Discussion 14 : Trade on the Gambling Table!

Great day ahead!

Due to recent feedbacks that I've gotten from my readers who repeatedly question the success of technical trading, I consider myself to have an obligation to share this discussion with all my readers.

Before we begin, I apologize if I ever hinted a guaranteed success trading with Technical Analysis (TA). TA, in no way, guarantees absolute profitability to its practitioners. TA's role is merely to enhance the probabilities of you guessing the right market direction.

Therefore, TA alone, is not sufficient in making you a successful trader.


THEN WHAT MAKES A SUCCESSFUL TRADER?
When I ask most average traders whether they realise that there are risks in trading, all of them would say "YES". But when the stock price fell, they hold onto their stocks, hoping that the prices would go up. From a trader, they suddenly became an investor! Obviously, they understand only the English Language of 'risk', but not the Financial Literacy of 'risk'.

The key to making yourself a successful technical trader is not so much on the extent of the Technical Analysis that you practise or what Technical Indicators you use, but very much dependent on the way you manage your risks with each trades, and the discipline to follow through your strategy, enduring losses as they happen!


MAKING A SENSIBLE TRADE
You give a million dollars of cash to an average gambler, and you see your money got wiped out in a few hours.

A professional gambler, on the other hand, is able to make a lot of money on the casino table, with just very little initial capital.

Being a trader is akin to being a gambler. Being an ignorant trader is equivalent of being an ignorant gambler who will get wiped out, regardless of how much money he brought along into the casino. A professional trader, would be able to make a fortune with very little initial capital.

A professional gambler makes money on the table due to a few factors:

1. The probabilities of winning is higher than the probabilities of losing.
2. The rewards of winning is higher than the costs of losing.
3. The risks of his gambling capital to be wiped out after a streak of consecutive losses are low.

THE USE OF TECHNICAL ANALYSIS
Professional gamblers are masters of probabilities. They are aware of their odds of winning and losing and are able to brilliantly keep up with their odds on the trading table after each cards are dealt from the deck. When the odds of winning is with the gambler, he may either raise or call, but when things turn bad, he would know when to fold the hand, taking the loss of the initial 'table money'.

Same goes to trading. As a trade turns bad, traders cut their losses (fold). When the trade goes in their favour, they may consider buying/shorting more (raise), or wait and let the profits run (call). TA is an indicator of probabilites that would help a trader to keep track of their odds in the environment of the market (trading table) after each trading period (cards dealt from deck).

Since TA enhances the probability of winning, it is undeniably a good component to include in devising your trading strategy. You need not win each and every of your trades, but if you are able to minimize your losses (cut losses) and letting your profits run when it happens, and the probability of you making profits is higher than the probability of you making losses, you are doing fine.

Think. Why gamble when the odds are not with you (going against the trend)? Will you even consider gambling when you are unaware of your odds of winning (trade without TA)?


RISK AND REWARD RATIO (RRR)
If I were to buy a stock at RM1.00, and am prepared to cut loss at RM0.80, with a profit target in mind of RM1.60, it can be translated (in terms of gambling) to "I am putting RM0.20 as a 'bet' for a winning reward of RM0.60". In other words, my RRR is RM0.20 : RM0.60, which is 1 : 3.

If I were to buy a stock at RM1.00, and am prepared to cut loss at RM0.80, with RM1.10 in mind as profit target, my RRR is RM0.20 : RM0.10, which is 1 : 0.5.

Which of the two trades above is a more sensible one? I believe the first one would be. It does not make sense if you traded for an expected gain of half the amount of the money you wagered on the 'bet'. No professional gamblers would gamble on such terms, unless the odds of winning is significantly higher than the odds of losing.

I always avoid involvements in trades that have RRRs that are lower than 1 : 2. To most traders, the RRR would have to be at least 1 : 3 before they find that the trade is sensible. Some traders might even accept a trading RRR of as low as 1 : 1.5! Determination of which RRRs are acceptable to you generally depends on how good and reliable the odds of winning are in your trading strategy.


RISK OF RUIN
The Risk of Ruin is a term that is often used in gambling. It is the risk of you losing a substantial amount of capital due to a streak of successive losses to render it unwise or unprofitable to continue gambling.

Since professional gambling is a business of odds, there are times when a gambler would experience a streak of consecutive losses. No matter how good a trading strategy is, as long as it is subjected to odds, he would not make money if he loses all of his capital before his streak of consecutive losses ends.

All traders face this problem. In the game of probabilities, you may lose all your earned money in a blink due to a streak of successive losses. That is why risk management is so crucial if you intend to be a successful technical trader. This problem is more apparent during the initial stages when traders just started off their trading careers. This is due to them having small portfolios and their inexperience in trading that make them more susceptible to successive losses that wipe them out before even making a penny of profit.


EXAMPLE OF RISK OF RUIN
Adapting an illustration from The Edge, I would use the FKLI contracts as an example. You opened an account with RM7,700, keeping in mind that margin required for FKLI is RM2,700, so your risk capital would be RM5,000 (RM7,700 - RM2,700). Assume that you trade 1 contract and stopping out after 2 points of losses (which is RM125, including commissions).

This way, you can afford to lose 40 consecutive trades before raising the white flag (liquidating your account). In the event that things work well, and let's say that you have managed to accumulate RM22,000 in your account, and you are now trading 3 contracts (assuming you raise a contract after every RM7,500), your losses would now be RM375 a trade.

You can then afford to lose 19 consecutive trades before reducing your account balance to RM14,875. This time, you reduce your trading contracts to 2 (RM250). Now, you can afford to make another 30 consecutive losing trades before your account balance reduces to RM7,375. You'll then lower your trading contracts to 1 (RM125) and can afford to lose another 38 consecutive trades before turning your account balance to RM2,625, which you will then declare your account as 'ruined'.

From here, we can see that to be ruined from RM22,000 to RM2,625, requires a consecutive loss of 87 (19 + 30 + 38) trades, giving you ample opportunities to remain in-play. The 'Risk of Ruin' concept is widely practised by Turtle Traders in managing their risks.

You may not be win while you remain in-play, but you lose once you've lost your ability to play.


CONCLUSION
Being a successful trader requires you to

1. Maximize your probabilities of winning;
2. Given the maximized probabilities of winning, make a sensible trade;
3. While making a sensible trade, be aware of the Risk of Ruin; and
4. The Discipline to go through tough times of consecutive losses.

Always remember, it is very often NOT the knowledge that makes you a successful trader, it's the DISCIPLINE and SMART APPLICATION of knowledge that makes you one.


Thank you for reading, and have a profitable week ahead! =)

Discussion 13 : Trend Following With Moving Average Convergence/Divergence (MACD)

Hello and a very good day to you! 

While viewing the charts that I have included in my previous Discussions, you guys might have seen some Momentum Indicators (MI) and Momentum Oscillators (MO) being plotted to enhance the reliability of signals generated. These Western technical tools are generally used to gauge the force behind a price trend or movement, and very often, are used to generate entry and exit signals for technical traders.

MOs, such as Stochastic and RSI, are leading indicators of a price movement. Oscillators would make use of two lines to gauge an overbought and oversold region. It is generally understood that one should sell when the price is in the overbought region, and buy when it is in the oversold region.

MIs, such as Moving Averages (MAs) and MACD, are lagging indicators. They will urge you to chase the boats that you have missed! Despite the fact that MIs often give signals late, causing you a late entry to an already established trend, it is many times more reliable than MOs, which are renowned for their high frequencies of emiting False Signals.


INTRODUCTION
Moving Average Convergence/Divergence (MACD) is a Momentum Indicator created by Gerald Apple in the late 1970s, and futher improved by Thomas Aspray in 1986. MACD, pronounced as "mack-dee" by technicians around the world, appears in chartists' toolbox as a deadly trend following indicator. It generates entry and exit signals for long term trend tradings, and is also often used to enhance reliability of signals generated by Candlestick Patterns.


SETUP OF MACD
MACD indicator is generally comprised of 3 components:

1. MACD Line - 12 days EMA of stock price minus 26 days EMA of stock price.
2. Signal Line - 9 days EMA of MACD Line.
3. MACD Histogram - Difference between MACD Line and Signal Line.

Note that in MACD, EMAs are used in favour of SMAs. Exponential Moving Averages (EMA) put a higher weighting on the more recent stock price against the older ones. This is essential due to the principle that the latest stock prices would logically 'spearhead' the upcoming/existing trend.


ZERO LINE CROSSOVERS
Principles:
Buy Signal - When MACD Line crosses over Zero Line from the bottom.
Sell Signal - When MACD Line crosses over Zero Line from the top.

The zero line acts as a 'realm divider' between an uptrend and a downtrend. According to the MACD, an uptrend is confirmed when the MACD Line crosses above the Zero line (positive region), and a downtrend is confirmed when the MACD Line drops below the Zero line (negative region). Illustration (i) shows FBMKLCI daily chart of year 2008 and year 2009, with the Zero Line and MACD Line clearly separating the two trends.

Illustration (i) : FBMKLCI - MACD & Identification of Trend

MACD Line takes the difference between a faster EMA (12 days) and a slower EMA (26 days). As the differences increase, the MACD Line will sway further away from the Zero Line, be it in positive or negative regions. As the differences decrease (happens when stock prices consolidate), the MACD Line moves closer to Zero Line. A crossover happens when there is a change in polarity from negative region to positive region, and vice versa (happens when consolidation is over, i.e. consolidation breakout!). See illustration (ii).

Illustration (ii) : FBMKLCI - MACD & Consolidation Breakout Play

However, caution should be taken while implementing this strategy. A Zero Line Crossover could happen in an instant due to a sudden change of price momentum from upwards to downwards, or vice versa. In that case, the crossover is no longer due to a consolidation breakout, and chasing such trend could be dangerous, as the trend might have already been exhausted by the time it crosses the Zero Line.


MACD CROSSOVERS (SINGLE LINE CROSSOVERS)
Principles:
Buy Signal - When MACD Line crosses over Signal Line from the bottom (Bullish MACD Crossover).
Sell Signal - When MACD Line crosses over Signal Line from the top (Bearish MACD Crossover).

Signal Line is the 9 day EMA of the MACD Line. This acts to 'smoothen' and 'average out' the MACD Line. As the MACD Line crosses over the Signal Line, it means a change in momentum is under way. Buy and sell decisions based on MACD Crossovers should therefore be more profitable, compared to Zero Line Crossovers, as MACD Crossovers give an indication of a change in momentum, which is a necessary build-up to a change of polarity.

Illustration (iii) shows how KFC fares using the MACD Crossover strategy.

Illustration (iii) : KFC - MACD Crossovers

Traders should be careful when practising this approach as it tends to give quite a number of False Signals, particularly when MACD Line and Signal Line braid themselves during short term consolidations. Traders should make use of other predictive indicators such as Candlestick Patterns, as they could give an early psychological indication of a potential momentum outbreak.


MACD HISTOGRAM
The improvement made by Thomas Aspray on the MACD system is the introduction of MACD Histogram. MACD Histogram measures the difference between the MACD Line and Signal Line and present them in the form of histogram.

Principle:
Buy Signal - MACD Histogram reduces in length and formed below the Zero Line.
Sell Signal - MACD Histogram reduces in length and formed above the Zero Line.

When MACD Crossovers give a buying or selling signal, they are very often a late entry and exit signal. This is due to the lagging nature of Moving Averages (which is the heart of MACD system). Thomas Aspray then came up with an idea that entries and exits should not be based on MACD Crossovers, but should be triggered when the differences between MACD Line and Signal Line reduce. That is the earliest possible entry and exit points that would yield maximum profits.

Compare illustration (iv) with illustration (iii). Both charts represent KFC in the same exact situation. See the differences in profits if MACD Histogram is heeded ahead of MACD Crossover!

Illustration (iv) : MACD Histogram



MACD DIVERGENCE
This is by far the most powerful signal that any MI or MO can give. A divergence means that the price actions (price movements) are inconsistent with signals generated from the MI or MO. Divergences occur in MACD as well.

The general rule for divergences in any MI or MO is, the price action would ultimately follow the direction signalled by the MI or MO.

Study OSK's daily chart in illustration (v) and see for yourself!

Illustration (v) : OSK - MACD Divergence

CONCLUSION
MACD is a useful indicator for intermediate term swing traders and position traders, as trend following is the core concept of this system.

Shorter term traders such as day traders and short term swing traders may make use of this indicator to confirm the direction of the prevalent trend, on multiple time-frame charts. Scalpers may want to scalp only in a long position on 5-minute chart if the MACD on hourly chart shows upwards momentum. The risk of losing is then highly minimized.

There are many further information and knowledge that revolves around this topic, which I couldn't finish discussing even with another 10 similar articles! MACD is a system that looks simple, but contains highly sophisticated trading disciplines that could greatly enhance trading precision and winning probabilities, particularly for a long term position trader.

The best way to learn a technique is to learn it from its creator. I highly recommend these 2 books for my readers who are interested in perfecting this technique. One of them is written by Gerald Appel in 1985, entitled "The Moving Average Convergence - Divergence Trading Method (Advanced Version)". Another would be "Understanding MACD", a book he co-authored with Edward Dobson in 2008. These 2 books, together with other MACD materials, are now available at TLSBookstore.com.

So, ride the trend for the week ahead with MACD! I'll see you again next week~! = )


The Moving Average Convergence-Divergence Trading Method (Advanced Version)

Discussion 12 : Head and Shoulders

Greetings! Made any profits last week? = )


INTRODUCTION
Head and Shoulders (H&S) is a chart pattern which is extremely reliable in identifying an end of an uptrend and gives birth to a new downtrend, and is very commonly seen on daily charts, as well as intra-day charts. The silhouette of H&S pattern resembles a human with one head and two shoulders.

The reverse of this chart pattern is known as Inverted Head and Shoulder Pattern (IH&S), which I regard as rather rare in KLSE, and is comparatively less reliable than H&S. IH&S is a bullish reversal chart pattern which is seen at the bottom of a downtrend.

The heart of Discussion 12 is H&S, which is a bearish reversal chart pattern.

CHART PATTERN OF HEAD AND SHOULDERS
H&S is basically identified by its pattern of having three consecutive tops, with the middle top higher than the tops on the left and right side. A neckline is drawn from the low of the retracement of the left top, to the low of the retracement of the middle top, projecting it further to gauge the retracement low of the right top. Refer illustration (i).

Illustration (i) : KNM - H&S and Neckline

BREAKING THE NECKLINE
The H&S pattern is complete when the price breaks the neckline on the right. Then, the stock price would have effectively fallen out of the prevalent trend. If the neckline at the right shoulder is not broken, then there is a possibility of it being a false signal. The high of the right shoulder should not be broken if the signal is to remain valid. After breaking the neckline, the neckline support now turns into neckline resistance. Refer illustration (ii).

Illustration (ii) : KNM - Breaking the Neckline

PREDICTIVE NATURE OF HEAD AND SHOULDERS PATTERN
The distance between the head and neckline would be taken as a guideline to gauge how far will the price drop after breaking the neckline. There is a rather complicated rationale behind this technique, which I would not explain further as at now. Having said so, I find that the gauge is rather accurate when practised in KLSE. Refer illustration (iii).

Illustration (iii) : KNM - Predictive Nature of H&S

THE ROLE OF VOLUME IN HEAD AND SHOULDERS PATTERN
Ideally, we would want to see higher volume on the build-up of the left shoulder (preferably a volume blowoff at the left shoulder top) compared to the build-up of the head. This means there are declining interests in the build-up towards the top of the head. The descent from the top of the right shoulder that breaks the neckline should be accompanied by increasing volume. Refer illustration (iv).

Illustration (iv) : KNM - Volume in H&S

OTHER CONFIRMATIONS
It is crucial that any TA techniques not to be used in isolation. Traders/technicians must seek confirmation(s) or convergence(s)/divergence(s) of other technical indicators to further enhance the signal emitted by any one indicator.

In explaining the the above theories, I have made use of KNM as an illustrative example. Keep in mind that you might have already seen this chart in Discussion 11 (Part 1) : Playing the Gap (Basic Hand). Aside from Gap Analysis and H&S Pattern, many other indicators can be used to further confirm this signal. For instance, Volume Analysis (as detailed above), Stochastic Divergence, and Moving Average. Refer illustration (v).

Illustration (v) : KNM - Stochastic Divergence / Moving Average Convergence

ANOTHER EXAMPLE
Please see the below chart for another illustration of H&S Pattern in WCT (illustration (vi)).

Illustration (vi) : WCT - Head and Shoulders Pattern

CONCLUSION
With the recent KLCI moving upwards after a few successive declines, it is imperative to deduce that the index is currently in a downward momentum. With this upward movement seen as a temporary pullback (in my opinion), I would be expecting to see more downward movements in the near future, and I mean real near future. >.<

I hope that by sharing this bearish reversal chart pattern would help serve my readers to as an early indication of any possible trend reversals that might unfold. Capital preservation is number one priority in stock trading. Therefore, remember,

"Cut your losses short, let your profits run!"

Happy trading for the coming week ahead~!   = )