this: When risk is measured at the portfolio level, a risky asset with a low correlation to other assets in the portfolio can actually reduce risk in the portfolio. A diversified portfolio offers much higher returns per unit of risk than does a single blue chip share. Over the long term, investment markets and portions of markets generally sort themselves out. In the short term, it is not unusual to see a negative sloping, risk-reward line, i.e. the market fell and shares under-performed relative to the bond market. The trader with a long term return objective must know that down (and up) swings exist, but these are always temporary and have little impact on the way to meeting his or her goals. Statistically, small stocks have a higher return and risk than second liners or blue chips. For reasons mentioned above, it is never safe to talk about a company’s performance in terms of percentage rates. In the international arena, even size of companies become relative. For instance, Anglo American Corporation is considered one of our largest blue chips with a market capitalisation of nearly R450 billion. Yet, compared to some overseas companies Anglo looks like a beginner. For instance, US based company General Electric has a market capitalisation of US$210 billion, which is worth R1.5 trillion (May 2011 exchange rate: US$1 = R7). In addition, emerging nation stocks have a high return profile, but also high risk. These are primarily large growth areas, but they also fall considerably below the large first world blue chip stocks when a crisis hits emerging markets. This was amply highlighted during the 1997 Stock Market Crash. Comment: What is important is how much risk the portfolio has and that it is reasonably conservative. In addition, this book is about strategy, which also implies a long-term approach. Even the "best" long-term strategy will not be the best each year and since we are dealing with securities and associated risk profiles, it is important to understand that even the "best" strategy does not provide investors with a guarantee against occasional negative periods.
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Lesson 6 - The market will decline at some point: Investors often refer to risk as “the chance of the market falling.” There is no doubt that no-one likes to see their securities fail, but if they are quality securities, losses should ultimately turn into gains. It must be stressed that traders do not have to wait for the market to turn before gains are achieved. A solid trader’s portfolio should include hedging positions. Traders also seem to have any number of mental yardsticks that they employ relentlessly either against themselves or their financial advisors during periods of under-performance. Traders not only want to outperform their country’s main stock index, but they want to do that every day. Here is a truism – not even a superior portfolio will outperform the index every day. In other words, reality will rears its ugly head just when you think the bull run will continue. The last 30 year period has been characterised by falling interest rates, falling inflation and superior stock markets, but during this period there were also serious market crashes. No one should base their planning on high annual returns every year. As a rule of thumb, traders should expect long-term results of about eight to 10% above the inflation rate. If you do better, celebrate! Just do not base your whole strategy on attaining returns that are so much higher than normal. Lesson 7 - Trust in your long term strategy and ignore the Overall Index: Traders often have one more mental yardstick for comparison. The temptation to second guess yourself or your strategy is enormous. Investors are, after all, quite human, and they believe, quite reasonably, that they should have it all. For instance, often they want to "beat the Overall Index." We have gone to a great deal of trouble to build a portfolio that is better (in the long term) than the Overall Index, which tends to have a relatively low return per year. For instance, if you take all the performance of all the sectors of the JSE and look at the annual performance of each sector relative to each other, you will find another obvious lesson. The Overall Index usually lies somewhere in the middle, i.e. it is the average of all the sectors, which means the negative and positive growth rates of the sectors. If 10 sectors moved up by 20% and five fell by 12%, what would the Overall Index growth rate be? Assuming all the sectors had the same weighting, then the Overall Index growth would be 9.3%, which lies midway between the 10 stock that moved up and the five that declined. An investor’s strategy is to seek out asset classes that have a higher rate of return and very low correlation with domestic large company growth stocks. It therefore stands to reason that this type of portfolio should not track the Overall Index. There will be times that the Index will outperform even a superior portfolio. Comment: Unless traders and investors can focus on their own goals, risk tolerance and strategy, performance becomes an impossible moving target. Investors must understand that a superior portfolio will under-perform from time to time, no matter what mental yardstick they are using. Lesson 8 - Tailor make your portfolio: Investors who desire higher risks and rewards can reduce the proportion of shares in their portfolio in lieu of Futures. Traders can also shift the asset allocation to more value and small company stocks and, secondly, include emerging market stocks in their portfolio. Lesson 9 – Survival lessons to remain sane: These lessons are described as follows: Do not do totally insane things with your money. The Orange County disaster of the early 2000s was the perfect example. Part of the portfolio was a derivative investment that Page 64 of 192
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underpinned how investors can make irrational decisions. The portfolio manager had offered a bond to investors that paid interest at a rate that was determined by a formula: 10.85% less the sum of the German mark, Swedish krona and Italian lira swap rate plus the British pound and Swiss franc. In other words, the interest was divided by a factor of five and traders ended up with valueless portfolios.
Never borrow short and lend long. In fact, you should not borrow to make investments. Borrowing multiplies your risk. If you borrow R1,000 to buy R2,000 worth of stock, then you will double your original money (minus interest charges) if the stock rises 50%. However, you will lose your entire stake if the stock falls by 50%.
Make appropriate investments. A consultant must always be with a legally recognised stockbroker or institution. In addition, it is important to continually check your own finances, check figures – never take anything at face value. In other words, trust less and ask more.
Never have a preconceived scenario and fall in love with it. Never have an absolutely unshakeable belief that economic variable will move your way, that interest rates would continue to fall and that shares will always be positive or negative.
Never implement a strategy without an exit window. When providing a portfolio manager with an order to buy or sell shares, make sure there is a stop-loss technique, i.e. always set a definite price for a sell order.
Do not buy anything you don't understand. If you do not understand Future, Commodity trading, Options, Derivatives or gilts – stay out!
Don't judge an investment simply by its track record. Some companies produce spectacular returns in the first two years of operation, but run into problems later on. The key for an investor is not merely to look at what has been done in the past, but to understand why the company has been so successful.
In the market, no good thing lasts forever. This has been said many times, if you touch hot investments, you'll get burned.
Believe in amateur stock market sayings and die. These include: o
Knowing which stocks to buy and when to be in the market is the key to investment success.
o
A good investor can predict which way the market is going and which stocks will profit the most.
o
This power is held by just a few wise stockbrokers.
o
These stockbrokers will readily share their power with you for a nominal cost.
o
This minor cost will be repaid many times over by enhanced performance.
o
However, one must always avoid the charlatans who give false advice. A wise man is one whose stocks go up, and a charlatan is one whose stocks go down.
o
Knowing when the market will fall is a prime concern to the successful investor.
o
One should leave the market when it is about to go down in order to preserve one’s principal investment, i.e. the capital amount. Page 65 of 192
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o
Successful investors trade often and dart in and out of the market or a particular stock with uncanny skill.
o
Their portfolios benefit from a hands-on approach.
o
It is easy to spot good companies through an examination of financial data and to determine what the stock in those companies should be worth.
o
An astute investor can apply superior insight to make big killings on mispriced stocks. Using his superior insight he will be able to take action long before other investors catch on.
o
Studying past price movements is an aid to predicting future price movements. This skill can be applied to both individual stocks and the movement of the market as a whole.
o
Economic predictions are reliable and form another strong foundation for success. It is reasonably easy to select good advisors and managers, because their past track record is a reliable indicator of future success and skill.
Given all that, many traders tend to think of the investment process in the following terms:
What securities should I buy?
Should I be in or out of the market now?
When should I sell my securities?
Which manager should I hire? Or, what mutual fund should I buy?
Unfortunately, almost all of this conventional wisdom is wrong. It does not do us any good to think of trading in these terms. In fact, it creates problems and keeps us from enjoying the fruits of a game strongly tilted in our favour. Remember that it is important to consider the merits of the investor's obsession with individual stock selection and market timing. Just how much do these two elements of the investment process contribute to overall success or failure? Is there a better way to think about investing?
CHAPTER SUMMARY Important lessons from the past provide a direct link to establishing the three portfolios of billionaire traders. IN THE NEXT CHAPTER In Chapter 9, Step 1 is finalised.
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Chapter 9: The Three Portfolios of Billionaire Traders “Design a portfolio you are not likely to trade… akin to premarital counselling advice; try to build a portfolio that you can live with for a long, long time.” Robert D. Arnott (1954 - ) US entrepreneur, investor and President of First Quadrant Corp.
First – An Outline Of Basic Portfolio Types Traders and novice investors who approach me to join my mentoring programme (
[email protected]) often hear the wisdom of diversification and having a balanced portfolio. these are in fact two of the most important aspects of portfolio management. The concept is simply: buy across various sectors in equal amounts. If you have R100,000 to invest, buy 10 shares of R10,000 each in at least three different sectors. This way, your portfolio is balanced (R10,000 per stock) and diversified across various sectors. In this manner, no single share or security can influence the whole portfolio. Therefore, it becomes obvious that one of your strategies has to be to keep the portfolio balanced in future. If one stock climbs or falls radically, take action to keep the portfolio balanced.
A radically rising stock: Take profits. A radically falling stock: Sell if it falls to stop loss.
Diversifying across sectors does make sense as it reduces risk, but there are different ways of diversifying, and different for each portfolio type. The following common portfolio types: aggressive, defensive, income, speculative and hybrid are important to understand before we can develop more personal ones. The following is thus split into three:
The first section briefly looks at five common forms of portfolios to gain a better understanding of each type.
The second part looks at the three types of asset allocations for traders, namely Conservative, Moderate and Aggressive asset allocations.
The third looks at how to combine the above to form the Three Portfolios of Billionaire Traders
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Aggressive Portfolios Such portfolios include highly geared and riskier securities, such as Futures, Commodities and Forex. The ability of traders to deal solely in such markets means that they have few trades and positions at any one time, as these have a high sensitivity to the overall market and are often highly correlated to global markets. These factors make such trading highly stressful as any minor movement in overall markets tend to move geared instruments in an unpredictable manner. Consequently, these securities are more volatile and have larger fluctuations relative to overall market indices or the equities market. A trader who wants to build an aggressive portfolio needs to look at companies with expensive (high p/e ratios), high earnings and accelerating share prices. In South Africa, these tend to be the technology, banking, cellular markets and mining exploration. Trader’s secret: Tight risk management to minimise losses Take regular profit
The Defensive Portfolio These tend to be made up of mainly cyclical in nature and mirror economic movements. Note that some sectors have both cyclical and anti-cyclical stocks. For instance, when the commercial property sector is moving up, retail property seems to be moving down. The advantage of buying cyclical stocks is that economic cycles are longer and offer traders extra protection against market anomalies. A defensive portfolio – or some aspect of such stocks - is prudent to keep trading risk down
The Income Portfolio Investors tend to use income portfolios to earn dividends and tend to be the larger blue chip stocks. Larger market cap stocks tend to offer higher dividend income than smaller listed companies. Investors should be on the lookout for stocks that have fallen out of favourite and have still maintained a high dividend policy. These are the companies that can not only supplement income but also provide capital gains. Utilities and other slow growth industries are an ideal place to start your search.
Speculative Portfolio A speculative portfolio is one where the trader buys stocks that he or she believes could make it big quickly and mostly without analysis. As such, this form of portfolio has more risk than those discussed above. Higher risk is not necessary a bad thing, but it must be managed and the recommendation is that, at most, 10% of the portfolio should be in higher risk shares. These type of purchases include AltX companies in South Africa and AIM listed companies in the UK. In addition, traders tend to look at companies that have little in the form of assets – like Technology companies – and those in sectors that could be taken over in merges and acquisitions.
The Hybrid Portfolio Hybrid does not mean a combination of the above, but rather investing across the various forms of securities. This means having equities, bonds, commodities and futures positions in the same portfolio.
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This type of approach offers diversification benefits across multiple asset classes. Traders need to ensure that these securities have a negative correlation to each other. Comment Traders must always be open to gaining knowledge on different forms of portfolio or a combination of them.
Trader’s Asset Allocation The following are portfolio asset allocation suggestions and includes foreign investment. Note that these are suggested allocations and every individual trader should structure his or her portfolio in a manner that enables them to sleep well at night. In essence, when a trader or investor cannot sleep, because he or she is worried about their securities, it means that they are too heavily invested in certain types of shares (possibly speculative shares) or their strategy is not the correct one for them. The following portfolio allocations use a time frame of three years, 10 years and 30 years. These portfolios are based on the categories outlined below. Categories of different portfolio security-types
Aggressive shares: Capital appreciation funds, Venture Capital shares, emerging market shares, Specific global funds and shares.
Conservative shares: Growth and income unit trusts, blue chip shares (first world countries) and conservative growth funds.
Fixed income: Long-term convertible debentures and long gilts.
Hybrids: Balanced funds, asset allocation funds, high yield gilts, equity income funds, global gilts and emerging country debt funds.
Cash: Money market funds, liquid savings accounts (cash in the bank) and short-term convertible debentures.
The following portfolios are for Conservative, Moderate and Aggressive investors: Types of securities (figures in %) Conservative shares Fixed Income securities Aggressive shares Cash Hybrids TOTAL
THE SHORT TERM PORTFOLIO (three years) TYPES OF INVESTORS Conservative Moderate Aggressive 25 20 10 40 40 40 0 10 30 30 20 5 5 10 15 100 100 100
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Types of securities (figures in %) Conservative Fixed Income securities Aggressive stocks Cash Hybrids TOTAL Types of securities (figures in %) Conservative Fixed Income securities Aggressive stocks Cash Hybrids TOTAL
THE LONG TERM PORTFOLIO (10 years) TYPES OF INVESTORS Conservative Moderate Aggressive 25 20 5 30 30 20 20 20 50 15 15 5 10 15 20 100 100 100 THE LIFE-TIME PORTFOLIO (30 years) TYPES OF INVESTORS Conservative Moderate Aggressive 25 20 5 25 20 10 30 50 70 10 0 5 10 10 10 100 100 100
Comment: The longer the portfolio time horizon, the less cash-type securities are in portfolios of any kind.
Even the most conservative investor holds very little cash, but he or she does hold a large portion of funds in fixed income securities.
The shorter the time span, the higher the risk of investing. Therefore, even the aggressive investor, who is seeking to maximise profits as quickly as possible, holds conservative shares and fixed income securities.
The trader or investor must keep a long-term goal firmly in mind while having the flexibility to evolve as new research provides better solutions to the risk management problem or new market opportunities present themselves.
Discipline remains the key to success for long-term investors, i.e. falling into a panic trap of selling during bear markets or buying during strong bull markets.
A successful investment strategy involves patience, discipline and periodic reviews that must be viewed as an opportunity for fine tuning and occasional modest course corrections, not radical revision and second guessing.
The Three Portfolios Of Billionaire Traders The above sets the scene for building a set of portfolios that should replace any speculation, specific shares influencing the overall portfolio and, more importantly, enables emotion to be removed from the equation.
PORTFOLIO 1: THE FOUNDATION OF WEALTH Page 70 of 192
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Nearly all novice traders who come to me to join my share mentoring program want to make instant wealth. This is not a very solid foundation to build your long term wealth. In the same breath, many say that they want to learn to trade because “I believe I can change careers and retire on more wealth than my current pension.” Then they say that they don’t want to save for their retirement from trading – or, stated differently,. They have no “Trading Pension Plan.” How can you build wealth and financial independence without first having sound foundational principles to build upon. I have found that many people simply haven’t thought about their trading plans in a logical or thoroughly enough. There are steps you can take to make sure that you are maximising your wealth, while simultaneously protecting profits. Without a logical or disciplined approach, novice traders you simply destined to experience elation at making profits, then panic as they lose those earlier gained profits. This is cycle that has to be broken if you want to build a foundation of wealth for your future. The irony is that even skilled traders think that all gains are theirs to spend; what about costs of trading, living expenses or retirement funds? The answer is that such traders and investors start to lose their future earning power and end up with no long-term wealth. As such, certainly no foundation on which to build even more wealth. Take the following true example: Ken Smith came to me some seven years ago. His contention was that he could successfully trade the Single Stocks Futures with a few well-placed technical indicators. His aim: To turn his R2 million into R20 million within three years. My recommendation: It would be easier to make his target by gambling at the casino. The Result: He decided to go it alone and – within three weeks – had panicked and lost all his capital in three quick trades. More to come ….
So, before you can start, have a plan, think about wealth and how much you really want to spend time in building that wealth. Once you have created a basic trading plan to achieve long-term wealth, start by taking a step back: think about a retirement free of financial stress. One in which you can enjoy life in a relaxed manner due to the income streams you have created through a disciplined and long term approach. The first portfolio is, admittedly boring and not the excitement many novice traders expect when they start out in stockbroking. This is the basic equity portfolio, which enables you to invest your funds in longer term shares, but it does give you a number of very important benefits over other portfolios:
You own the stock, so there is no close out or geared effect over the growth of the share. A long-term benefit is that you have time to build wealth through compounding.
The time also gives you the building blocks to learn more complex risk management techniques required when you move to the second phase of portfolio management.
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Any emotion related emotion is removed if you have well thought out strategies to buy and sell shares; as set out in the Six Steps outlined in this book.
Recommendation: You should have a maximum of 12 shares in your portfolio.
These should be diversified across at least three sectors.
The shares should be evenly balanced.
Timeframe: more than 18 months.
Risk Profile: The shares should be split as follows: o 70% in Blue Chips (Market caps of over R1 billion) o 20% in Middle Cap stocks (market caps of between R500 million and R1 billion) o 10% in cash or high risk shares (AltX companies and Main Board penny stocks).
OVERALL PORTFOLIO CASH TO BE INVESTED IN PORTFOLIO 1 = 80% OF TOTAL FUNDS
PORTFOLIO 2: TAKING ADVANTAGE OF MARKET ANOMALIES Once you get bored, it is time to start thinking about the second form of portfolio. take a step back – my definition of being bored does not equate to the boring task of setting up Portfolio 1 or not making the wealth you first expected when you decided to enter the market. By being bored, I mean that you have successful set up Portfolio 1 and are now managing the portfolio in a manner that is disciplined and logical. So, you now have 12 shares, split into blue chips, middle caps and higher risk ones. These are, in addition, diversified and balanced. You have invested 80% of your total wealth in Portfolio 1, which consists solely of equities. What do you do with the remaining cash? Here is where the Ken Smith example comes back in? Example continued: I took some time to set up Ken’s Portfolio 1, which we eventually did. After trying his patience, he finally understood enough to start with Portfolio 2. More to come … The second portfolio is a geared one, either in Single Stock Futures or Contracts for Difference. The choice is yours. The aim of this portfolio is to have a medium term one – less than three months, as opposed to Portfolio 1, which is a much longer term one. In addition to the Six Steps to Trading Like Pro, as set out in this book, traders in geared markets need to have an understanding of what Beta means and how it is calculated. All I want novice traders to learn is that Beta is calculated by using regression analysis. It is defined as the securities’ movement in relation to the overall market. So, if the security’s price moves with the market, it has a beta of 1. If the beta is less than 1, it indicates that the security will
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be less volatile than the market. Conversely, a beta that is greater than 1 indicates that the security's price will be more volatile than the market. For example, a Beta of 1.25 indicates that a security will be 25% more volatile than the overall market. So, here is the aim: you have 20% of your funds available to buy Geared instruments. This is what is recommended that you do:
Split the investments into at most four trades. The trades must be in equal portions. 10% of your funds must be in cash to offset any margin call. Trade in blue chips only. Look for small growth, ie. 3% growth in the underlying securities’ share price. Remember that these are geared instruments, so a six times geared instrument will give you 18% growth. In the first year of trading, only invest in shares which have already released interim results. The full year profits should be more stable. In the following years, trade companies that have already released full year results. Review all positions weekly. Ensure that the positions you have will not be closed out.
Back to Ken: after selecting four Futures positions, one went wrong and, before he started to panic – he realised that the one loosing position had not influenced his whole portfolio. For example:
Ken had R2million to invest. He thus had R400,000 to trade the Futures Market. He had bought four positions in equal amounts. Assume that the loss of his one bad trade was complete, ie. Lost all that entire investment.
If Ken’s portfolio had been 100% Futures (as he had done when he first came to me) he would have lost 25% of his wealth, which is R500,000 (25% of R2million). Instead, he lost 25% of the 20% of his entire wealth. Remember that 80% was invested in Portfolio 1. In essence, Ken lost R100,000 and that represents only 5% of his entire initial investment wealth of R2 million. Conclusion: No Panic.
This means that ken can go away and assess what he did wrong, check his trader’s journal and ensure that strategies are in place to avoid similar mistakes in future.
Remember that the 80% - 20% ratio should be maintained. So, profits from shorter term trades should be used to increase the value of Portfolio 1.
PORTFOLIO 3: THE DAY TRADERS’ WAR CHEST Note that I haven’t recommended that cash be set aside for this portfolio, ie 80% in Portfolio 1 and the remainder in Portfolio 2. The reason is that you need to make money before you can become a day trader. You also need to develop trading habits that enable you to research and assess companies around the world to ensure that your “Trading Retirement Plan” is working. In essence, you already have a Foundation Page 73 of 192
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of Wealth and a higher risk trading portfolio to expedite growth by trading market anomalies and opportunities. So, why do you need a day trader’s portfolio? Day trading is actually simple to do if traders have effectively set up the first two portfolios and are making money. The recommendations is that you cannot move to Portfolio 3 until you have made between 20% and 30% combined growth in your wealth. When you have done so, take enough cash to in invest in a separate account to trade the highly volatile foreign exchange and physical commodity markets. The aim of this portfolio is to take advantage of global markets. Some professionals include futures related commodities, like platinum, gold and uranium markets. A risk approach is to ensure that you always trade for short periods and always close all positions overnight. CHAPTER SUMMARY The essence of portfolio strategy is laid out and important concepts are briefly mentioned. These are directly pertinent to establishing a solid foundation for your trading ideals; know them well and it is recommended that you do further research on each topic to broaden your knowledge base. IN THE NEXT CHAPTER In Chapter 10, Step 2 of the Six Steps is explained in a top-down approach.
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Chapter 10: Step 2 Choosing Companies To Trade Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed. Benjamin Graham (1894 - 1976) US economist and investor
AIM OF STEP 2: THE WORK BEGINS. YOU HAVE ESTABLISHED A PORTFOLIO STRATEGY. THIS NOW NEEDS TO BE HONED IN ON WHAT COMPANIES TO TRADE.
A Time To Forget There I was – standing in front of the entire stockbroking firm’s elite. The directors were there and so were portfolio managers, traders, arbitragers, corporate finance and commodity and bond traders. In fact, I lost count at 30 members of this particular very large stockbroking firm.
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It was the morning meeting and it was my turn to stand up and tell everybody what I thought they should be investing and trading in. This was my first morning meeting and a test of endurance, but also an opportunity to make an early impression as an industrial analyst. The boardroom was large, extremely ornate in dark wood and black leather. It is easy to get intimidated when you are young. I had my list of shares to recommend to the crowd – now starting to crowd me in. I stood up, said a quick “morning everyone” and introduced myself. I started with a market overview, a detailed analysis of companies’ results released the day before – I had been up until 2:00 in the morning preparing for that meeting. I had only 15 minutes allocated to me, but I did manage to get through the detailed analysis clearly and to the point. There were a few questions, then a silence seemed to fill the room. I supposed it could have freaked me out, but thankfully didn’t. Then a trader lifted his hand and asked the question that boiled all the research down to a single bullet point: “What do you expect the price to do today?” There was no interest in the analysis, or how the stock related to its peers or the overall market. It was a simple question, but one that highlighted that this was a money game, not an analytical one. Who cares if you spent two weeks in in-depth analysis or that your computer model was so complex and sophisticated that you had to have it trademarked. The only interest was – what would the company do today? My allocated time was over and the next analyst stood up and started to outline mining results.
The True Issue – Be Prepared The lesson was well learnt. The art of being successful in stockbroking is to prioritise; whether it is analysis of corporate results or technical analysis. Be mean and selfish with your time, ensure that you have all the elements in place to make quick and decisive trading or investment decisions. Nobody cares how you come to your decisions. It is therefore up to you to become proficient as a trader. However, this does not mean that carelessness can become the order of the day. Instead, it directs you to develop a system that you can rely on to use continuously to enable you to make constant profits. How you do that should be your secret. So, where do you start I your establishment of Step 2 in the Six Steps to Trading Like a Pro? In the previous chapters Step 1 outlined portfolio strategy, which was not outlined in isolation to Step 2. Remember that each step in the process outlined in this book for you to become a successful trader is inextricably linked to other steps. As such, a strategy to identify companies to trade (Step 2) must be in sync with your personally defined portfolio approach. This chapter sets out two linked methods to choosing stocks. Understand that these methods are meant as filters to select many stocks and then to remove those that do not meet your trading or investment criteria. There may be stocks that you wish to add to your watch list that have been eliminated by the filter – that is your prerogative. Where should we start? I believe that a good place to start your company search is with a scan of the general market conditions. The decision process in trading any market should always include a Page 77 of 192
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top-down logic, which essentially means scanning the global economic and market arena, honing that down to the region and then the country in which you wish to trade. This macro-economic search is then filtered down to micro-economic conditions, which includes company analysis.
Macro-economic: involves analysis of the whole economy and includes total amount of goods and services produced, income earned, level of employment of productive resources and general behaviour of prices.
Micro-economic conditions: involves analysis of individual consumers, firms and industries in relation to distribution of total production and income.
The variables you select to enable you to ultimately filter down hundreds of companies to a reasonable few, is entirely subjective and, admittedly, no single approach, is wrong or right. There are traders who will only buy JSE Top-40 stocks, or mining shares or higher risk so-called penny stocks. That is their filter. What I am proposing is a filter to enable you to choose shares from the entire spectrum of companies listed on any stock exchange. Finding interesting patterns is equivalent to finding “landmarks” in the price action. For some, an interesting pattern may be a peak or a valley in the prices. For others it may be the shape of a set of candles. Non-traditional charts can facilitate this process. Once selection of the trading instrument has occurred, determining entry and exit points are logical next steps. The resulting trade can be a win, a loss, or a break-even. At any period of time, the trader needs to be able to assess the total performance and identify strengths and weaknesses that occurred. Note that this chapter ignores risk issues and variables that influence specific ideologies. The following proposed filter is aimed at reducing the vast number of investment and trading potential to a select few. It is my recommendation that traders use the following filter to hone down to those few stocks and then to implement their personal filters. Aim of filters: to reduce the emotive element of choosing companies. A filter is a cold factual tool that ignores the host of conflicting forecasts, bullish fever and bearish panic. In addition, many professional traders say that developing and implementing a filter is equal to having a plan, which is better than novice traders who simply throw themselves into the market armed with a few “well chosen” technical indicators. Therefore, traders are not asked or advised to ignore events that take place in the market, such as strike action hampering share prices or natural disasters influencing corporate action. It is suggested that a filter incorporate such events as an additional plan and not be the sole means of trading.
Phase 1: Find Growth Sectors The main thrust of the proposed macro-filter is to identify sectors or Indices that are showing high growth when compared to other Indices. Why would a trader want to trade or invest in property companies if the sector is telling him or her that the market is sluggish, or in a downward motion? The aim is therefore to first select sectors by identifying indices that are showing positive growth. The question that must be asked, therefore, is where are investors buying? Will such trading, as a combined number, surely reflect in a growth in the overall sector? How do we find what traders’ sentiment is toward shares?
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The answer is to identify sectors that are growing by looking at volume growth in the Indices. The secret is that not all companies listed in a sector forms part of the Index. So, we are immediately eliminating smaller and thus higher risk shares within sectors by choosing Indices. The first filter is thus to identify which Indices have the highest volume growth.
VOLUME BASED TECHNICAL ANALYSIS Sentiment indicators are not easy to employ as they tend to be developed for specific purposes by the global stockbroking firms. The essence of such indicators is to quantify the levels of optimism or pessimism present in various sectors or overall markets. Consequently, I found a number of indicators that can be used to highlight investor sentiment and thus Index growth. These include economic variables (money flow and supply/demand balances) and technical indicators (Chaikin money flow). I prefer more simplistic volume related indicators, which highlights three main factors that traders must assess:
Money flow Identifier Volume of net trades Volume surge Identifier
Money flow Identifier: This is used to identify whether there are more buyers than sellers entering a security’s position. o
SBV Oscillator and Money Flow Index (MFI) are used to define Positive (Bullish) or Negative (Bearish) money Flows.
o
Money Flow Index: This is a momentum indicator that takes volume and high, low and close prices into the calculation.
It gives traders a sense of the strength of the traded volume.
A better definition: look at indictor and the price will move in the opposite direction.
Therefore, if the Money Flow index is up, money is leaving the share and the share will fall.
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o
Volume of net trades, also called Bearish and bullish volume accumulations, is used to assess how strongly net buyers over sellers arte influencing a stock, index or overall market.
o
Examples: SBV Oscillator and Volume Accumulation Oscillator (VAO).
Volume surge Identifier: When sectors are dominated by institutions, a of volume surges is extremely critical as it can highlight or signal major institutional trader action.
INDICES – THREE IDENTIFYING TREND INDICATORS Indicator 1: The Advance-Decline Line INDICATOR 1 Name Type of indicator Calculation Aim Trader perspective
The Advance-Decline Line A market breadth indicator Daily or weekly data. define general market action watch for divergences.
If the Overall Index (JSE All Share or Dow Jones) and Indicator 1 are moving in the same direction, traders can assume that the current trend will continue. However, if the Index does achieve a new high or low without a corresponding move by Indictor 1 – a warning trigger is issued. The reason for advocating Indicator 1 is that traders can calculate and draw their own chart. All you have to do is calculate the net difference between increases and declines and then adding the net amount to an index; which you make up. For example, if you decide on an index number of 1000 and the net difference between buyers and sellers today is a number of 10 (buyers are 90 and sellers 80 = 10), then your index has risen to 110. Continue to do that daily and quickly you establish your own Indicator 1.
Indicator 2: Upside-Downside Volume Ratio INDICATOR 1 Name Type of indicator Calculation
Aim Trader perspective
Upside-Downside Volume Ratio market breadth indicator Divide volume of increasing issues by volume of declining issues. Daily or weekly data is used Determine overbought/oversold positions The indicator provides Traders with an understanding as to whether a stock has momentum
Phase 2: Reducing Share Filter The following may seem too simplistic. However, the aim is to move rapidly through a host of companies to see which you have picked to conduct proper analysis and technical assessments – as set out in the following chapters.
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The way that traders can do this is via a filter to set the parameters according to their specific strategies. This includes market cap, price range, liquidity/tradeability, earnings growth and strength of financials – ratio analysis
STEP 1: MARKET CAP
Decide on the size of company you wish to invest in. Remember that the larger the company is, the less the risk associated to trading that stock.
The size of the company (in rand terms) is calculated by multiplying the number of shares in issue with the company’s share price. This is called the company’s Market Capitalisation.
If you choose a figure that is too high, you will have too few companies to select. The aim is to look at companies within a market cap range. For example, Trader A wishes to select at companies with a market cap of between R500 million and R1 billion.
If you move your parameter up, the companies become larger and less risky.
If you move the parameter down, the companies become smaller and more risky.
STEP 2: SHARE PRICE now that you have selected a range of companies according to market cap, you need to decide how much you are willing to spend per share. This means that if you want to buy shares in R100,000 lots ad you want 10 share in your portfolio, you will need R1 million to trade.
If you don’t have that amount of cash, reduce the amount of cash you wish to spend per share. This enables you to reduce the selected shares (Step 1) by looking for at price per share.
At this point, you have not even looked at the strength of the company.
STEP 3: LIQUIDITY/TRADEABILITY There is no point in selecting companies to trade if these have no shares to trade.
The average number of share that needs to be traded per week is at least 500,000 shares. Any less, and the company does not have enough free shares to trade.
Getting in may be easy – getting out is often impossible.
STEP 4: EARNINGS GROWTH Always buy shares in companies that have positive earnings per share growth.
Decide on the growth (in percentage terms) that will make you feel comfortable and filter out shares that don’t meet that criteria.
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invest your money in the money market at 4% a year interest, why would you invest in shares that have less growth? Now: you have selected shares from growth Indices. You have filtered these down according to your risk profile (size of company), then you looked at the price of the company and removed those companies that are too expensive. After that, you eliminated illiquid stocks and those that have low profit rates. Now comes the section that is a little more difficult, but remember that you have reduced every hundred shares down to a possible six shares. This is the rate at which your filter should work and you have yet to conduct any analysis. Step 5 is the use of ratios to eliminate – or determine strength – of the remaining stocks in your filter.
STEP 5: STRENGTH OF FINANCIALS – RATIO ANALYSIS I have a computerised system to conduct ratio analysis rapidly; send me a request on
[email protected] for a copy.
Get hold of a company’s annual results, either the hard copy or the electronic version. All companies have web sites from which you can access annual reports.
The following filter is simple. If a company’s ratios do not meet industry norms, stop the analysis.
These norms do differ between industries. If you want a copy of current industry norms, contact me on
[email protected]/.
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AREA
Ratios used
Solvency
Liquidity
Profitability
Efficiency
Gearing
Investment Performance Ratios
General solvency check Current asset ratio Quick ratio (Acid test) Stock to working capital ratio Defensive interval ratio Profit margins Return on shareholders' equity Return on net assets Return on capital employed Stock turn Accounts receivable days Accounts payable days Debt:equity (gearing) Proportional debt ratio Ordinary shareholders' interest Long term debt to capital employed Interest cover Gross cash flow to total debt ratio Earnings per share Dividend per share Dividend cover Earnings yield Dividend yield Price to earnings ratio
The mathematics behind the above ratios are set out in hereunder:
Solvency Check RATIO 1 General solvency check
[(Fixed assets + investments + current assets) (Long term loans + current liabilities)] 100
This is a broad indicator to assess how many times total assets cover total liabilities. A ratio of less than 2:1 is a warning that there could be serious problems with the company’s financial strength. If the ratio is displaying such tendencies, look at the company for break-up value – buy certainly not as a long-term portfolio asset. However, a problem could arise if the solvency ratio is taken at face value. It could create a totally incorrect impression. If the company recently started operation, or if it had to pay a substantial sum for an acquisition - which is perceived to have solid long-term prospects - the solvency ratio would be low. It is up to the investor to determine whether the ratio represented the true state of the company or not.
Liquidity Ratios RATIOS 1 Current asset ratio 2 Quick ratio (Acid test) 3 Stock to working capital ratio 4 Defensive interval ratio
Current assets current liabilities (Current assets - stock) current liabilities (Stock net current assets) 100 Defensive assets projected daily operating expenses
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These ratios are a solid test to determine if a company will meet its financial commitments on time. There are two major categories of liquidity ratios, namely ratios to determine the overall position of the firm and those that help assess the liquidity of specific assets. The latter are also called activity ratios. The following ratios, therefore, concentrate on how to calculate the overall measure of a firm's liquidity. Current asset ratio: This easy to apply ratio is used to calculate a company's short-term financial position by using current assets and liabilities. If the ratio is high it indicates that the firm's current assets cover current liabilities (at least 1,5:1) and that it is able to pay short term debt with relative ease. The popular observation is to assume that, if the ratio is low, the company is without doubt unable to finance its day-to-day operations and could, therefore, be placed under liquidated at any time. While this is often the case, there are exceptions, e.g. “accounts receivable” includes debtors. In a recessionary climate, can it be taken for granted that debtors will pay? In addition, part of current liabilities includes bank overdraft, which has become an essential part of a firm's debt funding programme and, therefore, the current asset ratio plays a less significant role today. Quick ratio (Acid test): Although similar to the current asset ratio, it excludes stock as this item is the least liquid asset under current assets. It thus provides a better measure of a firm's liquidity. Some analysts believe that, in addition to excluding stock, the debtors book should be assessed to determine the reliability of future payment, i.e. a divisional analysis of the quality of debtors should be carried out. However, very few (if any) annual reports provide such information and company directors are unlikely to divulge this type of detail. The assumption is, therefore, that this is a more accurate measure of liquidity than the current asset ratio. Stock to working capital ratio: Another means to assessing liquidity is to do the opposite to the Acid Test ratio. Instead of subtracting the stock item from current assets, this formula uses stock to determine a company's liquidity position. In the Acid test ratio, the assumption is that, because stock is the most illiquid current asset, it should be removed from a calculation to determine a firm's liquid position. In using the stock-to-working capital ratio, the investor is able to confirm the Acid Test ratio. Stock is divided by working capital, which is current assets less current liabilities, and the higher the ratio the more illiquid the firm is. Defensive interval ratio: This is not a well-known ratio, but is of significant importance. It shows the number of days in which a company can continue to operate without using cash flow generated from operations. It is a difficult ratio to use as the variables involved are not displayed in the financial statements of listed companies. It can, however, be used by businessmen in the computation of their own finances, especially where the business is operated as a sole proprietor, closed corporation or private company. The variables involved in this ratio include: Defensive assets Projected daily operating expenditures
=
Cash + marketable securities # + accounts receivable
=
(Cost of goods sold + expenses*) 365
# Any security that can be traded through the JSE, namely shares, bonds, futures, options and even Kruger Rands * Selling, delivery and administration expenses (less depreciation).
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Profitability Ratios RATIOS 1 Profit margins 2 Return on shareholders' equity 3 4
Return on net assets Return on capital employed
(Any profit figure turnover) 100 (Attributable profits shareholders' funds) 100 (Attributable profits net assets) 100 (Operating income capital employed) 100
Profit margins: Any profit figure can be used to determine efficiency of operations. For instance, if the operating profit figure is used, the ratio would indicate the level of productivity within a firm. The higher the ratio, the more profitable the firm is. If the ratio has been improving over a number of years, it could indicate improved work methods, reducing costs per sale, gaining market share, better internal controls over stock and expenses. Return on shareholders' equity (ROSE): This is a measure of a company's profit in relation to the shareholders' investment in that company, i.e. ordinary shareholders' funds. The use of attributable profit as a numerator in the equation indicates that the higher the profits achieved (after interest and tax), the higher the ratio will be. An exception would arise if the firm's equity base (the denominator in the equation) was increased through a share issue. This would distort the ratio. This ratio is preferred by shareholders as it excludes preference share capital, loans and minority interests. Return on net assets (RONA): Also a measure of profits, but relates to total investment rather than only ordinary equity. This ratio is preferred by portfolio managers, as it indicates profit per net company asset. It is often used as a target setting for managers, who have to improve profits relative to its existing asset base. Return on capital employed (ROCE): This ratio accounts for the total capital employed, rather than only ordinary shareholders' funds. It indicates the profitability of the company in its use of all available funds, including borrowings. Unlike ROSE, this ratio is expected to be less likely to rise. This is due to companies being expected to increase borrowings over time, while ordinary share issues are not an annual occurrence. If ROCE is increasing, investors are being warned that the level of borrowings is eating into profits attributable to ordinary shareholders. Ultimately, investors will receive less dividends.
Efficiency Ratios RATIOS 1 Stock turn 2 Accounts receivable days 3 Accounts payable days
Group turnover average stock Accounts receivable (turnover 365) Accounts payable (turnover 365)
Stock turn: The ratio is used to determine whether management is efficient in its control of particular current assets. Generally, the stock turn ratio reveals the ability of management to buy inventory that will sell and not rapidly become outdated. It also shows management's inability to control different lines of stock. However, it is imperative to look at trends over a number of years. The reason is that an increase in the ratio may not mean that the problem is one limited to only a particular firm, but could be an industry trend, i.e. sales falling off generally. Other reasons for a sudden increase in the ratio could be an isolated case, such as the introduction of a new export law that delays shipment of goods. Page 85 of 192
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Average stock is used to calculate this ratio and is computed by adding the previous year's closing stock (which is this year's opening stock figure), to the present year's closing stock. This is then divided by two. An example shows investors how to use this ratio:
The turnover and current asset figures which appear in XYZ Company Ltd's income statement and balance sheet for the years 1999 and 2000: R'000 Turnover Current assets Stock
1999 50,000
2000 60,000
10,000
12,000
Calculation of ratio: Ratio 1
Stock turn
Ratio 2
Stock turn expressed in months
60,000 [(10,000 + 12,000) 2] = 5,5 times 12 5,5 = 2,18 months
The investor is able to assess that XYZ Company Ltd. sells entire stock on hand 5,5 times a year. Or, expressed in terms of months, it takes a fraction over two months to sell all stock on hand. Accounts receivable days: The first step is to determine daily sales, which is achieved by dividing the company's turnover figure by the number of days in the year (365); even if the firm does not operate every day of the year. The accounts receivable figure, which is listed in the balance sheet, under current assets, is divided by the subdivided turnover figure. The answer is in days and the higher the number, the longer it takes a company to collect its debt. Accounts receivable is an asset and liquidity can thus be impaired if debtors cannot be collected. The quality of a company's debtors book is also important, but cannot be directly assessed. One method that could use to assess the possibility of debtors not paying their accounts, is to investigate the growth in a firm's bad debts. If this has been growing over a number of years, it can be determined that a company has an inadequate screening policy and that bad debts are likely to continue growing. Alternatively, if the level of bad debts incurred is diminishing, it is indicative that stricter policies are been administered. Accounts payable days: This figure is obtained from the balance sheet, under current liabilities. It is calculated in the same manner as account receivable days. In this instance, the higher the number of days, the longer it takes the firm to pay its debts. The ideal is for a company to collect its debts at a quicker rate than it is paying creditors. This would release some pressure on cash flows and also assist in improving liquidity.
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Gearing Ratios RATIOS 1 Debt:equity (gearing) 2 3 4 5 6
Proportional debt ratio Ordinary shareholders' interest Long term debt to capital employed Interest cover Gross cash flow to total debt ratio
[(long and short term loans + overdraft - cash) Ordinary shareholders' funds] 100 Long term loans total assets (Ordinary shareholders' funds loans) 100 (Long term loans capital employed) 100 Attributable income interest paid [Gross cash flow (prior dividends) loan] 100
The extent to which loans are used to finance company assets is calculated by using gearing ratios. Debt: equity (gearing): The comparison of debt, made up of loans and overdraft, to equity (ordinary shareholders' funds) is a popular method of measuring the level of debt in a company. The figures are obtained from a company's balance sheet and a number of ratio combinations can be used to highlight the extent to which assets are financed by loans. These include the subtraction of cash on hand from total debt before dividing by ordinary shareholders' funds. The reasoning is that cash-on-hand could be used to reduce loans. Note that the greater the proportion of borrowed funds to company assets, the higher the financial risk to lenders and, ultimately, to shareholders. Proportional debt ratio: Sometimes it is important to determine the proportion of the firm's long to short-term loans. The necessity would arise in cases where a company has a high debt: equity ratio, say 50%, but also a high liquidity ratio of which substantial short term loans forms a part of current liabilities. In such an instance, it is possible that debt: equity is misleading. If most of the total loan debt is short term - these would have to be repaid within the firm's operating cycle - then a high debt: equity ratio should not represent a threat to the financial stability of the company. The method used to determine the proportion of long-to-short term debt is to start by calculating the Debt ratio. This is computed by dividing total liabilities (long and current) by total assets. Secondly, to calculate the long-term-debt ratio. This is done by dividing long-term debt by total assets. If the Debt ratio is 50% and the long term debt ratio 30%, it shows that the company has financed 30% of its assets with long term debt and 20% with short term debt. Ordinary shareholders' interest: This is used to measure the risk inherent within a company's financial organisation. It is simply the inverse calculation to the debt: equity ratio and, therefore, the higher the percentage, the lower the risk associated with buying that company's share. Long term debt to capital employed: This ratio is of particular interest to borrowers of loans. When a company approaches potential new investors - for loan capital - the investors would be keen to know how much of the company's capital structure (capital employed) is made up of loans and how much from issued share capital. The rule is not to provide companies with loans if they are already heavily geared, unless the loan is for a particular project which the investor deems will have a short pay-back period and will be cash generating. The reason is simple, the higher the ratio, the weaker the financial structure. Interest cover: Once again, the higher the ratio, the less a company is able to meet its interest bill. Page 87 of 192
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This is calculated by dividing pre-interest profit by net interest paid. It shows the company's ability to meet interest payments. A low cover would show that the company is not achieving enough operating profits to pay its loans, or that loans are growing at a rate which the company is unable to contain. Gross cash flow to total debt ratio: This is the one critical ratio that links the income statement to the balance sheet. It shows - as a percentage - how much of cash generated by a firm is used to pay debt. For instance, if a company's gross cash flow (before paying dividend) is R6 million, while total loans (long and short term) equal R12 million, then - using the formula set out in the table 50% of the company's cash flow is used to pay debt. Alternatively, the inverse shows that it would take the firm two years to pay off all its loans, if dividends were continually passed. The rule is - the higher the ratio, the weaker the financial structure and the less attractive the investment opportunity becomes.
Investment Performance Ratios RATIOS 1 Earnings per share 2 Dividend per share 3 Dividend cover 4 Earnings yield 5 Dividend yield 6 Price:earnings ratio
(Attributable profit issued ords) 100 (Dividends payable issued ords) 100 Earnings per share dividend per share (Earnings per share share price) 100 (Dividend per share share price) 100 Inverse of earnings yield
Earnings per share (EPS): EPS is an indication of the firm's profitability expressed per share. It thus shows an investor how much profit each share he possess has achieved over the past year. If EPS has been increasing over a number of years, investors can say that their investment has shown growth. Dividend per share (DPS): DPS is the amount of money paid to shareholders (expressed in cents per share) for their investment in the company. This can occur twice a year, at the companies interim and annual financial year ends. Dividend cover: A trend over several years will reveal interesting factors. If a cover is, for instance, 2 times, it means that for every 10 cents earned per share, five cents is paid to shareholders. There are a number of possibilities, if EPS is constant, but cover changes: o
If cover is increasing, it usually indicates that less dividends are being paid and that more money is placed into non-distributable profits. Companies could do this to bolster reserves prior a takeover bid, or to offset economic downswings etc.
o
In the case where cover is decreasing, it means that directors have taken a policy to pay shareholders more relative to the firm's earnings.
o
Companies usually aim to maintain a constant cover.
However, if EPS has increased or decreased, but the firm pays the same DPS as the previous year, warning signals are set off for investors. Problems arise when EPS falls, but directors decide to maintain the previous year's DPS. This means that reserves are being used to satisfy shareholders at the expense of the firm's financial profile. If this trend is continued over a number of years, the firm can be expected to run into financial solvency and liquidity problems. Page 88 of 192
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Earnings yield (EY): The company's EPS expressed as a percentage of its share price. It reflects earnings relative to market sentiment and thus reveals the return that an investor can expect if he buys shares. If EY is increasing, shareholders' capital growth is improving, while a decline in EY would indicate that the net effect of EPS to share price is falling and, therefore, the investment becomes less attractive. Dividend yield (DY): Similarly, DY is the ratio of the firm's annual cash payment to shareholders to the company's share price. The importance of DY is centered on the principle that only a part of profits achieved are paid out to shareholders. This is a more accurate measure - compared to ROSE - of a shareholder's return on investment. Price:earnings ratio (p:e): This ratio reveals the length of time that it will take an investor to recoup the cost of his investment in terms of earnings. Therefore, the higher the ratio, the longer it will take for an investor to re-coup his original investment and thus the more expensive the investment is. If a p:e ratio is 10 times, it indicates that - if an investor buys a share - it will take 10 years before the amount of EPS achieved by the company equals the share price. The following example explains:
In 1999 Company XYZ Ltd. achieved attributable profits of R10 million.
The issued share capital was 2 million ordinary shares.
In that year the share price traded between 15 cents and 22 cents.
At the end of the financial year the share price was 20 cents.
A. Calculation 1. EPS
= = =
Attributable profits R10,000,000 5 cents per share
shares in issue 2,000,000
2. P:E ratio
= = =
Share price 20 cents 4 times
EPS 5 cents
B. Conclusion It will take four years for XYZ Company's profits (in eps terms) to equal the cost of purchasing the share (the investor's capital outlay).
Testing For Market Volatility
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The final step is to ask: if the market stable enough to invest now, or should I wait? Bollinger bands are used to measure a market's volatility, as this tool warns traders as to whether the market is sluggish or fast paced.
Sluggish: bands contract Fast Pace: bands expand.
Invest when the market is fast and stay out when the market is slow!
CHAPTER SUMMARY From Step 1, a novice trader has chosen a portfolio structure and this chapter established an important filter to selecting shares for trading. Some brokers will tell you that you do not need to have a portfolio if you are a trader – to be successful, you do! IN THE NEXT CHAPTER In Chapter 11, a price range to trade the shares selected as per Step 2 is established. This will provide novice traders with a set of prices to consider before applying technical variables.
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Chapter 11: Step 3 Establish a Price Range “What seems too high and risky to the majority generally goes higher and what seems low and cheap generally goes lower.” William O'Neil (1933 - ) US entrepreneur, stockbroker and writer
AIM OF STEP 3: TO ESTABLISH A SOLID WATCH LIST WITH ESTIMATED PRICE RANGES There are simple exercises that can be conducted to determine whether a share is actually worth buying. Or, stated differently, whether a company is even worth investigating as a possible investment. There are simply too many share in world markets to waste time analysing shares that do not meet your specific investment criteria. The same exercises can also be used to identify a list of shares and to determine a trading price range – even before you start to look at technicals and related signals. One such exercise can tell you at a glance what a share is trading at and, more importantly, what is shouldn’t be trading at. All will be explained in this chapter.. This is discussed after an assessment of a brief explanation of investment cycles. The filter is as follows:
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Phase 1: Understanding Cycles If traders believe that they can ignore investment phases or cycles – they are absolutely and financially wrong. The investment phases of stock markets occur in all time frames and on every technical chart analysed. The general principle is that traders should be mainly in cash when the exchange is nearing then bottom of Phase 4 4 and moving into Phase 1. In Phase 2, traders need to have long-term positions established and entered into. In the following Phase the market is starting to peak and finally reaches its maximum height. There is no way of assessing when the peak will be – but at this Phase traders should be selling and holding cash. In Phase four, available cash should be used to enter into short positions. While the above may be a simplistic overview, it does assist traders to determine an overall strategy, which will dominate the more specific securities’ entry and exit levels. These Phase tell you if you should be long, short or in cash and obviously influence your overall portfolio strategy. Once you are able to identify what phase the market is in, you can then trade accordingly to those characteristics. After a while, you won't even have to think about whether your trades should be long, short or in cash. You will know, without question, exactly what you should be doing daily, weekly and monthly. The following four phases are briefly set out hereunder.
In 2003 I wrote and had a book called Jungle Tactics (Heinemann ) published, where the above was set out in much greater depth and targeted MBA students. Despite the highly complex and interesting text of Jungle Tactics, I prefer the simplicity of the above diagram, which concentrates and explains the essential characteristics of the four stock market phases.
Phase One: this occurs after a prolonged downtrend, where stocks have been falling in what seems to many traders as free fall. The main signal in this phase is that the rate of decline in share prices starts to slow and eventually moves sideways. This is called forming a base and is essentially a movement away from sellers to an increasing amount of buyers. The latter becomes more aggressive and the cycle moves to Phase 2.
Phase Two: at this stage stocks start to move into a bull trend, where the majority of funds are used to buy shares. Prices start to move rapidly up during this phase, despite some fundamentals still being of negative, i.e. corporate results are still poor and investor sentiment Page 92 of 192
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wavers between optimistic and pessimism. It is at this point that professional traders start to accumulate stocks.
Phase Three:, stock begins to trade sideways. It is often at this late stage that novice traders suddenly wake up to the fact that the market is in a bull run. They jump in, only to find out that there is little left of the uptrend. The trends in Phase 1 are being repeated at this level, with buyers and sellers moving into net buying and selling equilibrium.
Phase Four: This is the phase where most traders make serious money – if they are wise, astute and use various forms of trading tools. While this is the dreaded bear trend, solid fundamentals are still moving the market (or parts of the market) in short bursts. The trader can use shorting techniques or play the market anomalies. Those less wise tend to hold onto stocks in the hope that these will turn around.
I have been asked on many occasions: ”How can you tell if the market is moving up into a bull run, down into a bear run or just moving sideways? What, in fact, is the early warning and distinguish features of the above phases? In answer is that during a consistent uptrend – or bull market – as in Phase 2 the shares are daily displaying a series of higher highs and higher lows. In Phase 4, the series of closing prices turns to being lower highs and lower lows. This is displayed in a series of peaks and troughs on charts that traders can trade quite successfully identify. Below is an example of the share characteristics explained above:
It is also important to note that stocks only move in the above manner between 30% and 40% of the time. This means that more than half of the market’s movement is in a sideways, or ranging bound, movement. The rest of the time they move sideways in trading ranges. The following share trend highlights the uptrend and sideways movement.
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Which one would you rather trade? Trader’s Trigger: Stocks in strong uptrends tend to have short reversals (bounces). This gives traders the opportunity to go long.
Stocks in strong downtrends tend to have short reversals. This gives traders the opportunity to go short.
USING THE 4 PHASES The best way of looking at the four phases is as a tool in preparing your trading week. The first step, therefore in any technical analysis is to have graphs of overall markets. I suggest the following main global exchanges or indices; including the Dow Jones Industrial Average, the SP500, The FT-100, The Hang Seng, Nikkei and JSE all Share. Draw a three year chart of each – updated weekly. This way, you are looking at the four phases regularly and keeping abreast of any significant changes in overall trends, which in turn influences your specifically share selections. In terms of technical indicators, many professional traders use the Elliot Wave and Fibonacci to identify major movement in trends. These two highly complex indicators are discussed in many books dedicated solely to these charts. In this chapter, therefore, I will set out a brief and basic overview of these two systems.
Elliot Wave
The summary of the Elliot Wave Theory is:
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Every action is followed by a reaction. There are five waves in a main trend. These are followed by three corrective waves. A 5-3 move completes a cycle. The time the wave takes to complete varies with each cycle.
There are three cardinal rules in labelling waves: Wave 3 can NEVER be the shortest impulse wave Wave 2 can NEVER go beyond the start of Wave 1 Wave 4 can NEVER cross in the same price area as Wave 1 The problem I have in advocating Elliot Wave as a general market indicator is that markets never move in the same manner twice, i.e. patterns do reoccur, but time times will be different. Therefore, it does take skill and experience to identify Elliott waves with ease.
Fibonacci The following Fibonacci-based methodology is used to calculate a date that a trend could change. The following steps are used to identify a probable change in market’s direction:
Step1: Count the number of days, or price bars, between two peaks or market tops. Use 20 as an example.
Step 2: Multiply the number (as counted above) by 0.618, 1.618 and 2.618.
20 x .618 = 12.36
20 x 1.618 = 32.36
20 x 2.618 = 52.36
Step 3: Next, count the above calculated number of days from the second price peak to forecast when the trend is expected to change.
Any length of time between price peaks that is greater than five price bars will yield the best results.
When measuring price peaks measure minor peaks to minor peak and major price peak to major price peak.
These measurements can be done using any time frame and this projection method is about 70% accurate.
Professional traders use the Fibonacci retracement levels as potential support and resistance levels. Maybe you want to use one or the other? Personally, I look at the Indices for changes in share characteristics. That is more than enough for this step in the process to learning how to become a professional trader. I believe that you will be far more successful as a trader is you design your own strategy, rather than simply looking at complex graphs and following someone else's analysis of those charts.
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PREPARE FOR THE TRADING WEEK Preparation for the week must be part of the overall strategy you have developed. Remember that some weeks will be busier than others, given public holidays (time away from your trading) and the timing of economic and corporate events announcements. Some week s will be extremely busy, while other will be quiet. I have said this before. The serious trader uses quite times to research and analyse markets, sectors and companies. After all, what is the point of downloading overall charts if you never have time to identify market phases? Daily and weekly planning gives you a perspective of how you should trade within the overall market phase. At a glance, a trader should be able to see how busy his or her week will be. It does take time and diligence to have a solid plan in place, because the trades have to be precise to take advantage of economic and corporate press releases. SAMPLE DIARY:
TRADER’S WEEKLY & MONTHLY DIARY Week’s Objectives 1 2 3 4 5
Month’s Objectives 1 2 3 4 5
Economic Events 1 2 3 4 5
Corporate Events 1 2 3 4 5
Notes 1 2 3 4 5
Notes 1 2 3 4 5
An excellent source for economic news http://www.bloomberg.com/markets/economic-calendar
and
diary
events
is:
Always look at economic calendars to see what types of reports are coming out that could move sectors and specific shares.
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Phase 2: Correlation Analysis Why do you need to undertake any correlation? What is in fact correlation and what do you intend to correlate? In addition to an assessment of risk and return, professional traders believe it is important to assess how securities can be expected to move together or, said differently, how trades correlate to one another. Today, many traders use his techniques for asset classes instead of individual securities; thus constructing globally diversified portfolios.
CONCEPT OF CORRELATION Correlation is a very simple concept. If investments always move together, there is perfect correlation, and that is assigned a value of +1. If they always move in opposite directions, there is perfect negative correlation, and that value is -1. If you can tell nothing about the movement of one investment by observing another, they have no correlation, and that relationship is assigned a value of 0. Of course, two investments can fall anywhere in the spectrum between +1 to -1 in relation to one another. Take, for example, the correlation of two retail companies. Both the companies are affected by interest rates, cost of labour, technology, consumer purchasing power and cost of fuel. Traders could expect (barring growth from acquisitions) that the share prices of these companies would have a similar movement throughout the market cycle (phases as set out above) and, therefore, these two shares could be considered to have a strongly correlation. The same can be said about two markets in different parts of the world. However, there are factors that can be negative for one industry, but positive for another. In the above example, if the price of oil rises, oil multinationals would benefit, but retailers are expected to suffer. As a result, the price of their stocks should move in opposite directions and these have a low, or negative, correlation. What does this mean for traders? Let’s assume there are two high-risk, high-return possible trades in different parts of the world. In addition, the second trade has perfect negative correlation with the first. Every time the first share price moves upwards, the second will decline, and vice versa. If we put these two trades into a portfolio, will the combined portfolio have high return and zero risk? Short-term gains in one holding are perfectly offset by losses in the other investment. However, because the underlying trend in both investments is a high return, the combination has a high return. Can this be true? In reality, traders will never find two holdings with perfect negative correlation, but the good news is that they don't need to. Any correlation less than a perfect positive correlation will reduce the risk in the portfolio. However, traders must understand that risk has not been removed. For the first time, traders are able to construct portfolios free of the old risk-reward line. In mathematical terms, the portfolio has a rate of return equal to the weighted average rate of return of the holdings, but the risk may fall below the weighted average of the portfolio. Traders have now gained an important lesson: Diversification is good, but the extent of the benefit depends on how the portfolio is constructed. For instance, investors would have a better diversification benefit by including a multinational oil company and a retailer in their portfolio than by holding two retailers.
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While classic diversification reduces business risk, it can actually serve to reduce market risk. Ideally, traders will want investments that combine attractive risk-reward characteristics with low correlation to other investments. Traders’ optimum combination: Determine acceptable level of risk and then seek the optimum level of return. o
For instance, an investor might want to be 90% certain there is a limit of a 10% decline in value during any one year. A trader can then construct a portfolio that has the highest possible expected return within that risk criteria.
o
Alternatively, the trader can first determine a required rate of return and then assess a portfolio to do that at the least possible risk.
These are powerful tools to manage risk and construct portfolios to meet various constraints.
MARKET TO GLOBAL Assessing your market to global ones is for traders who wish to trade across foreign markets. It is amply set out in Lore of the Global Trader, so it is suffice to say that traders need to follow a few simple rules if they wish to look at world markets for guidelines as to the influence of foreign markets over theirs. This takes understanding of correlation analysis between markets. So, the easiest way is to look at one index relative to another. Simply divide your preferred index by that of the foreign one. This will tell you what the correlation is. For instance, if the correlation is 2% between the US’s Dow Jones and the JSE’s All Share index, then if the Dow Jones rises overnight by 1%, it can be assumed that the JSE All Share Index will rise by 3%. Conversely, if the Dow falls by 4%, the JSE All Share will fall by 6%. The above is merely based on assumptions and do not always work. Some traders add a confirming indicator, i.e. if the Dow fall, then wait for the Far Eastern indicators to also show a decline. If they don’t, stay out of the market.
Leading vs. Lagging Indicators When trying to establish a price range, a trader needs to understand that some sectors lead others. In other words, when Sector A moves up, Sector B moves down or vice versa. There is therefore a need to fully understand strengths and weaknesses of indicators used to identify whether one security or Index leads or lags another. For instance if you don’t know that the a country’s stock market is the leading indicator of economic activity – every action you make as a trader will be premised on incorrect assumptions. Think about that for just one second? Trader’s Triggers: Lagging indicators provide signals after trends have started. Leading indicators provide signals before trends have started. It is obvious that traders would, at initial glance, say that they would rather use a leading indicator because they would then be better5 placed with each trade. The problems is that leading indicators often provide false signals. A prudent trader would rather use a lagging indicator as confirmation of a trend that has started.
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More information: Leading Indicators Leading indicators are oscillators, which is any data that moves back and forth between two points. More specifically, an oscillator usually signals entry and exit points. Examples: Stochastic and Relative Strength Index are all oscillators and are explained in this book. Each of these indicators is generally used as warnings signals that a trend could be changing or reversing.
More Information: Lagging Indicators Lagging indicators are momentum Indicators. Examples: MACD and moving averages, which are set out in this book. These indicators are used to identify trends once they have been established. The negative is that traders are entering a position late. The bright side is that there's less chance of being wrong. If you're able to identify the type of market you are trading in, you can pinpoint which indicators could give accurate signals and which ones are worthless at that time. So, how do you figure out when to use oscillators or momentum indicators, or both? That's another million dollar question! After all, we know they don't always work in tandem. For now, just know that once you're able to identify the type of market you are trading in, you will then know which indicators will give accurate signals, and which ones are worthless at that time.
In the future sections, we're going to teach you how to correctly identify the market environment you are trading in to better use these indicators!
THE MAGLIOLO EXPENSE RATIO Company PE to sector averages To establish the true value of a stock, you need to assess what the market sentiment is towards that stock. If a share is trading at 500 cents, but the market believes that this is too expensive – what do you think will happen to the price. So, establish a Buy and Sell range based on market expectation. I call this the Expense Ratio. How do you do that? The first step is to determine what the market sentiment is towards a sector.
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The above sector is the Retail Sector. The first step is to find that Expense Ratio. Some software packages allow you to download price earnings ratios of sectors and shares. Make sure that your package permits you to do so. Download the price earnings ratio into an excel spreadsheet.
Step 1: find the average price earnings ratio Step 2: plot this relative to the general price earnings ratio
The above indicates that the Sector is cheaper than the average. As such, market sentiment is returning to that sector.
The Single Company At a glance and without any technical analysis – the following share (Company X; a JSE listed retailer) shows that the share has reached the bottom of a support level and could bounce. However, without knowing market expectations, what do we do?
We look at the Expense Ratio.
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Now, the Expense Ratio highlights that the retailer’s share is expensive and above the average price earnings. As such, the share is not a buy. The question si whether this company is cheaper or more expensive than its main competitor.
Company PE vs Competitor PE The next phase is to look at Company A relative to a close competitor, Company B. Assume that Retailer B is also considered to be expensive and not a Buy. However, when you divide the Price earnings ratio of Company B to that of Company A, you get the following:
Result:
Retailer A is cheaper than Retailer B and below the average price earnings. This indicates that – if a trader wishes to be in a retail stock – Company A is still a better buy.
This takes us to assessment of the share price.
Phase 3: Share Price Analysis Using the Stages of stock broking Phases, traders must run scans to find some potential trades. Specifically, they need to assess for stocks that:
Are in Stages 2 or 4 These need to be in strong bull or bear trends Meet the criteria as set out in this chapter.
Using this trading strategy, traders use the Williams %R (outlined in later text) to assess whether they should go long or short. Once that happens, then need to run through their watch lists to find potential trades. The ability to establish a solid watch list is important to expedite trades. The first step is to understand the companies that you have placed in your watch list. For instance, if you have assessed that the chemical industry is the one to be in, then you need to find companies
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that fits that criteria. You will find many misconceptions in the market. With lack of solid data, you will invest in the wrong company. A method that some traders adopt is to compare the company’s share price its 12 month high and low and its net asset value. The following table is an example:
NATURE OF BUSINESS
PRICE
SHARE PRICE 12 MONTH HIGH 12 MONTH LOW
NAV
BUY - SELL
Name COMPANY 1 COMPANY 2 COMPANY 3 COMPANY 4 COMPANY 5
The benefit of doing the above exercise is that - at a glance – you will be able to see and assess a company’s share relative to itself. For instance, if Company A’s share price is 120 cents and this is close to its 12 month high of 130 cents, is the share still worth buying? Well, if the share price is still below the 160 cents net asset value, it may be? It triggers possible shares in the watch list. Once you have made the trade, stick to your analysis. Use your exit strategy to either take profits or losses, but don’t be swayed by market news and innuendo. The success of this trading strategy relies on ability to find good stocks to trade within reasonable ranges.
CHAPTER SUMMARY Economic cycles were set out as a precursor to an explanation of concepts of correlation and pricing values. The aim of the chapter was to provide traders with a system to develop a price range for each share selected in Step 2. IN THE NEXT CHAPTER In Chapter 12, groundwork is established for understanding the three technical systems that make up Steps 4 to 6.
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Chapter 12: Essential Signals “Investors repeatedly jump ship on a good strategy just because it hasn’t worked so well lately, and, almost invariably, abandon it at precisely the wrong time.” David Dreman (1936 - ) Investor and founded of Dreman Value Management
Good Place to Start: Essential Signals From experience, there isn’t a single technical indicator that is right every time. An old colleague once told me: “the aim is not to be right all the time. Just be right more time than you are wrong. That way, you should be successful as a trader.” Other excellent points to remember:
Use few indicators – no more than six signals. Understand these thoroughly. Use reliable indicators. Ensure that these indicators are used in conjunction with your trading plan. Be consistent and disciplined in your use of signals.
Let's take a look at the three most popular types of charts:
Line chart Bar chart Candlestick chart (set out in Chapter XXX)
Now, a basic explain of the first two charts are set out in this chapter, before we move into more complex explanations later on. The following graphs are for the same period for listed company XXX Ltd.
LINE CHARTS A basic definition of a line chart or graph is simply a line drawn joining one closing share price point to the next closing share price point. When several days’ (or weeks and years) closing share line points are joined you get a line that shows a trend. In essence, a trader can see the general price movement of the share for the period of time he or she have decided on. The following is an example of a line chart for listed company XXX Ltd.
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XXX Limited: Line Graph
From the above line chart, traders can see:
The share price has fallen from 100 cents in Week 1 to close to 50 cents in Week 3. In Week 1 the share fell to 90 cents and seem to stabilise at this level. In Week 2 the share returned to 100 cents and briefly broke through this ceiling. Between Week 2 and 3 the share price bounced before resuming a downtrend.
BAR CHARTS XXX Limited: Bar Graph
A bar chart is only slightly more defined and shows more than just a closing share price. It indicates and highlights the opening and closing price, as well as the highs and lows achieved by the share at the point taken.
Bottom of the vertical bar: lowest traded price for that time period Top of the bar indicates the highest price paid.
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From an economic perspective, however, it is important to note that the word bar refers to one set or group of information as set out by that data point. Confusion exists in that this one data point can be a week’s information or even a year’s. It depends on the time frame taken for the trader in drawing the bar chart. The following explains the above magnified portion of the chart.
Open: defines the opening price of the share. High: defines the highest price paid for the share at that point in time Low: defines the lowest price paid for the share at that point in time Close: define the closing price for the share
CHAPTER SUMMARY The chapter set out and explained what Line, Bar and Candlestick charts are and how these relate to developing technical analysis skills. IN THE NEXT CHAPTER In Chapter 13, the first part of Step 4 (identifying trends) is set out.
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Chapter 13: Step 4 – Phase 1: Identifying Trends "I think that there are changes that have occurred in technology that make it that more people can have the same level of information that I have. My advantage is that I'm very good at interpreting the information." Jim Cramer (1955 - ) Hedge fund manager
Note that Step 4 (in the Six Steps to Trading Like a Pro) is split into two chapters, as follows:
Phase 1: Identifying Trends Phase 2: Identifying Patterns
This section is the first part of a two-fold phase to Step 4. The first is to identify which of your selected shares (Chapter XXX) have trends that comply with your strategy and, secondly, to identify trading patterns.
PHASE 1: METHODS TO IDENTIFYING TRADING TRENDS AIM: TO DETERMINE WHETHER THE SHARE IS LIQUID
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STEP 1: CANDLES
As a precursor to starting you out on your technical analysis journey, I would like to introduce the concept of Candlesticks to you. These are similar to Bar charts, but Candlesticks are more graphic in that they display a range of information that is often critical for traders to see at a glance. In addition to opening and closing prices, Candlesticks display high and low price statistics.
In the above chart, the filled black bar indicates that the share closed weaker than its opening price. However, if the closing price is higher than the opening price, then the block in the middle will be white or hollow. Note that the top of the block is the opening price and the bottom of the block is the closing price. If you are to use Candlesticks as your preferred “line” to display shares and other securities, then it is important to learn the following:
If the closing price is above the opening price, then a hollow Candlestick is drawn.
If the closing price is below the opening price, then a black filled Candlestick is drawn.
The hollow or filled section of the candlestick is called the "Real Body".
The thin lines above and below the Body displays the High/Low range.
These lines are called Shadows.
The top of the Upper Shadow is the High, while the bottom of the Lower Shadow is the Low.
Long bodies indicate strong buying or selling activity.
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Selling or buying pressure is indicated by a longer body, while short bodies imply poor buying or selling activity.
Upper Shadows signify the session high and lower shadows signify the session low.
The purpose of using Candlestick charts is to effectively see basic price statistics in graphic form. I recommend that traders get used to using these charts instead of the normal line charts as:
Candlesticks are easy to view and thus interpret. They are perfect starting charts for the novice trader to start his or her chart analysis.
Candlesticks no more difficult to draw than other line forms . Simply click the button on your trading stock package that states “Candlesticks” and unclick the Price button.
Candlesticks are excellent tools to identify reversals from an uptrend to a downtrend or a downtrend to an uptrend.
There are many different types of Candlestick patterns and patterns can be single, dual and triple candlestick formations. Professional traders usually combine candlestick analysis with support and resistance levels to obtain better trading signals or triggers.
Now that we have covered the preferred diagram method, let us move to the business of technical analysis. Step 2 looks at how we determine a trend.
STEP 2: IS THERE A TREND? Trend lines are simple and straight lines drawn that touch three points on a graph. If drawn correctly, trend lines can be as accurate as any other method, but many traders make the mistake to trying to make the line fit their strategy.
Therefore, an uptrend line is drawn along the bottom of easily identifiable support areas, called valleys.
In a downtrend, the trend line is drawn along the top of easily identifiable resistance areas, called peaks.
How do you draw trend lines? To draw trend lines properly, all you have to do is locate three major tops or bottoms and connect them. The following highlight up, down and sideways (also ranging trends)trends.
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Note the following:
Two points touching a line at the top and at the bottom defines a valid trend line
However, if three or more points touches the line, the trend is confirmed.
Trend lines are strong indicators when many points touch the line, but these become less reliable if the line is very steep.
STEP 3: WHAT ARE THE SUPPORT & RESISTANCE LEVELS? Also extremely easy to draw, Support and Resistance lines have become widely and popular used signals in trading. Let's take a look at the basics first.
In the above chart, the share price is moving strongly upwards, bouncing off the support and resistance levels. It can be said that the share is in a bull run as each Support level is getting progressively higher. This is also called Higher Lows, as each day’s lowest price is actually higher than the previous day’s lowest price. In addition, the Resistance level is also getting progressively higher. This is also called Higher Highs, as each day’s highest price achieved by the company is actually higher than the previous day’s highest price. There are a number of exceptions, which tend to be better viewed when using Candlesticks. There will be times when a share seems to break through its Support or Resistance level, only to resume its previous trend. Experts suggest that this a possible change in investor sentiment and the share is now testing Support or Resistance levels.
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How do novice traders know if support and resistance has really been broken? Unfortunately, there is no definite technical answer, other than to use the break as a warning that a Support or Resistance Level may be broken. One possible way is to have multiple Support and Resistance lines, which some experts call Zones.
The above graph highlights some interesting aspects:
When the price passes through the first support level, the share moves higher to form a new Support/Resistance Level. As such the Support level became its new Resistance Level.
When a support or resistance level breaks, the strength of the follow-through move depends on how strongly the broken support or resistance had been holding.
When the market moves up and then falls back, the highest point reached before the share falls back is the resistance. The share As the market continues up again, the lowest point reached before it climbs back is now support. One thing to remember is that horizontal support and resistance levels are not exact numbers.
Now that the basics of trend lines and Support/Resistance levels have been set out, let’s look at how to apply these in trading. There are two simple trading techniques, namely the Bounce and the Break.
The Bounce The first method of trading support and resistance levels is to trade straight after a share bounces off the support.
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Too many novice traders tell me that they want to buy shares before the share hits the support. After all, they say, you cannot get the share once it hits the Support level. There is some truth to that statement, as many institutional buyers often mop up shares if they fall below value. However, the problem of buying before the share hits the Support level is that it may not stop at the Level. Many traders make the error of setting their Buy or Sell orders directly on Support and Resistance levels. What actually happens in the market is that everyone else has done the same thing – so you get kicked out of your position, and the share bounces. What a waste! After all your trading strategy, you get sold out of your position because your stop loss wasn’t just below the Support Level. If you intend to buy a stock, first wait for the share to bounce off the Support Level. If you already have the share in your portfolio, have a stop loss just below the Support Level. That way, if the share falls to the Support and major selling occurs– and the share bounces – you will have kept your position. When playing the bounce, traders need to find confirmation that the support or resistance will hold.
The Break Through As a trader, it is important to have a strategy when you have identified that the Support or Resistance levels will be more permanently broken through. There are few basic strategies; outlined hereunder:
You can be aggressive and dump your stock when it gets to your stop loss (breaks though the Support Level) or move the Support line to the Resistance level if the share comprehensively breaks through the Resistance level.
You can sit back and see the share fall through your stop loss in the hope that prices will return to original trends.
Sell at your stop loss, wait for the Pull back and buy the stock. In this case, the Buy Signal is your original Stop Loss.
STEP 4: DRAW THE CHANNELS Channels are no different to Support & Resistance lines, except that Channels are parallel lines following the same angle of the uptrend or downtrend. Similar to Support & Resistance lines, Channel’s top and bottom lines represent potential areas of support or resistance. In fact, the bottom of a channel is usually a Buy trigger, while the top of channel is a Sell Trigger. There are essentially only three types of channels: Page 112 of 192
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Rising channels (higher highs and higher lows). Falling channels (lower highs and lower lows). Sideways channels (ranging).
STEP 5: SUPERIMPOSE MOVING AVERAGES A moving average is calculated by taking the average closing price of a security for a defined period of time. On the following chart, two moving averages have been used; a 21 Day MA and a 9 Day MA.
There are two basic types of moving averages, as follows:
Simple. Exponential.
Simple Moving Averages A simple moving average is calculated as follows: A 9 Day MA: You would add up nine days of closing prices and then divide that number by nine. Each day, the last number is dropped and the new closing price is added and then the total is divided by nine. Most charting systems will do all the calculations for you. The aim of moving averages is to compare the current price to its average; as determined by the last defined period. The moving average provides the trader with an ability to gauge the general direction of its future price. Using SMAs, traders can assess whether a pair of averages (like the 9 and 21 Day MA) is moving up, down, or sideways.
Exponential Moving Average Exponential moving averages (EMA) give more weight to the most price movements. In the above example of a 9 Day MA, the EMA would put more weight on the prices of the most recent days, which would be Days 7, 8, and 9. This would mean that the earlier days would have less relevance to the graph.
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SMA vs. EMA The combined use of SMA and EMA can assist you in determining short and long term trends. These are discussed in greater depth in later chapters. Suffice to say that these averages can be used by traders as warning signals to catch trends early. The rule is that the shorter period the MA is, the quicker the signal will respond to a price action. The downside to using the moving averages is that there are times when a signal will tell you to SELL, but incorrectly so. This happens during consolidation periods or when the share is slowing down before a major announcement. Alternatively, if you want the average to be slower to respond to price action, then a longer period is recommended. Many traders use several different moving averages simultaneously. For instance, if they want to assess a general trend, they would use a longer term SMA and a shorter period EMA to create a Buy Trigger.
Let’s reiterate: a single moving average helps traders to determine a trend. However, using two averages simultaneously can tell you when that trend is changing. The simplest way is to just plot a single moving average on the chart. When price action tends to stay above the moving average, it would signal that price is in a general uptrend. If price action tends to stay below the moving average, then it would indicate that it is in a downtrend. The following chart highlights these trends.
The following use of two averages on charts gives traders a clearer signal of whether the pair of averages is trending up or down. Comment: In an uptrend, the faster moving average (9 Day MA) should be above the slower (21Day MA) moving average.
In a downtrend, the slower moving average should be above the faster moving average.
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Moving Average Crossover Trading Traders will notice that, by using two averages, there will be times when these cross over each other. If the 9 Day MA crosses over the 21 Day MA upwards, it is a BUY SIGNAL.
STEP 6: VOLUME IS THE FINAL VARIABLE At a due JSE listings presentation in 2010, an analyst said that changes in a stock’s trading volume will give you important information about changes in market sentiment. Now, we have set out trends, resistance and support levels and established moving averages. We now need to understand what the market sentiment is towards a propsed stock selection. I always recommend a top down approach. First look at the overall market sentiment (Exchange Volume), follow that with an assessment of the Sector sentiment (Index Volume) and finally sentiment in the actual stocks (share volume).
Is Volume Really Important? Many technical traders believe completely that volume-based analysis is one of the most important aspects of trading. The following are some reasons given during a stockbroking survey which I conducted during writing Six Steps to Trading Like a Pro.
Volume indicates general market health. Price movement is always accompanied by volume, so price analysis without volume analysis is limited in the sense that we would have s price trend without understanding how many people are actually interested in that share or market. Only a combined analysis of volume and price can provide a complete and accurate picture of a trend.
Volume indicates health of an existing trend. Price analysis shows traders a trend, but that trend’s strength can only be determined with an additional indicator – such as volume.
Volume can detect major shifts in sectors. Volume of indices is considered to be crucial in predicting trend reversals.
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Volume is an indication of supply and demand. The calculation of Volume is the number of units traded (any security) during a specified time period. So, the more demand for the share than supply, the stronger the pressures on price. Only volume can tell you that pressure exits on a price.
Volume shows reversal points. This means that volume can tell traders when to buy or sell. Therefore, traders must note to include leading indicators in their technical tool bag. Trading volume is one of a few leading technical indicators that shows traders when and where a change in market sentiment will occur.
Volume tracks Institutional trading. Volume surges are often ignored by the market. Towards the end of a rally, a wide volume surge often signals that the institutional traders are dumping their stocks because the move is at an end. If you weren't aware of it before, note this indicator and use it as a warning trigger.
Additionally, unlike many indicators, volume is applicable to every timeframe and cannot be left out of any serious trader’s bag of signals.
THREE SETS OF VOLUME SENTIMENT
Exchange Volume: Exchange Volume represents the sum total volume of all stocks in a particular exchange or stock market and thus is a predictor of general market mood or sentiment. For me, analysis of such technical indicators helps reveal bullish and bearish markets, define bottoms of the stock market crashes and tops of the market madness.
Index Volume: Index Volume represents the total volume of all stocks included in a particular index. What many novice traders do not understand is that an Index is made up of some and not all stocks in a sector. Therefore, the volume of the JSE Property Index would be sum of all companies indicted as Blue Chip for that sector. Thus, index volume represents the trading activity in a particular market sector or particular group of stocks that are covered by this index. Index volume also helps to define the money flow and sentiment in specific market sectors.
Stock Volume: Stock Volume is the number of shares of a security that are traded (bought and sold) during a specified period of time. It tells you how many shares changed hands between buyers and sellers. In essence, stock volume represents the volume of a single stock and defines the liquidity of that stock.
CHAPTER SUMMARY The absolute first step in technical analysis is to understand whether a number of share data, expressed as a line on a chart, represents a trend or not. The basics of candles, support and resistance levels, channels and moving averages were set out in this chapter as a precursor to far more challenging trading jargon. If these extremely basic concepts are too difficult to understand, send me a request for a workshop on
[email protected]. IN THE NEXT CHAPTER In Chapter 14, Step 4 of the Six Steps is completed with an explanation of share patterns and how to trade these.
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Chapter 14: Step 4 – Phase 2: Identifying Patterns "Risk Management: Improving your Odds in the Crapshoot" Harry Markowitz (1927 - ) US Economist and Nobel Prize recipient for economics
PHASE 2: DETECTING TRADING PATTERNS
In the desire to find patterns within graphs, traders – particularly the young and inexperienced – tend to see dragons in the woods. Essentially, the see patterns where non-exist. This chapter is devoted to showing you some essential chart drawings which should help you to organise and set up the first step in your technical analysis strategy. There are five basic configuration that are pertinent to traders in today’s volatile investment environment.
Step 1: Head & Shoulders
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A head and shoulders pattern is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A "neckline" is drawn by connecting the lowest points of the two troughs. The slope of this line can either be up or down.
Traders trigger: When the slope is down, it produces a more reliable signal.
In the following example, traders can observe the head and shoulders pattern. As started above, the head is the second peak and also the highest point in the pattern formation. The two shoulders also form peaks but do not exceed the height of the head. With this formation, traders should place their entry level just below the neckline. The strategy is two-fold:
For traders going short: to have a purchase entry at the level where your stop loss would be. So, if the neck line is at 200 cents, then your stop loss or entry point would be at 197 cents or 195 cents. Note that these levels were discussed in Chapter XXX. The share will continue to fall as explained under the next heading.
For traders going long: While there seems no logical reason for the following calculation, it seems that historic trends prevail. The length of the share’s decline from the neckline is normally calculated by measuring the high point of the head to the neckline (Points A-B). This distance is how far the price will move after it breaks the neckline (Points C-D). So, here you would place your entry level at price (Point D).
Traders can see that lines AB and CD are the same. This knowledge can be used effectively when trading once the price goes below the neckline. Inverse Head and Shoulders are essentially the opposite of the above trends. A valley is formed (shoulder), followed by an even lower valley (head), and then another higher valley (shoulder). These formations tend to happen after downward movements. The strategy is the exact opposite to the above diagram. When the share breaks through the neckline going upwards, the share is expected to move up by the same distance as the Neckline – Head (AB and CD). Measure the distance between the head and the neckline, and that is expected distance that the share price should move after it breaks through the neckline going upwards.
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Step 2: Double Tops & Bottoms
Before terminology gets the better of you, and you start to wonder if all these signals are actually necessary, look carefully at the above pattern. The double lines are just the Support and Resistance Levels outlined in previous chapters. There will be times when the share price has hit the resistance level twice and then fall through the support level. This tends to happen when a share price has hit the resistance level twice in quick succession, but that resistance level seems to be absolutely solid. Look at the price graph and you will probably see that the level was seldom broken. At this point the share falls through the support level and this is called a Reversal Pattern.
Trader’s Trigger: With the double top, short term traders should place their entry levels below the neckline (at Point C) because the anticipated fall will be Line CD (calculated from Line AB). Long-term traders should calculate CD and place entry at such levels.
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The double bottom is also a trend reversal formation and in essence the exact opposite to the Double Top formation. Traders see a double bottom formation and go long instead of short at point E. the expected climb is line EF, as calculated by Line CD. You can see from the charts above that after the previous downtrend, the price formed two. Notice how the second bottom wasn't able to significantly break the first bottom. This is a sign that the selling pressure is about finished, and that a reversal is about to occur.
Step 3: Triangles & Rectangles A rectangle is one of the simplest pattern formations: it is formed when prices become bound by parallel support and resistance levels. What such a pattern indicates is market indecision. Resistance and support patterns have bee amply defined in previous text, so let’s concentrate on bearish and bullish rectangles. An obvious statement to make is that a bearish rectangle is created when investor indecision takes place at some point during the share’s fall. often, it is an indication that investors and traders are wondering whether the share has fallen far enough.
In the above chart, the share falls, moves into a sideways motion, then resumes its downtrend.
Trader’s Trigger: Once the share falls below the Rectangle Support Line, it tends to make a sudden move that is similar in size of the rectangle.
In a Bullish Rectangle, a share in an uptrend pauses to consolidate.
The trend is the same as the Bearish Rectangle. Traders can expect the share to resume its uptrend and jump by at least as the same amount s the rectangle formation.
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Step 4: Wedges Traders need to understand that trends do not go on forever – and that there will be times when shares and share price actions will stall. Wedge pattern formation signal a pause in the current trend. When a Wedge is identified, traders will see that volume of trading has started to fall or has stalled. Wedges tend to be used by professional traders as either continuation or reversal signal triggers. The definition of a rising wedge is when a share price consolidates between an upward moving wedge-type formation; see following diagram. In essence, a share price moves between support and resistance lines in a sloping formation.
Here, the slope of the support line is steeper than that of the resistance. This indicates that higher lows are being formed faster than higher highs. This leads to a wedge-like formation, which is exactly where the chart pattern gets its name from! With prices consolidating, we know that a big splash is coming, so we can expect a breakout to either the top or bottom. If the rising wedge forms after an uptrend, it's usually a bearish reversal pattern. On the other hand, if it forms during a downtrend, it could signal a continuation of the down move. Either way, the important thing is that, when you spot it, you're ready with your entry orders!
The important issue to note is that the share price is reaching rapidly new highs and lows every day. It is this formation that highlights that the uptrend is about to end. It is a warning signal. The question, therefore, is how far will the share fall at the end of the expected Wedge? The answer is yet again the same s I the previous chart formations: the price movement after the breakout is about the same magnitude (Line CD) as the height of the formation distance (Line AB).
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Traders Signal: a rising wedge = Breakthrough the support line.
Just like the rising wedge, the falling wedge indicates that a trend is about to change.
In the above chart, the falling wedge serves as a reversal signal. After the share has been falling (lower Highs and Lows), it seems to gather momentum. Upon breaking above the top of the wedge, the share moves upwards from Point C to Point D. This movement is, in length, about equal to the height of the formation (Line AB). Traders should thus place their Buy Signal at Level C or just below that line and a Sell Signal target would be the height of the wedge formation.
Step 5: Pennants Pennants are also continuation patterns formed after a significant bullish or bearish movement. The difference to the previous diagrams is that the consolidation is short lived and the price jumps in on the strong move, forcing the price to bust out of the pennant formation. The calculation of this movement is at least the height of the earlier move, also called the mast. Pennants can be either bearish or bullish.
How Traders Use Chart Patterns It is not enough to know what the above charts mean. We have to understand their benefits to traders. To trade the above chart patterns:
Place an order beyond the neckline; up or down.
This must be in the direction of the new trend.
Use the height of the formation as Buy or Sell signal; depending on whether you are going short or long.
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TAKE A GLANCE FROM MAGLIOLO’S DETECTION STRATEGIES As promised, I am making my personal trading strategies available to you. The following is a summary of to help you remember all those chart patterns and what they signal. Forms During
Type of Signal
Expected Next Move
Uptrend
Reversal
Down
Downtrend
Reversal
Up
Uptrend
Reversal
Down
Downtrend
Reversal
Up
Downtrend
Continuation
Down
Uptrend
Reversal
Down
Uptrend
Continuation
Up
Downtrend
Reversal
Up
Bearish Rectangle
Downtrend
Continuation
Down
Bullish Rectangle
Uptrend
Continuation
Up
Bearish Pennant
Downtrend
Continuation
Down
Bullish Pennant
Uptrend
Continuation
Up
Chart Pattern Double Top Double Bottom Head and Shoulders Inverse Head Shoulders Rising Wedge
Falling Wedge
&
As you probably noticed, we didn't include the triangle formations (symmetrical, ascending, and descending) in the above sheet. That's because these patterns can form either on an uptrend or downtrend and can signal either a continuation or reversal.
CHAPTER SUMMARY This chapter completed an explanation of Step 4, which included how to identify share price patterns and how to trade these, such as Wedges, Pennants and Triangles. By now the novice trader has learnt to set up his or her portfolio and related strategies, established a method of choosing shares from a vast array of companies listed across the world and determined a price range for these shares. On the technical analytical side, the trader has identified patterns and trends. IN THE NEXT CHAPTER In Chapter 15, methods to detect whether a chosen share has the momentum and strength to continue is set out.
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Chapter 15: Step 5 - Finding Momentum & Strength “The price pattern reminds you that every movement of importance is but a repetition of similar price movements, that just as soon as you can familiarize yourself with the actions of the past, you will be able to anticipate and act correctly and profitably upon forthcoming movements.” Jesse Livermore (1877 – 1940) Famous US stockbroker
AIM OF STEP 5: THIS IS THE SECOND STEP IN THE TECHNICAL ANALYSIS PROCESS TO TRADING. TREND PATTERNS HAVE BEEN RECOGNISED, MOMENTUM IDENTIFIED AND CONFIRMED BY STRENGTH INDICATORS.
Phase 1: Looking For Momentum STEP 1: THE MACD Definition: The letters MACD stand for Moving Average Convergence Divergence and it is a technical oscillator, based on a mathematical formula. It is based on price movement and aims to give you overbought and oversold signals of a given stock.
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This signal is easily available on most software packages, but traders have to input their own moving average numbers , according to their strategies. This indicator is an important analytical tool in the traders’ arsenal to help them to identify changes in overbought and oversold positions and acts as a warning signals that new trends could be about to happen; whether bullish or bearish. In the previous chapter, traders identified trend patterns. In this section it is important to know whether patterns are strong or could change. This is the reason why momentum indicators are used. The question traders ask: if I buy a share today based on detected patterns, will the pattern last? The most popular momentum indicator is the MACD, which is usually populated with three main numbers, namely:
Number 1: time frame used to calculate the faster moving average.
Number 2: time frame used to determine the slower moving average.
Number 3: this is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
It is important to note that the MACD line drawn is the difference between two exponential moving averages. In the following chart, the two moving averages are 21 and 50 day moving averages. The single line is the difference between these two averages.
Traditionally, when the MACD is below the origin (line 0), the share is considered to be oversold, and when above the origin to be overbought. The problem with using moving averages is that – as averages – they lack substance of the real price. They lag and thus provide late signals. Yet this is one of the most favoured tools by many traders.
STEP 2: ON BALANCE VOLUME Definition: Adds volume to the mix of analysis. Essentially, changes in OBV can indicate forthcoming changes in shares prices. This signal is easily available on most software packages and is simple to implement. The reason traders use this indictor in addition to the MACD, is simply to confirm an overbought or oversold situation, but in this case to determine whether such conditions will change the direction of the sharer.
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Trader’s Trigger: Volume is increasing if the day's closing price is higher than the previous day's (up-volume).
If the share closes at a lower price than the day before, volume is seen as flowing out (downvolume).
OBV is simply calculated by adding/subtracting the day's volume figure (obtained from any newspaper stock prices) from the cumulative total of volume for the share. This is according to the day's price movement:
If the share price is higher than the preceding day, today's volume is added to yesterday's OBV figure
If the share price is lower than the preceding day's price, today's volume is subtracted from yesterday's OBV.
Therefore, an upward trend in OBV is often a precursor to an increase in price. This is due to additional investors buying the share; thus volume of trades is increasing. When an OBV trend changes, it signals to traders that a corresponding breakout in the share price is possible. Professional traders warn that changes in the OBV trend should be seeing over a period of longer than three days, or you may get false readings.
Phase 2: Finding Strength STEP 1: RELATIVE STRENGTH INDEX (RSI) Definition: The Relative Strength Index Technical Indicator (RSI) is a price-following oscillator that ranges between 0 and 100. This signal is easily available on most software packages, but traders have to input their own moving average numbers, according to their strategies. The popular input data is the 9-day and 25day Relative Strength Index indicators. The question traders ask: now that I have identified a trend pattern and confirmed thatbthere is momentum in the trend – is there enough strength for that trend to continue?
Trader’s Trigger: Look for a divergence where the security is achieving a new high, but the RSI is failing to a level that is lower than its previous high.
This is an indication of a possible reversal.
When the RSI turns down and falls below its most recent trough, it is said to have completed a failure swing. The failure swing is considered a confirmation of the impending reversal. Relative Strength Index, or RSI, is similar to the stochastic in that it identifies overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings below 30 indicate oversold, while readings over 70 indicate overbought.
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Other RSI indicators Tops and bottoms: The RSI usually tops 70 and bottoms below 30 before the share moves due to traders’ volume of trades reaching overbought or oversold situations.
Divergences: these occur when the share price achieves a new high (or low), but that move is not confirmed by a new high (or low) in the RSI. The norm is for prices to correct and move in the direction of the RSI.
STEP 2: OB/OS Definition: based on volume and shows the difference between the number of advancing (rising) and declining (falling) shares. This is a simple indicator and highlights how many traders are buying or selling the share at a defined period of time. It in effect indicates interests in the market. The norm is that when the share is considered to be Oversold, it means that there are too many sellers in the market. In economic terms, it can be said that supply exceeds demand. Normally, the share price falls to attract buyers in the market or share.
CHAPTER SUMMARY The aim of this chapter was to establish a process to detect trends, momentum and strength before buying the share. Technical indicators - MACD, OBV, RSI and OB/OS - are explained in greater detail. IN THE NEXT CHAPTER In Chapter 16, we take a step back from technical analysis to establish greater understanding of financial modelling and variables that influence markets, such as sentiment and timing indicators.
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Chapter 16: Sentiment Analysis “The stock market is filled with individuals who know the price of everything, but the value of nothing.” Philip Fisher (1907 – 2004) Famous US stockbroker
Throughout this book a common theme seemed to develop: for the six steps to succeed, there is a need to understand what makes up market sentiment and how do traders use this information to make better trading and investment choices? Consequently, market sentiment has become the main decision point as to whether the trader should – despite all analysis – still buy the security. The second filter is timing, as set out in the next chapter. However, before we proceed with sentiment analysis, let me take a step back. When I asked an old colleague to look at this book and to provide constructive comment before going to the printers , all he could say was: ”What about a section on financial modelling?” In the next chapter, I set out advanced trading techniques, but not in the normal sense of the word. Instead of setting out hackneyed systems, I look at growing trend of investing in new companies that list. These have no history, so how do we assess a fair value to trade the share? A methodology was developed and is set out in this book. In other words, methods of making money in the market not often set out in financial books on technical or fundamental analysis. Another statement from my colleague: “A section on financial modelling is critical. Traders use mathematics all the time to trade.” So, I relented and included a section on financial modelling and set out basic – but important – recognised methods to analyse shares.
Financial Modelling These are "what-if" models that attempt to simulate the effects of how a change in one aspect of a company or market will alter the price or trend of a market. This can include changes in alternative management policies and assumptions about what can influence the firm's financials. In addition, models can be deterministic or probabilistic. The first type does not include any random or probabilistic variables, whereas the second incorporates random numbers and/or one or more probability distributions for variables such as sales and costs. Financial models can be solved and manipulated to derive current and projected future changes to trends. As a result of technological advances in computers (such as spreadsheets, graphics,
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database management systems, and networking), more and more traders are using modelling systems.
NEGATIVE ASPECTS OF FINANCIAL MODELS
Models are abstractions of reality and there is thus no guarantee of perfect correlation between the model and future prospects.
Variables used in models are usually limited and critical events unfolding elsewhere in the world could influence reality in unexpected ways.
Many models are industry specific, whereas many groups have divisions in different industries.
Even the best trend analysis is only a contingent forecast. It is up to the astute trader to realises that the future is unlikely to mirror the forecast.
Finally, most strategic planning techniques produce forecasts that are representations of the expected or desired future at any given point in time, i.e.
essentially
POSITIVE ASPECTS OF FINANCIAL MODELS. The use of sensitivity analysis can give the company information on:
Where strategic plans are most susceptible to deviations from the forecast.
Whether the company is still on target, given changing current trends.
The use of sensitivity analysis is really threefold:
For planning purposes: to assess the impact on the expected performance criteria due to possible changes some variables.
For measurement purposes: to assess whether the strategic plan is still on target.
For control purposes: to predict the amount by which control variables must be changed to keep the company on target.
Sensitivity analysis should be able to answer all three questions of: The impact of given possible changes.
The measurement of progress on an exception reporting basis.
The estimation of control actions. The key to useful sensitivity analysis is the ability to answer all three questions in the context of the strategic determinants of the business, its environment and the market as a whole. This means that impact, measurement and control must be quantified in relation to the core business criteria.
Basic Trading Systems THE COST AVERAGING SYSTEM Cost averaging is an investment method in which a constant rand amount of shares is bought at regularly spaced intervals or, alternatively stated, a time diversification strategy. This method may be used for stock deemed to be a good long-term investment
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Equation: Average price
=
Total market price per share Total number of investments
By investing a fixed amount each time, more shares are purchased at a low price and fewer shares are purchased at a high price. This approach typically results in a lower average cost per share because the investor buys more shares of stock with the same dollars An investor invests R100,000 per month in ABC Company and engages in the following transactions Date 6/1 7/1 8/1 9/1 10/1 TOTAL
Investments $100,000 100,000 100,000 100,000 100,000 500,000
Market price per share $40 35 34 38 50
Shares purchased 100000/40 = 2500 100000/35 = 2857 100000/34 =2941 100000/38 =2632 100000/50 =2000 12,930
The investor has purchased fewer shares at higher prices and more shares at lower prices. The average price per share is: 40+35+34+38+50 5
=
39.4
With a total investment of R500,000, however, 12,930 shares have been bought, resulting in a cost per share of
500,000 12930
=
38.67
On 10/1, the market price of the stock (R50) exceeds this average cost, reflecting an attractive gain. This is probably the simplest plan among the three. This system consists of investing a constant dollar amount in common stocks over a long period of time at fixed intervals. The fixed intervals means weekly, monthly, annually, or some other time period as long as it remains the same. For example, a person might invest R500 per month in common stocks. Or this same person might invest R3,000 every six months. The idea is to invest smaller amounts of money on a regular basis. It is a long term system. The theory is that stocks can always be sold on the average for more than they cost. It does not get you in and out of trades. It only gets you in trades. The person must have a steady amount of income coming in and be willing to invest over a long period of time. This system shouldn't be used on just one stock. The investor may want to choose five or six different stocks to invest in this way. One or two different stocks could go down constantly. However, a properly diversified portfolio will go up eventually. This system doesn't mean that you should keep under-performing stocks in your portfolio. By all means, get rid of the dogs. There is a school of thought that says an investor should not purchase stocks with this program when they reach very high (overbought) conditions. However, when a Page 131 of 192
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person does this, they may spend the money elsewhere, it is difficult to tell when stocks are too high, and the investor may not continue the program. I recommend that if stocks are at a level where they may be too high, the money should be invested in stocks which do well in a declining market. An example is utility stocks. Some advantages to this method are: The average cost of shares purchased is usually less than the actual market price. The investor eliminates the possibility of buying too many shares when the price is too high. Also, periodic declines in the stock market provide buying opportunities at lower prices. Some disadvantages are: The possibility of liquidating the portfolio when stock prices are low. This could cause a portfolio loss. One way to minimize this danger is to plan to liquidate the portfolio several years before the actual liquidation time. This gives the investor time to pick and choose the best times to liquidate each holding. Another disadvantage is that the investors income might not be as steady as would be hoped. This could curtail purchases at times that are attractive for additional purchases. Another disadvantage is that the investor might try to time his purchases. This turns him into more of a speculator than an investor. Another disadvantage is that the person may be tempted to use the investment money for something which comes up (e.g. new car, home repair, etc.) and is also quite important.
THE DU PONT MODEL As a shareholder, the return a company is providing on your funds (return on equity) is a key consideration in judging the performance of the firm's managers. Du Pont analysis provides a framework to show how management of a company's operation and its financial structure impacts on return on equity. Du Pont analysis derives its name from the Du Pont corporation, which developed and began using this approach in the early 1920s. This system of analysis highlights the interaction between a company's operation and its capital structure. It gives investors a tool with which to judge the performance of management on a few levels. It also helps to remind investors that ratios should not be examined in a vacuum, but studied to see how they affect the overall organization. The Du Pont system combines the income statement and balance sheet into either of two summary measures of performance, i.e. return on investment (ROI) or return on equity (ROE). There are two versions of the Du Pont System. The first version of the Du Pont formula breaks down return on investment (ROI) into net profit margin and total asset turnover
=
Net profit after taxes
=
Net profit after taxes
x
Sales
ROI Total assets =
Sales
Net profit margin x total asset turnover
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FACTORS THAT INFLUENCE ROI
Explanation
The top portion of the worksheet deals primarily with the income statement (good operations management), while the bottom portion emphasizes the balance sheet (prudent use of financial leverage). This separation highlights that return on equity is affected by firm profitability and balance sheet structure.
Sales, interest income (other income), cost of goods sold, selling and administration expenses, interest expense, and taxes are entered from the income statement to determine net earnings (or net income on some financial statements). Net earnings divided by sales gives us the profit margin. It might be worth noting that Sara Lee did not break out depreciation as a separate line item on its income statement, so we left that cell blank. Data from the statement of cash flows or even changes in accumulated depreciation can by used to determine the depreciation, but for the purpose of DuPont analysis it was not important to break the information out.
As you work with different companies, you will find slight variations in how they present their financial statements. The worksheet, with its other categories, should prove flexible enough to deal with the variations or it can be easily modified to conform to the variations.
Asset data from the balance sheet is entered to determine the total assets. For Sara Lee, other assets include trademarks, investments in unconsolidated companies and intangibles. Dividing sales by total assets gives us asset turnover. Asset turnover times profit margin provides the return on assets.
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The liabilities from the balance sheet are entered to determine the total debt. For Sara Lee, other current liabilities consist of notes payable, current maturities of long-term debt and current obligations under capital leases. The other liabilities box includes long-term obligations under capital leases, deferred income taxes and other liabilities. Total debt divided by total assets provides the financial leverage figure. Financial leverage refers to the percentage of total assets financed through debt.
Dividing return on assets by one minus financial leverage computes the return on equity. Examining the interplay between the ratios is the key behind DuPont Analysis. Return on equity can be increased through higher return on assets or a higher degree of leverage--more debt relative to assets. The high degree of financial leverage is how buyout artists hope to make big profits when they take on huge amounts of debt in acquiring companies. The risk in the strategy is that the company will not generate enough cash flow to cover the interest payments. Proper use of financial leverage can help increase the return on equity.
Return on assets can be increased with higher profit margins or higher asset turnover. Margins are improved by lowering expenses relative to sales. Asset turnover can be improved by selling more goods with a given level of assets. This is why companies try to divest assets (operations) that do not generate a high degree of sales relative to the value of the assets, or assets that are decreasing their sales generation.
When examining profit margins or asset turnover, it is important to consider industry trends and compare how a company is doing within its industry. A supermarket chain, for example, would tend to have low profit margins, but make it up in high turnover.
THE MODIFIED DU PONT FORMULA The second version of the Du Pont formula, also called the modified Du Pont formula, ties together the ROI and the degree of financial leverage as measured using the equity multiplier, which is the ratio of total assets to stockholders' equity, to determine the return on equity (ROE). ROE
=
Net profit after taxes Stockholders' equity
=
Net profit after taxes x Total assets
=
ROI x Equity multiplier
Total assets Stockholders' equity
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Conclusions: The Du Pont formula provides a lot of insights to financial managers on how to improve company profitability and investment strategy. Specifically, it has several advantages over the original formula (i.e. net profit after taxes / total assets) for profit planning. They are:
The importance of turnover as a key to overall return on investment is emphasized. In fact, turnover is just as important as profit margin in enhancing overall return.
The importance of sales, which is not in the original formula is explicitly recognized.
The breakdown stresses the possibility of trading margin and turnover, since they complement each other. Weak margin can be complemented by strong turnover, and vice versa
It shows how important turnover is as a key to profit making. In effect, these two factors are equally important in overall profit performance
The formula indicates where there are weaknesses -- margin, turnover, or both
THE CONSTANT RAND SYSTEM In using the constant rand plan, where the amount invested in shares remains constant over time, a well-diversified portfolio is essential. If an investor believes that, for example, he can live off the dividend income that R1 million can earn per year (after tax on the interest earned from the dividend in the bank), then every time dividends are paid to this investor, he withdraws the income. In addition, if capital growth pushes the value of the portfolio above the R1 million, the investor sells the shares to keep the portfolio at a constant R1 million. Conversely, if share prices fall and the value of his portfolio drops below the R1 million, he would deposit funds into the portfolio to maintain the R1 million level. In addition, the investor may rePage 135 of 192
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assess the portfolio on a regular time interval and do one of three things. Either he withdraws the cash in excess of the R1 million, pays in cash to raise the portfolio back to R1 million or he can change the level of constant system. One of the greatest benefits of this system is that it forces investors to buy shares when they are falling and sell when they are rising. The disadvantage to this type of system is that a certain degree of timeliness is involved in determining when to initially set the system up. In addition, a period of constantly rising or declining prices does not work well. The system works best when prices fluctuate above and below the original level.
A WORD OF WARNING
While Rand-cost averaging is a sensible investing strategy, it does not assure a profit nor protect against a loss in declining markets, or against a loss if the investor stops the programme when the value of an account is less than cost.
Traders should also consider their financial ability to continue making purchases through periods of low price levels.
There is no method of investing that can guarantee a profit if an investor decides to sell at the bottom of the market. However, the potential for a high return on an investment is increased with long-term commitment to rand-cost averaging.
A Risk-Reducing Strategy: Along with being a simple strategy to follow, dollar-cost averaging can reduce your investment risk, too. Suppose you have $10,000 to invest in the stock market. You could invest the entire amount immediately - as long as you are prepared for the potential for substantial loss.
A Disciplined Approach: A commitment to rand-cost averaging ensures that you are investing regularly - even in the face of market declines. If you wish to follow this approach, it might be a good idea to establish an automatic program that many fund sponsors offer to investors at no charge. In this way, your instalment investments are made without your intervention - through regular transfers from a bank account or exchanges from a money market fund account. In addition to providing your investment program a measure of discipline, you'll protect yourself from your emotions - and the natural tendency to cease investing - in a sour market.
THE CONSTANT RATIO SYSTEM This system has the investor maintaining a constant percentage ratio in his portfolio between shares and gilts. For instance, if the ratio is 30% shares and 70% gilts, when share prices rise, some are sold and gilts are purchased. As share prices decline, gilts are sold and shares are bought. Profits can be made if share prices fluctuate above and below the 30% line.
Stock splits At times listed companies will declare a stock split, which is usually done to improve liquidity. For instance, if Company UU Ltd. has one million ordinary shares in issue, at a share price of 100,00 cents, it is unlikely that there will be too many investors trading the share. There are two reasons:
The share is expensive. There are not enough shares in issue.
The company would decide on a split ratio and announce to the public what that split will be, when it will take place etc. Essentially, if the split is 10:1 it means that for every share that the investor has, he will now own 10 shares, i.e. the share has been split into 10 shares. However, the price is also split in the same ratio and the share is now worth 1,000 cents. The investor has more shares, but at Page 136 of 192
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a lower price, i.e. the value of his investment has not changed, but there are now more shares in the market to trade. For investors, the opportunity to buy a share (at R10) that was R100 is an opportunity that many often cannot resist. However, there is no guarantee the share will rise in price after a stock split, but if the split is not too server (100:1), the share often does rise.
Reverse stock split or share consolidation The opposite of a share split is a reverse split. When a company undertakes a share consolidation, it consolidates a number of shares for one share, i.e. consolidates 100 shares for one. This does not increase the market capitalisation of the company. In addition, the share price increased. The investor is no better off before or after the consolidation. Except that the company hopes that the higher stock price will make the company look better and thus more investors will purchase the shares and the stock price will rise as more people buy it. Again, there is no assurance that a company's share will rise in price after a reverse split. Many times it will decline. There is no way to predict what will happen.
Share dividend There are many occasions when a company’s dividends is not paid regularly and, at other times, the company will offer a share payment instead of a cash dividend. Assume a company declares a 10% share dividend. This means that for every 10 shares of a person owns, he gets one new share as a dividend. If a corporation has 1,000,000 share of common stock outstanding and declares a 10% stock dividend, the corporation will have 1,100,000 shares of stock outstanding after the stock dividend is paid. The individual investor maintains his proportionate share and the same total book value in the company. While book value per share will be less, due to more shares in issue, his investment in the company remains the same. Basically, the company is capitalising its earnings. For the long term investor, the benefits of accepting a share dividend in an increase in his portfolio that will have future dividend and added capital growth.
THE FREE CASH FLOW METHOD Specialists in Leverage Buyouts (or takeovers) look at this amount in planning their strategy. Free flow
cash = Cash flow
-
capital expenditures
–
Dividends
= operating cash flow - interest expense - income tax expense = Net income + depreciation
Where Dividends = dividends per share * number of shares. The difference between the levels of fixed assets over two periods is an estimation for Capital Expenditure.
CALCULATING AN INVESTOR’S TOTAL RETURN One of the most commonly asked questions posed by investors to traders and portfolio managers is:
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"How well am I doing with my investments?" If the question really meant a simple increase or decrease in the value of a portfolio, the formula would be a simple percentage calculation, as highlighted by the following basic example: Example: Ken Rodney invests R111,200.00 with Institution V for a period of nine months. Institution V placed all the funds equally in two companies, namely Company DD and Company GG. Company DD’s share is valued at 930 cents a share, while Company GG is valued at 8200 cents a share. The investment equates to 5,979 shares in Company DD and 678 shares in Company GG. In the nine months since Ken invested the money, the share price of Company DD has risen to 1390 cents a share, but Company GG has seen its share fall marginally to 8100 cents a share. No additional shares have been acquired or redeemed during the investment period. At the end of nine months, Ken’s portfolio is as follows: Details Initial entry level Initial portfolio (value):
Current (value):
portfolio 03/01/199 9
Capital gains/(losses):
03/01/199 9
Capital gains
03/01/199 9 03/01/199 9
Capital growth
Dates 02/04/199 8 02/04/199 8
Portfolio -
Shares -
Price -
Rands R111,200.00
Company DD Company GG
5979 678
930 cents 8200 cents
R55,600.00 R55,600.00
Total Company DD
5979
Company GG
678
1390 cents 8100 cents
R111,200.00 R83,108.00 R54,918.00
Total Company DD Company GG
49.5% (1.2%)
-
R138,026.00 -
R26,826.00
-
-
-
24.12%
-
-
-
Capital gains is the monetary value of his investment gains. Capital growth is the value of his investment growth in percentage terms, i.e. a percentage figure that represents the change in the total value of a fund account over a period of time.
However, in addition to capital gains, an investor must also factor in:
The reinvestment of dividends per share paid from net investment income. The reinvestment of distributions per share paid from net realized capital gains. The change in net asset value over a specified time period.
Calculating the total return for your fund investment is relatively straightforward (assuming no additional purchases or redemptions were made during the period)). To determine your total return, simply take the difference between your account balance at the end of the period and your account balance at the beginning of the period, and then divide by the beginning balance. Multiply the result by 100 to arrive at the percentage figure.
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The formula is shown below: Total Return
=
Ending Balance - Beginning Balance
X 100
Beginning Balance Using the above example: Total Return
=
Ending Balance - Beginning Balance
X 100
Beginning Balance Total Return
=
138,026.00 - 111,200.00
X 100
111,200.00 Total Return
=
0.2412410071942
Total Return
=
24.12%
X 100
Stated differently, the above formula for percentage returns can be determined as follows: Total
=
((Ending Balance/Beginning Balance)-1) x 100
=
((138,026.00/111,200.00)-1) x 100
=
((1.2412)-1) x 100
=
0.2412 x 100
=
24.12%
Return Total Return Total Return Total Return Total Return
Adding other factors to the above formula The above example uses a basic formula to calculate percentage returns. Now the investor needs to add dividend income, share sales and acquisition during the period. Note that is it statistically inaccurate to take a cumulative total return figure and divide by the number of years in the period to arrive at an average annual total return (just as it is inaccurate to add together a series of average annual total returns to find a cumulative total return).
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Example: Ken Rodney invests the same as in the first example, namely Company DD and Company GG, and in the same amounts. Add to the above example: 1. Company DD declares a dividend of 400 cents a share for the six months to end December 1998. 2. Company GG declares a dividend of 1000 cents a share. 3. In addition, Rodney buys 10,000 shares in Company XX, at 320 cents a share, and sells all these shares at 370 cents two months later. The cash is kept in his account. The above example now changes to: Details
Dates
Portfolio
Shares
Price
Rands
Initial entry level Shares kept for full period (value):
02/04/1998 02/04/1998
Company DD Company GG
5979 678
R111,200.00 R55,600.00 R55,600.00
Bought during period
03/06/98
10000
Portfolio value at end of period:
03/01/1999
Company XX Total Company DD
930 cents 8,200 cents 320 cents
5979
Dividend income Company GG
678
Dividend income Company XX Bought at Sold for Cash on hand Interest months)* +Total Capital gains for remaining portfolio :
03/01/1999
Total capital gains
03/01/1999
1,390 cents 400 cents 8,100 cents 1,000 cents
R32000.00 R143,200.00 R83,108.00 R239.16 R54,918.00 R6780.00
10,000 10,000 -
320 370 -
R32,000.00 R37,000.00 R5,000 R1028.24
-
-
151,073.10
Company DD
24.12%
-
-
Company GG
10.82%
(six
R39,793.62 Total capital growth
03/01/1999
35.78%
+ Total = Value of Company DD (+dividend) + Company GG (+dividend) + Cash on Hand + interest on that cash.
Compound interest is calculated as set out in chapter …. Interest is compounded per month, for six months, at a rate of 19% pa.
MARKET SENTIMENT Over time, I have interviewed hundreds of traders around the world. I always throw in a question about analysing market sentiment. Strangely, despite the importance of the information, few have any clue on how to combine fundamentals and technicals to develop a chart to identify investor sentiment. Each and every trader interviewed has a different explanation as to why the market is moving a certain way. I have noticed that the answer tends to rely on how well a trader has done on that day. If, for instance, the or she has competed the Six Steps successfully; the answer is that investor sentiment was positive and identified during the analytical process. Page 140 of 192
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When trading goes wrong, the answer is always the same: “Investors changed their minds – for no discernable reason!” Sometimes, no matter how convinced a trader is that the investor sentiment will move in a specifically identified manner and direction, with all the signals triggered, he or she still ends up losing. Market sentiment can, therefore, be described as a combination of many views, ideas and opinions by many different types of traders, analysts, media, portfolio managers and investors.
Everyone Influences Markets This combined participant movement of markets has the basis of what is defined as market sentiment. So, the way to see this ultimate Point Of Decision is to develop a system to database and chart dominating market emotions. I am still sceptical that the following does work – and need feedback on your own experiences. Please send me comment on
[email protected].
Sentiment-Based System Junior traders are repeatedly told to gauge market sentiment. In the past, under the open outcry system traders and dealers could get a strong sense of market noise because they were on the trading floor talking to clients and other traders. Today, these trading floors have virtually become extinct. Using a computer to trade means that you have to develop other means to identify market sentiment, whether bullish or bearish. So, the answer may sound simplistic – lets develop a sentiment-based system to help identify where traders should buy or sell. The first indicator that can be used is volume traded as an indicator of sentiment. Trader’s Trigger: If a shares is rising, but volume is declining: signal - the market is overbought. If the stock is falling, but volume is rising: signal - market sentiment may be changing from bear to bull. Without any tools to measure volume, how can a trader measure market sentiment?! Many technical analytical tools were assessed to identify ways to determine market sentiment. While many of these technical patterns can indicate changes in market sentiment (via changes in trend direction, like reversals), the following have been identified as sentiment indicators to gauge the market’s mood.
THE GLOBAL MARKET SENTIMENT
The CBOE Volatility Index (VIX) is a registered technical analysis system developed by the Chicago Board Options Exchange, Incorporated. The VIX is often referred to as the fear index. o
Based on option prices, VIX is a key measure of market expectations of near-term volatility as displayed by US’s S&P 500. Since its introduction in 1993, VIX has been considered by many professional traders to be the world's best barometer of investor sentiment.
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New York Stock Exchange High/Low is calculated as the net difference between stocks at 52week highs and those at 52-week lows. When prices swing radically traders expect to see ratio rise.
The $NYHL Index a market breadth indicator that is slightly different to the previous indicator as this one takes into account the difference between stocks making New 52-week Highs from those making New 52-week Lows. These values are plotted cumulatively to create a NYSE High-Low trading Line.
SOUTH AFRICAN MARKET SENTIMENT In creating a South African market sentiment indicator, the following data was used: number of shares reaching new high levels, reaching new low levels and the difference between these two. A market average is calculated on a 20 day moving average.
Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Day 10 Day 11 Day 12 Day 13 Day 14 Day 15 Day 16 Day 17 Day 18 Day 19 Day 20
HIGHS
LOWS
NET
NET AVE
350 360 320 180 210 220 195 660 200 320 360 330 280 270 180 178 150 120 110 80
120 100 80 5 660 130 80 10 450 340 178 339 335 180 120 170 133 10 8 120
230 260 240 175 -450 90 115 650 -250 -20 182 -9 -55 90 60 8 17 110 102 -40
67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15 67.15
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What the chart shows: The movement of this line can therefore measure the strength of the market, or the direction in which it may be heading. The indicator can be read in two ways.
The line oscillates around the average. If the line is above the average, there are more new highs than new lows which shows a more bullish market.
Conversely, below the average, the market may be seen to be more bearish.
Sentiment indicators provide insight into the underlying strength of market movements. They are easy to draft and extreme readings can be strong indicators that prices are set to change.
CHAPTER SUMMARY Financial models and advantages/disadvantages of using them are set out and include extremely important mathematical concepts of Du Pont analysis and Averaging strategies; with examples. IN THE NEXT CHAPTER In Chapter 17, the Final Step and perhaps the most important one, of our system to select and trade shares is explained.
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Chapter 17: Step 6 - Timing “Time is your friend; impulse is your enemy. If you have trouble imaging a 20% loss in the stock market, you shouldn't be in stocks.” Jack Bogle (1929 - ) Founder and retired CEO of The Vanguard Group
AIM OF STEP 6: THE FINAL STEP IS TO UNDERSTAND THAT PROFITS ARE HIGHER WHEN YOU TIME YOUR TRADES. THERE ARE THREE FORMS OF TIMING.
Three Steps To Timing
STEP 1: DETERMINE STRENGTH OF A SHARE The easiest indicator to determine current strength is Average Directional Index (ADX), which is easy to use as it is an oscillator that fluctuates between 0 to 100. If the reading is less than 20 signals are that the trend is weak, but readings greater than 50 signal strong trends. Note that the ADX is an oscillator, but does not warn of trend that are bullish or bearish. I prefer this indicator – as a first step - to highlight the strength of the trend as it is easy to interpret as it only measures the strength of the current trend.
STEP 2: DETERMINE THE SHARE’S TREND Now that you have set out and found the share’s current strength, you want to know whether the company‘s share will continue on that path, i.e. will the company’s trend continue? Is it strong enough to continue? Page 144 of 192
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To identify whether this is the case with the chosen trade, use the Stochastic Oscillator to indicate whether the share is overbought, oversold or not. This indictor in effect compares today’s price to a preset window of high and low prices to create a range between zero and 100.
When the Stochastic lines are above 80 it means the market is overbought. When the Stochastic lines are below 20, it means that the market is oversold. As a rule of thumb, traders should buy when the market is oversold, and sell when the market is overbought.
STEP 3: DETERMINE THE POTENTIAL FUTURE PRICE STRENGTH OF THE SHARE This is a seldom used indicator, and one that is not included in all software packages. It is, however, one that can be of great assistance to traders. The Ichimoku Kinko Hyo (IKH) is an indicator that traders use to assess possible future price momentum with forecasted support and resistance levels. The following is a basic explanation of IKH, but if you are interested in knowing more about this form of technical analysis, send me a request on
[email protected]. The Japanese words Ichimoku Kinko Hyo tell it all, meaning "one glance cloud chart." It consists of five lines, as follows:
The standard line The turning line The delayed line The first preceding span The second preceding span
Standard line calculation: Today’s point in the standard line is calculated for the past 26 days inclusive of today by the formula:
Turning Point Calculation: Similarly, the turning line is calculated for the past nine days (including today) by the following formula:
Delayed Line Calculation:
Use a spreadsheet to write down the values calculated using the above formulae.
In the same spreadsheet record today’s closing price for the past 26 days. This becomes a point in the delayed line.
First Preceding Line Calculation: This is calculated by using the standard and turning lines for the past 26 days (as set out above):
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Second Preceding Line Calculation: The line is calculated from historical prices for the past 52 days
Using a spreadsheet, chart all the above lines together with the closing share price; as follows:
The IKH is combined with the closing share price line and the space between IKH line and share price line called The Cloud. Traders use the lines that make up the cloud as support (lower line) and resistance (upper line) levels. Trader’s Trigger: When the price is within the Cloud area, the market is not in any specific trend.
When the price is above the Cloud area, the higher Span is the first support level and the lower Span is the second support level.
A Secret Revealed While the IKH is brilliant to identify potential future price movements, it is extremely difficult to keep the information updated for then many shares identified in your watch list. If you look closely at the formulae above, there is a very close similarity to using the much easier moving averages. Using the same time spans as the IKH, use moving averages (nine and 26 days MA) as the IKH standard and turning lines. Therefore, a traditional moving average technical indicator and the IKH standard/turning lines will give a similar result. As discussed in this book, a buy signal is triggered when the shorter term MA crosses the longer term MA going upwards. A sell signals is triggered when the opposite takes place. The above triggers also apply to IKH when quantifying market expectation over a specified time period. Page 146 of 192
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Entry & Exit Points THE 3-2-1 METHOD One of the most asked questions in trading is about pricing of shares. Do you buy securities at market, or do you try and get these at a discount to the current market value? In a highly volatile and rapidly changing securities market, the answer is entirely up to you, your strategies and your investment timeframe. The norm is that, the longer your trading timeframe is, the more time you have to buy the share. Conversely, the shorter your trading timeframe is, the quicker you want to get the stock. My personal philosophy is:
Short term trades: Buy at a premium. If you need to get the stock NOW, a market order will just place you at the end of the electronic trading execution queue. By the time you get the stock, the price will have moved and you will have lost the deal. This is especially true in geared markets.
Long term traders: Use the 3-2-1 strategy, as follows: o o o o
For the first three days: place your offer at a discount of 6% to market. If your offer has not been take up, change your offer to 2% discount top market for the next two days. After this timeframe, change your offer to at market – for one day only. If – after this time period – you still haven’t being able to get the stock, move the offer to a 2% premium.
EXIT STRATEGIES Always have a stop loss or a trailing stop loss. A stop Loss is simply a level; at which you feel comfortable in selling the share if it fall. so, if you think 10% is an acceptable loss, sell the security if it falls to this level. A trailing stop loss is the same strategy as the stop loss, except that the fall is based on the shares’ upward movement. Example:
Trader buys a share at 100 cents. He believes that a 10% loss is acceptable. The stop loss is thus 90 cents. Assume that the share rise to 130 cents. A stop loss would be triggered if the share fell from 130 cents to 90 cents. A trailing stop loss would be triggered if the share fell to 117 cents (10% of 130 cents).
Two strategies are important to note:
The stop loss exit points have to be determined before you get into a trade.
If the trailing stop loss is triggered, but your overall portfolio is still only marginally affected, consider holding the stock until it hits the stop loss.
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CHAPTER SUMMARY The aim of this chapter is to complete the Six Steps by setting out three systems to time (as best we can) markets and thus entry points. These include a system to detect the current strength of a company’s share, then to see if that strength in based on a trend. The final system detects whether (and what) the price could be in future. IN THE NEXT CHAPTER In Chapter 18, more advanced technical and fundamental analytical tools are explained. The first concept is that of placing a value on new companies being listed.
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Chapter 18: The IPO -No Trading History “ Investors must keep in mind that there’s a difference between a good company and a good stock. After all, you can buy a good car but pay too much for it .” Richard Thaler (1945 - ) US Economist
On a very unpleasant wintery day in April 2010, I stood in front of the JSE’s Alternative Exchange new listings committee and was asked a simple question: “How did you value this company?” I had been warned by the Designated Advisor (listing stockbrokers for AltX companies in South Africa) that this question would be asked and a trap had indeed been sprung. The trap is that the valuation of an unlisted company is always discounted to that of a listed one. Many brokers tend to compare, and thus value, their potential listing to that of peer companies already listed. I wasn’t really concerned. After all, this very subject of determining a share price for a company without a trading history is the subject of my proposed dissertation (accepted) at the Nelson Mandela Metropol University economics department. In addition, the methodology of valuing unlisted companies has been accepted by a number of universities in South Africa after the publication of The Corporate Mechanic (Juta). Succinctly, I explained the process of how I had valued the company. The listing committee nodded and the rest is, as they say, history. The new company received one of the fastest “Unconditional” listings in the history of AltX.
New Public Issues Also called Initial Public Offers (IPO), new issues to the market mean that an entrepreneur is listing his or her company for the first time. As such, how do traders know what a realistic price for the share is? Does the trader really have to accept what the stockbroker says the value is? Once a company is listed on an exchange, normal market forces of supply and demand apply to determine a share price. The problem is how do you determine a price prior to listing? Let me stress: the ability to value IPOs occupies an extremely important place in economics and finance, as it provides entrepreneurs the first opportunity establish the worth of a set of corporate assets and it gives traders and investors an opportunity to participate in that company’s corporate activities before investor sentiment occurs. Consequently, any “manipulation” of share price prior to listing could have disastrous influences for traders. Therefore, it is crucial for anyone interested in IPO trading to examine whether, and to what Page 150 of 192
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extent, historic, current and future trends in similar peer companies could have and how such could influence the targeted IPO. So, where is the trading opportunity? The reality is that a listing only determines a price based on very little information which means that the market is depending on stockbrokers to set the price. The following highlights some of the problems traders have in buying into IPOs, but it also suggests why IPOs can be profitable investments:
There are NO RULES in South Africa (from the Companies Act to JSE listing regulations/schedules) to determine a fair and realistic share price for a company before it lists on the JSE or on AltX.
Pre-IPO share prices are currently determined using a variety of methods, from Discounted Cash Flow (DCF) to Net Sales or Asset values. Companies that are in similar industries can thus be valued using different methods and, consequently, different values can be obtained for similar companies.
The valuation method and thus determination of ultimate share value is completely left up to the stockbroker and entrepreneur involved in the listing process.
This usually means that the method offering the highest share price before listing is used to substantiate a pre-IPO value to the JSE committee and to the investment community.
Therefore, the valuation benefits the owners and not aimed at being fair to investors or traders.
Investigation needs to be undertaken to assess how the US, UK, France and Far Eastern countries determine a pre-IPO share price. My experience in stockbroking suggests that these countries also do not have an enforced methodology to establish a fair price.
Yet, South Africa – like their foreign counterparts – has a set of corporate governance rules and regulations. In South Africa, the King III set of criteria was first merely guidelines, but are now enforced.
This chapter examines the IPO process involving companies engaged in becoming publicly-traded organisations. No-one is suggesting that owners and stockbrokers shouldn’t benefit from listings. After all, if owners, staff and new investors believe in the company’s future prospects, then the share price will rise in future. The trading opportunity is in how you value an IPO.
The Magliolo Indicative Valuation Method An IPO is a process fraught with both promise and trading perils. At the very least, an IPO can permit an organisation to raise money to meet a new business objective and it can certainly make individual shareholders very wealthy. Of course, if a company has structural or managerial problems, then it may end up costing shareholders money and it can certainly do harm to the business in a number of ways. These problems are a nightmare for traders, who assume that a company listing on an exchange has undergone strict and rigorous due diligence. Therefore, the question which is pertinent in this book is how traders should approach the IPO process to ultimately settle on a forecast share price, that will help them to establish their own trading guidelines.
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Some of the suggestions that follow are fairly intuitive, but common-sense in trading is usually a prerequisite to success. The methodology to assess a share price of as company with no trading history is two-fold.
The first is to assess Gross Value.
The second is to hone that value down to a fair and reasonable level via a set of three discounts.
PHASE 1: PEER ANALYSIS & GROSS VALUE
PART 1
Analyze Gross Value [net forecast profit x pe ratio] 1. Comparable Company pe 2. Market, Industry & Sector pe
Subtract
PART 2
Reduce Gross Value by three discounts 1. Industry Cash Flow 2. Tradeability & Liquidity 3. Company specific = Company Indicative Strategic Valuation
A trader should approach an IPO by first knowing what it offers relative to its competitors and, no less importantly, he or she should have a firm grasp on the growth potential of its sector and the public demand for what its industry offers. I call the above criteria Price Earnings Market & Company Peer Analysis. Definition of Price Earnings Ratio (p/e ratio): This ratio is best described as the amount of cash investors are prepared to pay for R1 of company’s earnings per share. So, if the share price is 100 cents and the profit per share (company’s earnings described per share) is 10 cents, then the p/e ratio is 10 times. Formula: p/e = Share Price divided by earnings per share.
Phase 1 is a combination of global market research and local trend analysis. Here, the company is assessed relative to industry trends, specific sector price earnings ratios and comparable peer analysis (see example below). Many analysts use price earnings as the overall valuation of the company, i.e. if IPO of Company A is comparable to Listed Company X then why not use the same price earnings ratio? Expert contention is that the IPO is an unknown quantity as a listed entity and thus difficult to assess as a trader, but potentially highly lucrative as a trading instrument. Page 152 of 192
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The comparable price earnings ratio should therefore be the basis to calculate what I define as gross value. After this, a set of criteria (discounts) has to be used to hone in to a more relevant ratio and thus share price. In South Africa, large venture capital firms have a basic method of price earnings valuation: all companies deemed fit to invest in must be value at between 2.5 times and 4 times price earnings. In turn, this is also an unfair practice as no analysis of future growth potential takes place and all companies (no matter which sector they are in) are valued in the same manner. The following basic valuation uses fictitious numbers:
The Indicative Valuation Methodology Example Example LISTING: ABC LIMITED Proposed Sector to be listed: Property ABC’s net profit = R100 million Shares in issue = 50 million shares ABC’s Earnings Per Share (EPS) is: 200 cents (Net Profit divided by Shares in issue) In analysing markets, sectors and comparable companies, the following was assessed: COMPARABLE ANALYSIS All Share Index Industrial Index Property Index Comparable Company A Comparable Company B Comparable Company C
PRICE EARNINGS RATIO Current Five year Average 18.5 19.8 15.9 17.4 27.5 23.7 22.3 19.4 19.2 15.7 17.6 17.9
Analysis: General markets (All Share and Industrial Indices) indicate that p/e ratios are currently below two year averages and thus cheap, i.e. entry points are determined.
The Property Index shows that the sector is still expensive relative to other markets, i.e. the current p/e ratio is above the two year average.
The same is indicated by the three comparable companies, i.e. their p/e ratios are above the two year averages.
It can this be said that, given that the sector and comparable companies are higher than two year averages, ABC is listing at an expensive time. It can also be stated that this could be due to the cyclical nature of the business.
As a guide, use the maximum and minimum to determine gross value: o o
Minimum p/e ratio: 15.7 times Maximum p/e ratio: 27.5 times
Comment:
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This stage determines which price earnings ratio to use, based on industry norms and comparable listed companies. Analysis of price earnings ratios includes: JSE All Share Index, which reflect the overall state of the South African market. The JSE All Share Industrial Index, which reflects the industrial component if the South African market and The JSE Sector Index, which reflects how comparable companies are doing as listed entities.
The gross value of ABC Limited is as follows:
ABC LIMITED INDICATIVE GROSS VALUE (Before Discounts)
Attributable Profit (Forecast) GROSS VALUE: PE x Profit
Max
min
mid-way
R100 m
R100m
R100m
R2,750 m R1,570 m
R2,160 m
PHASE 2: THREE DISCOUNTS Once a comparable gross value is determined, it is then discounted in three phases; as follows:
Industry Cash Flow. This is an industry assessment. Tradeability/liquidity discounts (listed to unlisted). Specific company related discount issues.
Data and methodology: This assessment and valuation draws from a wide variety of small and medium sector data that could be accessed. These include information from Statistics South Africa, South African Reserve Bank, Trade & Industrial Policy Strategies dataset and enterprise surveys. Company profile, corporate events and environmental influences (politics, economics, business and technology) should also be taken into account to determine factors that could negatively or positively influence a valuation.
Discount 1: Industry Cash Flow In many instances, small-to-medium sized companies do not have steady cash flows; not enough or, at least, not established. To make matters worse, many new listed entities do not have enough statistics to conduct a thorough Discounted Cash Flow analysis and valuation. Without such statistics, it is not realistic to use Discounted Cash Flow methods as an indicator for conducting valuation. However, if an indicative Gross Value is used, this can be discounted by statistics outlining Industry Cash Flows. The aim is to find an indicative value as most of these companies do not have substantial assets – not enough to produce a value. The following table of statistics is available on the internet. If you have difficulty in finding such data, send me an email to
[email protected].
PROPERTY SECTOR RATIOS LATEST YEAR FIVE YEAR AVERAGE Asset structure Page 154 of 192
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Total asset turnover
2,06
1,89
1,41 34,31 27,64
1,36 31,36 22,31
2,42 1,32 0,41 0,68 1,88 6,42 3,15
2,46 1,62 0,35 0,59 13,28 5,37 12,88
2,70 0,46 5,55 5,08 1,59 0,85 1,17 48,35 20,84
5,67 3,04 8,59 7,52 6,07 4,53 1,23 25,60 16,11
8,43
9,01
Funding structure
Total assets to funding Fixed assets as % of funding Long-term loans as % of total debt
Solvency and liquidity structure
Current ratio Quick ratio Debt to assets Debt to equity Interest cover Debt to cash flow Cash flow interest cover
Profitability structure
Operating profit margin (%) Net profit margin (%) Return on assets (%) Inflation-adjusted return on assets (%) Return on equity (%) Inflation-adjusted return on equity (%) Leverage factor Retention rate (%) Return on external investments (%)
Trading activity structure
Accounts receivable turnover
Share statistics
Net asset value per share (Rand)
81,54
67,82
Industry Cash flow per share (%)
8,62
7,95
Dividend cover Cash flow dividend cover
1,94 5,98
2,01 4,00
Price/earnings ratio (times) EPS GROWTH (%)
27.5 10.26
23.7 13.77
Based on the above statistics, the Property industry had an Industry Cash Flow discount of 8.62% and a five year discount of 7.95%. This means that the amount of cash generated by companies in this sector (as an average) was less than share prices, i.e. if a company’s share price was 100 cents, then the cash generated was 100 cents less 8.62% = 91.38 cents.
ABC LIMITED INDICATIVE GROSS VALUE LESS DISCOUNT1 Max GROSS VALUE
min
mid-way
R2,750.00m R1,570 m R2,160 m R135.33m R176.97m LESS DISCOUNT 1 R218.62m R2,531.37m R1,434.66m R1,983.02m VALUE
Discount 2: Industry Tradeability & Liquidity
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The next step is to take account of the desire or potential desire of staff, colleagues, directors and the public in general to acquire shares in the business. Experience in international negotiations suggests that this discount can range between 25% and 40%, depending on issues outlined in the following text. BCI uses the worst case scenario and a 40% discount is used; particularly with new companies.
ABC LIMITED INDICATIVE GROSS VALUE AFTER DISCOUNT 2 Max
Min
mid-way
VALUE AFTER DISCOUNT 1
R2,531.37m R1,434.66m R1,983.02m
LESS DISCOUNT 2
R632.84m
VALUE
R1,898.53m R860.79m
R573.86m
R603.35m R1,379.66m
Discount 3: Company Specific Analysis The final discount accounts for the strength and weaknesses of the directors and owners of a company. However, once the company has been sold (as a whole or in part) or listed, the influence of the previous owners fade. The discount is thus small, between 7% and 10%.
ABC LIMITED INDICATIVE GROSS VALUE AFTER DISCOUNT 3 Max
Min
mid-way
VALUE AFTER DISCOUNT 2
R1,898.53m R860.79m R1,379.66m
LESS DISCOUNT 3
R132.89m R86.07m R109.48m R1,765.63m R774.71m R1,270.17m
VALUE
FAIR & REALISTIC VALUATION R1,270.17m Page 156 of 192
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EFFECTIVE PRICE EARNINGS
12.70 times
With the above final indicative value, a trader is able to forecast an expected share price, as follows:
If p/e = Share Price divided by EPS, then: Share Price = p/e multiplied by EPS If EPS of ABC LIMITED is 200 cents and p/e is 12.7 times, then: o SHARE PRICE SHOULD BE = EPS (200 cents) X P/E (12.7 times) = 2540 cents
The trader knows that 2540 is fair value for ABC Limited. A trading plan can then be established. OR CAN IT? Here is a little secret: the listing stockbroker will always suggest that the company be listed at between 15% and 20% less than the estimated share price. This is called An Abnormal Initial Return which traders can use to finalise their trading range. However, besides the immediate discount to share price, the trader needs to assess where the share will be going to in the near future, to determine the full annual trading range. Take account of the following:
The Property Industry current EPS growth is 10.26%. The expected Discount to Value is 15%. The forecast share price from Year2 : 2800 cents o Calculation: Current EPS X FUTURE EXPECTED GROWTH (10.26%) = 220 cents Share Price = EPS (220 cents) X P/E (12.7 times = 2794 cents ROUNDED OFF = 2800 cents
The trader can expect:
The company to list at 2159 cents. To rise in the first week to calculated fair value of 2540 cents To fall back after the first week to between the listed price and fair value. The share will fluctuate between these levels until the annual report is released to confirm expected growth. The share will then move up to the 2800 cent level.
Summary
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Valuing a company is not a precise science and can vary depending on the type of business and the reason for coming up with a valuation. There is a wide range of factors that go into the process -- from the book value to a host of tangible and intangible elements.
In general, the value of the business will rely on an analysis of the company's cash flow and its ability to generate consistent profits.
This will ultimately determine its worth in the marketplace.
It's rare that buyers and sellers come up with a similar figure, if, for no other reason, than the seller is looking for a higher price. The goal of the trader is to determine a ballpark figure from which market buyers and sellers can find a comparably fair value for the company. It is also naïve to interpret valuations of IPOs in boom periods to be different to that of crash periods., but the new issue market is certainly well worth watching. Nevertheless, it is worth watching the market for IPOs, especially when short term factors influence the price to below true worth; as calculated above. I believe that a number of additional discounts could be added in future to improve analysis and share price calculation. For instance, you will not come across many instances where a company entering the IPO process has dissension among its members. However, if it does – then a price will be influenced. Look out for director dissatisfaction by looking at media releases. This, of course, affects the pre-IPO share price. However, professional traders understand that some companies are obviously much more successful than others at getting everyone on the same page. It is clear that dissension can only cease if everyone can agree on what the company wishes to accomplish, what business it will be in and what its goals and methods will be; if there is any disagreement on this, then becoming a publicly-traded company should not happen until unanimous consensus is achieved. The most successful companies are able to do this. In a matter as important as listing a business on a stock exchange, it is necessary that unanimity be achieved before the IPO process gets under way; the organisation should also make every effort to groom its executives for the rigors of being the leaders of a publicly-traded entity. In essence, if a set of guidelines as set out above exists to calculate a fair share price, much of the tension is removed from the IPO process.
Looking at Prospectuses When a company lists, it usually needs cash to begin its operations. They do this by issuing a capital raising document called a Prospectus. There are general rules relating to the information placed In such a document, so that investors can make a proper judgement as to whether they would be interested in buying the share. For traders, this provides them with a starting point in their decision making process. For instance, if a trader only buys and sells securities in mining and finance, then why would he spend time assessing a property-related Prospectus? The minimum requirements for a prospectus are laid down by stock exchanges, listing requirements and government acts. By the time investors read the prospectus, therefore, they can be fairly certain that the information in it has been checked for accuracy. What should investor and traders look for in trying to judge the merits of an IPO from a prospectus? The more pertinent parts or elements of a Prospectus are set out as follows:
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The nature of the business and its history. A long history and a company that is focused in areas which are assessed to be expanding sectors of industry are major selling points. A short record and dependence on one product or contract are not.
Premises and plant. Look for companies which own their factors and premises. There are times when a listed company means that landlords feel that they can push up rentals to a point where the company’s working capital becomes strained and thus has to incur costs of moving.
Directors, key management and staff. Directors and management should be skilled and experienced in their industry. Ensure that the Board complies with all legislation. For instance, AltX requires that Boards are made up of 25% non-executives.
Working capital. Traders can be certain of one fact: companies will invariably state that they have "sufficient working capital." I suggest that you assess working capital against current assets and liabilities.
Profits, prospects and dividends. The directors' forecast of profits should be realistic and, when compared to the previous year, should be reasonable. The norm is for companies not to declare a dividend in the first year of operation.
Auditor’s report. A profit record should be assessed and analysed for organic growth and stability of potential acquisitions, look at basic ratio analysis to determine whether fixed and trading assets are accurately calculated according to latest international accounting principles. Liquidity, such as cash and short term current assets should be at least 1.5 times higher than current liabilities.
Some companies have a habit of hiding negative details in a mass of information, such as pending litigation. As a trader, can you trust a company that does this?
CHAPTER SUMMARY This chapter concentrated on providing traders with a personally developed method to trade potentially profitable new shares, but ones that have no market related price. IN THE NEXT CHAPTER In Chapter 19, among a number of valuable investment tools the concept of cash flow per share is set out. Know this intimately, as this system will eventually be your saviour.
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Chapter 19: Valuable Investment Tools “Spend at least as much time researching a stock as you would choosing a refrigerator.” Peter Lynch (1944 - ) Wall Street stock investor and author
Too Many Indicators Equates To Failure When technical analysts talk about investment tools, they tend to mean adding “just one more signal to my graphs, so that I can make even more profits.” In 2009, at the height of the forex madness, a new client came to me and asked me if I would review his strategy. He had 67 technical indicators, among them the following.
If you try to assess triggers, where do start? There are so many that the share price becomes a straight line. imagine adding yet another indicator to the above mess? When I rather too bluntly told him that he need to use a maximum of six indicators to be successful in trading he laughed.
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“What fun is that?” he was appalled that I would even suggest such a thing, What I was actually proposing was that he amend his strategy to become more efficient with less work. The strategy was simple: Reduce the number of signals, but create a watch list to assess stocks that are triggered by the more relevant number of signals.
THE WATCH LIST To continually profit from a continually changing market, you must be focused in conducting due diligence on the companies triggered by your technical signals; and you need to do this before you buy the shares. The argument against conducting any form of analysis is common enough; by the time you have conducted your research, the share has already moved. The simple answer is that your research should be on-going and not reactive. Secondly, the share may have moved, but what if that move was against your expectations. It is all very well to say that research wastes the time you could be trading, but that research can save you from disaster. If you know your trading business well, you will admit that success is made up of more than just trading. You need to always be ready to recognise and take advantage of prices when the market makes them available. The ability to do this accurately takes knowledge and skill, which is not derived from merely having a multitude of indicators. As experience has shown, the difference between making a decent living from trading and making serious cash is paying the right price for the securities. The following is a sample of investment tools that will help you to become that efficient trader. Avoid mixing your trading signals Every month Johnny buys a 10 kg bag of dog food. He pays R25 a bag and the price has stayed unchanged for the past six months. As the months go by, Johnny believes the price of the 10kg bag will rise – it has to, it simply must – and he begins to wonder whether he should buy two or maybe three 10kg bags at the end of the next month. At the end of the month Johnny goes to the market, holding his breath. Has the price gone up? Why, didn’t he buy more bags the previous month? He gets to the market and he cannot believe it that the price has actually dropped. What does he do now? Does he buy five or 10 bags? Does he buy the normal one bag and enjoy the saving? After all, dog food does have a long shelf life. Surely the sensible thing to do is buy more than one bag and take advantage of a lower price, which simply means that lower prices equal an advantage for consumers. In the stock market, traders act in horror at a drop in price, but for the long term investor, a lower price must be seen as an advantage. Stated differently, quality stocks have a long shelf life and investors should buy them in order to use them a long time in the future. Instead of seeing temporary low price as an opportunity to buy a security that could grow in the future, the trader sees the lower price as an indication to sell his own stock. Assuming a trader had a certain share in his portfolio, surely he must have believed that this specific share had a long term potential. A temporary market aberration should be an opportunity and not a disaster in the making.
AVOID MARKET MADNESS When the market goes crazy, either bullish or bearish, I go away on holiday.
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There is a stock market contradiction that never fails to amuse. While it may be okay to be greedy, when traders get caught up in a market madness – panicking when bears roar and greedily buying during bull runs – they are reprimanded by their stockbroker bosses. There is no skill in buying or selling shares during strong bull or bear markets, but it takes unprecedented courage to go against mass hysteria and buy when others are selling. Across the world, traders repeatedly do the same thing; when markets climb, investors pour money in and when market fall, investors take money out. There is no other clearer evidence of a less profitable strategy than a classic buy high and sell low! What is worse, this process is continually repeated. Traders simply cannot restrain themselves from continuously changing their portfolios. In fact, trader and investor behaviour is often so weird they throw away years of long-term strategy to ultimately achieve dismal results. Industrial psychologists around the world have tried to understand what makes them function. Strangely, no matter how much time or money it takes to draw up a long-term plan to meet an investor’s specific requirements, their perceptions and expectations are substantially influenced by their market experience of the last few months and, in some instances, the last few days. Former South African Reserve Bank Governor General Gerard de Kock in the 1980s said that when markets are bearish for a number of months, South Africans begin to believe that these markets will continue to do poor forever and they begin to sell everything. If they have been doing well, investors become euphoric and begin to believe that this time it is different and the markets will continue to be bullish forever. The higher the market price goes, the more they want to buy. That strange philosophy was highlighted in 1997, just before the Emerging Market Crash. As head of research at a local stockbroker I was asked whether the company should dump its shares as the market was “too high to last!” I reiterated that a fall would be temporary and that dumping the shares would result in massive losses over time. The portfolios would be disrupted and rebuilding them would cost more than the small benefit of selling before the fall. I had hardly left the boardroom when the directors stated to sell everything they held. The market did fall, but had recovered within three months.
DON’T LISTEN TO DOOMSAYERS Despite the availability and use of powerful technical systems, why do so many traders still lose? A well-known answer is that traders are too close to the market and, consequently, cannot be objective. A colleague once remarked, smiling, that broker X had jumped off the top of a cheap hotel in an extremely poor suburb of Johannesburg. This person was what I term an ultra-bear, which means that no matter how well or bearish the market is doing, he believes the market will crash, crash and crash again. The broker had committed suicide, because he was not prepared to face losses he was rumoured to have made. My colleague was, essentially, happy in his misery. The markets were crashing and he was right – it had only taken 18 months of hearing him constantly proclaim the coming of doom. “What have you got to say now?” He said. “The Overall Index is still higher than when you started your doomsday cries,” I said and walked away. As traders, both broker X and my colleague were concerned with daily statistics to the exclusion of monthly overall trends and had lost sight of the big picture.
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Traders and investors have seen - despite a multitude of negative and positive political factors, financial and business turmoil and progress and personal freedom for all since the general election in 1994 - the JSE Limited Overall Index rise by over 480%. When a trader changes a portfolio weekly, he or she is making the assumption that during the next week the markets will behave like the last week. In other words, the best parameters for a forecast period of time, is unlikely to be the historic trend that has just occurred. All traders, in all markets around the world, go through losing periods - no matter what type of approach chosen or preferred. Performance cannot improve by constantly changing their strategic approach to managing investment portfolios. Since there are many more losing approaches than winning ones, traders actually decrease their chances of success by frequently changing systems. The best advice I ever received from a successful stockbroker: “If you want to be a doorman, be one at the Hilton.” In other words, if I wanted to be successful as a trader, I should know what the investing public want and buy before they do. Alternatively, if you want to be a global player, you have to be in the international arena. Remember that the same rules apply for all markets. If an investor can trade for an extended period in a wide variety of markets, he is likely to be successful, although success in never guaranteed. This works although markets change their short-term patterns, they tend to show similar long-term trends. That is your edge. If a trader plays the trends, he or she is likely to succeed in the long run. Attempting constantly to modify your system to mimic the changing patterns of the recent past will not improve your chances of success. It will more likely ensure failure.
ABILITY TO MEASURING LIQUIDITY Traders often avoid looking at financial statements, because these seem to complex and a waste of time. A client told me that annual reports were for “those who consider themselves above common people.” In fact, financial reports provide you with information about the company, but also about its market and often about competitors. In fact, one of the trickiest problems for traders and investors is the ability to measure liquidity from a balance sheet, particularly when a company is approaching the market in a Rights Issue. This is the term used for a new issue of shares for funds. The importance of a new issue is its influence on share price. A basic explanation, but logical, explanation on effect of share price is as follows:
A company’s earnings per share is calculated by dividing attributable profits by the number of shares in issue. Consequently, if more shares are issued, the earnings per share must fall as a number.
If you assume an unchanged price earnings ratio, then the share price will fall.
Remember that share price is calculated by multiplying share earnings per share by price earnings.
The astute trader also knows that the injection of capital into a company’s balance sheet will influence liquidity. A such, a cash injection improves the company’s liquidity ratio and ability to expand operations. This in turn means that the lower calculated share price should be temporary.
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It is common practice for a company to rule off its books when stocks are at their lowest, which obviously reduces the problem of stocktaking; it also means that the cash balance is at the year's highest and therefore the balance sheet shows the greatest strength. When trader’s set out to evaluate a group's liquidity he or she must first establish the nature of the trade and the time In the trade cycle that the books are being ruled off. Then – and only then – can the effect of a capital injection be determined.
CASH FLOW PER SHARE: THE NEW BOTTOM-LINE FILTER When all rubble has fallen around you, and you look at the remains of a company’s financial ruin, you want to be in a position that you can smile and walk away; unhurt, in a true trade’s sense. You can only do that if you are certain that every investment or trade that you make is based on an ultimate bottom-line safeguard. That filter is the cash flow per share. The logic is that a company without cash will ultimately fail as debts catch up and ruin financials strength and ratios. If, however, the company generates more cash per share than its share price, then you can be 90% certain that the company’s share price has a natural fundamental support level. Definition: CFPS (Cash Flow Per Share) is a measure of financial performance that assesses the cash flow generated by a company and divided by the number of shares in issue. The difference between CFPS and earnings per share (EPS) is that the latter looks at the attributable earnings of a company on a per share basis. The higher a company's CFPS, the better it is considered to have performed over the period.
Skilled traders also use the same method to calculate sector CFPS and then use the information to draw comparisons to other companies or sectors. The following examples shows a company with a 200 cents CFPS. When the line is drawn on a share price graph, you get an indicator of when the share is overpriced or not.
Essentially, all prices above the 200 cent mark suggests that the company is trading above fair price, while below the 200 cent mark, the company is undervalued.
PATIENCE Even when traders have carried out all fundamental and technical analysis and want to buy a security, they cannot control the market and related price actions. So, instead of waiting for the entry level to be triggered, traders often plunge in.
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Patience is a scarce commodity in stockbroking and particularly among traders. Here’s a simple suggestion: have more than one security which you want to buy. That way you are looking at multiple entry levels , which should keep you busy and avoid too early market entries. As investors and traders have no control over markets, look at what you can control. This really boils down to you and your patience. A suggestion is to conduct research while you wait for e should be moved to but you can control when you're willing to buy shares. The final device your entry levels to be triggered. If you want to become successful, you have to be patient enough to wait for a value price before making a purchase.
CHAPTER SUMMARY The chapter looked at very useful tools to improve your trading, including liquidity analysis and a cash flow per share verse share price study. IN THE NEXT CHAPTER In Chapter 20, the new trader is really stretched by looking at further use of technical tools. This time the importance of being able to combine averages is explained.
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Chapter 20: Cutting-Edge Day Trading “If stock market experts were so expert, they would be buying stock, not selling advice.” Norman Augustine (1935 - ) US aerospace businessman
Combining Averages STEP 1: DETERMINE WHETHER TO TRADE OR INVEST One method to use moving averages more effectively, but obviously in a more complex manner, is to use moving averages as support and resistance indicators. So, in this instance, you ignore traditional support and resistance lines and use signals based on specific moving averages. The trick is to combine exponential with simple moving averages to get a Moving Average Trigger. A brief reminder: common verses exponential moving averages.
Simple moving averages are basic lines based on a number of days taken as an average. These indicate the average price paid for a share over time, but are susceptible to giving traders false signals.
Exponential moving averages have a greater weighting on recent prices as opposed to average prices. The greater emphasis on current prices mean that traders can rely more accurately on signals. As such, traders can use exponential moving average to quickly detect changes in trends.
Note that simple moving averages are a smoother line than exponential moving averages.
The combination of simple and exponential moving averages provides a unique look at the market, providing traders with signals for both short and long-term trades.
It must be stressed that there are no hard and fast rules as to the length of time used for both the simple and exponential moving averages. This depends solely on your trading style and strategies. Whatever timeframe you use, ensure that you test and re-test signals before you adopt these as strategy. While there are no rules as to timeframes, experience shows that the following are popular among professional traders: Look at the 10 Day SMA and 30 Day EMA to determine if you should be focusing on long positions or short positions.
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Here are the rules for timing your trades to the market using moving averages.
If the 10 Day SMA is above the 30 Day EMA: Buy long positions only. If the 10 Day SMA is below the 30 Day EMA: Buy short positions only.
This simple technique identifies the underlying trend and helps traders quickly decide whether a position is right for them. Here is an example:
Looking at the chart above, a mere glance can tell you when to trade (buy for the short term) or whether to buy as a long term investment. The above strategy is fine and can be used without further signals being added. However. It is preferable to add an indicator to determine whether the above triggers could be affected by oversold or overbought positions. As moving averages are trend following indicators, they only provide sound signals in trending markets and not when the share is moving sideways. At this junction, we need to establish whether the trigger has substance, which we do by adding the Williams %R technical indicator.
STEP 2: ESTABLISH SUBSTANCE The Williams %R indicator is a momentum indicator and measures whether a position is overbought or oversold. The indicator is easy to use and the oscillator fluctuates between a zero level and 100.
When the indicator lies between 80% and 100%: share is oversold. When the indicator lies between 0% to 20%: share is overbought.
The indicator uses the closing price relative to a price range over a predetermined period. The default setting in most charting packages is 14 periods. Many professional traders use a setting of 3, which is far more sensitive. When combined with the sma and ema, the following rules apply:
Trigger indicating an Oversold position: 10 Day SMA > 30 Day EMA and the Williams %R is less than -80..
Trigger indicating an Overbought position: 10 Day SMA < 30 Day EMA and the Williams %R is greater than -20.
Comment: The greater the overbought or oversold position (as indicated by Williams %R), the greater the chance of a market reversal happening.
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Rule: o o
Go Long: Williams %R is at -90 or below Go Short: Williams %R is at -10 or above
Here is an example:
Comment:
Block A: Indicates that the moving averages highlight a LONG TERM BUY. This is supported by a Williams R% level of below -80%. o
The share moves from level C to Level D
Block B: Indicates that the moving averages highlight a SHORT TERM BUY. This is supported by a Williams R% level of below -20%. o
The share moves from Level F to Level D.
The importance of these triggers is that they are specifically for day traders as the triggers are not predicting future events, but short term trends. Many professional traders use the above method to identify when to establish long or short positions, and then they use different sets of criteria to determine length of holding, whether to go long or short and when to exit the trade.
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Stated differently:
Traders want to know when to buy or sell at the most opportune time. This is really just another of saying that traders want to buy at the lowest point and sell at the highest point. This is seldom achievable as Institutional funds tend to sway markets before you are able to find that top or bottom.
Another point of advice from the professionals: o
Traders tend to be bearish when the market moves strongly and gets near the top of the Sell trigger.
o
Speculators tend to be bullish when the price is climbing.
If you set triggers, then use them and not try to add the elements of speculation into the mix. That is always a disaster for traders.
CHAPTER SUMMARY The chapter was designed for those keen to further their studies of technical analysis. In this case, an ability to understand signals to such an extent that traders can combine various signals to personalise entry or exit triggers. IN THE NEXT CHAPTER In the final chapter, a conclusion and final word are set out.
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Chapter 21: Conclusion & Final Word “I think and think for months and years. Ninety-nine times, the conclusion is false. The hundredth time I am right.” Albert Einstein (1879-1955) Developer of theories of relativity and Nobel Prize for Physics in 1921
Conclusion Six Steps to Trading Like a Pro has taken you through a host of variables to enable you to create an effective trading methodology. It is important to see, however, that you take from this book only what you need to design your own workable trading system. There is a myriad of financial and trading books available to you to continually improve your skills. For instance, find books on accountancy. Not in the sense of drafting financial statements, but rather on how to assess income statements and balance sheets. There is no harm in finding out how to read a company’s accounts, after all, EPS is derived from the statements which, in turn, ultimately results in the company’s share price rising or falling. However, what about those who are less than interested in reading to improve their trading skills? Is there a quick answer to the overwhelming question asked during the many workshops which I have hosted: “IS THERE A SIMPLE SYSTEM TO TRADE TODAY – WITHOUT READING THIS WHOLE BOOK AGAIN?” Against my better judgement, the answer is yes and relates specifically to those using a swing trading system; outlined and explained in Lore of the Global Trader: Swing trading requires, in my opinion, extreme patience as you need to combine fundamental analysis with daily bar charts to help to time your market entry. In addition, most swing traders are well capitalised, which allows them to diversify among different global markets and thus reduce risks of declines in any single market. Being well capitalised means, of course, that you have substantial funds available to you to trade. Therefore, you need:
Daily chart pattern system
System must have simple moving averages
The above moving averages can be used to help you to quickly identify new trends. The simple signal is:
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TRADING SIGNAL TRIGGER BUY SELL
MOVING AVERAGE CROSSOVER When the shorter term indicator crosses the longer term indicator upwards When the shorter term indicator crosses the longer term indicator downwards.
Three more indicators are needed: Firstly, you will need to implement a Stochastic signal to assist you to see:
If the signal indicates that the securities’ momentum is still strong enough to continue. When the position becomes oversold or overbought.
Secondly, use an RSI indicator to confirm that securities’ strength. Thirdly, you need to decide how much you are willing to make or loose per trade. This really means setting up an exit and entry point. The following is an example of the above criteria:
The diagram indicates that the shorter term MA has crossed the longer term one in a downward move, triggering a possible Sell Signal. this is confirmed by the Stocastic indicator, warning of a slowiong down of momentum and weakening strength via the RSI. The OB/OS indicator is the final confiormation that a SELL is indicated. You can see that your investment criteria has been met, with all your predetermine indicators (moving average crossover, Stochastic and RSI) all pointing to a sell signal. Yet, do you know how many novice traders still ignore these and hold on in the h ope that the market will turn? My analysis indicates that more than 80% of new traders hold onto loosing shares. The final step in the above graph is to include a BUY and Sell entry point. You can use Resistance and Support lines to do this. Make a note of your entry price, stop loss and exit strategy. To summarise:
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The above is just another way to say that trading systems don’t have to be complicated or involve dozens of indicators. Remember that you created your trading system, so not following it can only mean that you are lazy, the system doesn’t work or that you are not serious about being a trader. Be disciplined and trust your system and your abilities.
Final Word It has taken many pages to get to this final message and I hope that it has been a worthwhile journey. My message is simple: if you have well designed system, are disciplined and serious about your new career as a trader, then you must follow your own plans and strategies. For instance, it is useless to say that you will trade IPOs and then decide to trade small caps. If you keep changing the parameters of your strategies, you will end up the loser and much poorer. If it helps you as a trader, let me finish this book with a few of the disciplines I have adopted over the years:
In the share market, only buy Ordinary shares and ignore all other types of marketable securities. I am not interested in buying Preference shares, even if they offer a higher dividend – I am not trading shares for their dividend, but for capital growth. I seldom hold shares for long enough to earn a dividend.
I reduce my risk of trading by: o
Diversifying across at least three contra-cyclical sectors.
o
Never hold more than 12 shares in my trading portfolio.
o
Day trading stocks are closed every night.
o
Never put more than 2% of your entire capital into any single investment or trade.
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o
Have a solid entry point and exit strategy. This means that at times I take profits too early or sell a little late; but I keep to my strategy and thus never (I stress) never have emotions of greed or fear.
o
Once I have completed analysis, I carry out y trade without hesitation.
o
I never buy on tips or rumours; ever!
o
My personal FINAL filter is to buy shares that generate more cash per share than share price.
Some other strategies:
Believing in your strategy does not equate to being flexible. Markets and companies change and at times change rapidly. When companies make unforeseen statements, be prepared to take action and switch trades, often from one industry to another.
Educate yourself: take time to improve your investment knowledge through books, workshops and keeping up to date on industries and companies by reading investment papers regularly.
Keep an eye on IPOs: I use the strategy and valuation techniques outlined in this book to pick up quality new investments.
Volatile shares are great for short term trades: Look at companies that are tightly held for opportunities to buy when they have been slammed by market conditions. If a company is 80% controlled by a Blue Chip Institution, that organisation often steps in and acquired the share at the lower value, which is a short term trading importunity for you.
There is a great deal of truth in the old saying that life is a gamble. Every action carries its own risks. Every trade and investment brings you face to face with a specific risk. Those who are thinking about trading as a career have to accept that you cannot sit back and accept (or think) that trading is easy. You can of course turn to a mentor to help you achieve your goals in an orderly manner. While markets change and industries move in cyclical manners, I can always rely that properly selected shares or other forms of securities will offer value. You have to be patient and serious. This is simply not an industry to be taken lightly, but it can be a highly profitable one. And one which gives you the freedom to be your own boss.
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Appendices
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