Discussion 3: Be a Man, Befriend the Trend

Why trade only in a price uptrend?

An established investor would be able to tell you the logic of this philosophy right away. Especially in the Malaysian market where opportunity for shorting is extremely limited, this is the philosophy that I always encourage investors to not deviate from!

Now, we all know that the price of stocks may go up (uptrend), go down (downtrend) or go on a consolidation (sideways). I'll depict an easy example, just showing how the trending line looks like.



Illustration (i) : Trendlines

As shown in illustration (i), the price trends of a stock would go up, down or sideways in such manner.

Notice that when a stock price goes up, it does not goes up like a rocket flying into space, nor does it free fall from a 60-floor skyscraper when the price does go on a downtrend.

When a stock price goes up to a certain level, the stock price retraces  to its support level before making another climb. Similarly, when the stock price is heading downwards, and touches a certain level, it will pull back to its resistance level before it continues its drop.

The former happens when prices hit the profit target of some investors, and they begin to take profits, thereby selling off all, or a portion of their stocks, which made the stock price dropped a little, before continuing its uptrend.

The latter happens as speculators would create an impression that the stock price is now too cheap. Thus, they will begin stocking up, and then throwing it all when other ill-informed investors thought the trend has reversed, thereby making a profit.

I will share with you my opinions on support and resistance in greater details in the future few articles. Before that, let us get this concept right in mind.

"Why would you trade when the price is trending downwards?"

Whenever I asked this question, most of the investors would say,

"It's cheap. I buy, wait for it (price) to go up, I sell."
"The fundamental of the company is good. Now it is underpriced. I'm going in at a bargain."
"I don't know, by stockbrokers told me it is good to go in now."
"I know I'll be making profits. If the price continues to drop, I'll DCA the stock, and will make more profits when the price goes up!"

That's very optimistic! Seek them out if you ever need motivational talks!

Let us be rational investors and take a look at the situation professionally. We know that to make profits in the market, we need to buy low, sell high. A Sophisticated Investor (SI) will look to enter (at position B) and exit (at position S).

Illustration (ii) : Uptrend Entry and Exit

Have a look at the illustration (ii) to the left. SI would want to buy at the low of an uptrend, and sell at the high.

This is because a competent investor know this at heart - in an uptrend, the stock prices make a higher low, and most importantly, a higher high.

Higher low means that the three B positions (which are the low of the stock at that given time) are higher than the previous one.

Conversely, higher high means that the two S positions (which are the high of the stock at that given time) are higher than the previous one.

Illustration (iii) : Downtrend Entry and Exit

Now turn your attention to illustration (iii). You can see that in a downtrend, stocks are trading at not only lower low, but also at lower high!

Many would then ask, what is the difference? You can still buy low, and sell high, and earn profits in between. So, why not trade in a downtrend?

What if you missed your exit?

As an optimistic investor, we always do tend to think that we will exit at the upcoming S (which is the most ideal). Well usually if we missed an exit, we would most likely have to wait for the next exit.

In an uptrend, if I missed an exit, I would just need to wait for the next exit, which would just be around the corner. And, I do not have to worry too much as the next high would be higher than the previous high. (In an uptrend, remember it has to be higher high, higher low).

In a downtrend, I would start to shake in fear. I missed an exit! So the next high would be lower than my previous high! Remember, in a downtrend, it is lower high, lower low. If you refer to illustration (iii), you will notice that the next exit (the second S) would be approximately the same as my entry price (the first B). After deducting brokerage fees, I might've ended up in a loss.

What if I missed that exit too? Then in the next exit, I would most probably be making a loss. Goodness! I thought that I would buy this stock and then sell it quick to make some quick money. Now I've accidentally became a long term investor! Now recall, how often does this happen to you? :-)

To avoid this, always remember to buy a stock only when the stock price is uptrending. I personally discourage trading against the trend. If I ever do trade against the trend, I would painfully take the loss if I missed the exit. I won't wait for the helicopter. There are plenty of other opportunities to reclaim my money!

One more thing I would highlight to my readers regarding loss cutting. I understand that it is very difficult to leave your lover, especially when you are so deeply in love. It is painful. ->,<- I do not know how most of you would react when a relationship turns bad, but I definitely know that in terms of stocks, we must be decisive to cut your potential liability.

Let's say we started trading at RM1,000 and found that in the next month, your investments are now left with RM500. Painfully, I would advise investors to take it (subject to extensive technical analysis).

The logic is simple. For a RM1,000 to go all the way down to RM500, it is a reduction of 50%. You will begin to think, "How could this be even possible?!"

Having thought so, most investors are so 'optimistic' to think that the remaining RM500 would climb all the way back to RM1,000 in that same stock. As long as they don't sell the stock, it's only paper loss, they would think. Come on, don't you realise that you are asking your money to work for a 100% return?!

Which means twice the odds! If your investment values got destroyed by 50% sounds odd to you, what would you think of a return of 100%? Sounds even more odd, right? But investors nowadays are that odd to be such an optimist. :S

As a summary, I would encourage fellow readers and investors to trade with the trend. If you realize that you have made a mistake (be it missed an exit or entered at the wrong position), I would advise that you take the losses before it doubles or triples. It takes a man to own up his mistakes.

Remember, "Be A Man, Befriend the Trend". :-)

Discussion 2 : Know the Animals, Know Your Breed

"I've never traded in the stock market. I couldn't imagine how the market works, or how to start playing along it. Is it too complicated for me? Should I just give it up and work harder for my organization instead? Will you advise me?"

Most of my friends who begin seeking financial independence and wanted to start off by stocktrading, would ask me that question. I would then tell them an old story, a story which stretches back thousands of years ago. An old, long lost, forgotten story.

It was a time when humans were not bounded by employment. In that era, gold had already existed, but none seek ultimate wealth. None had the desire of getting rich. Until one day, all these changed when two of the biggest animal tribes of that time engaged in a war. The war then went on for centuries.

These two animals battle in different ways - one by thrusting its opponents up using its two horns, another by tearing its opponents down using its razor-sharp claws. In this war, both animals experienced periods of glory (when they seem like winning) and agony (when the other animal seem like winning). The war was fought everyday, until one side resigns to the other.

Everyday, we (humans) sat aside and watched as these beasts fought bravely against each other, to their blood and death. Being bored of unemployment, we then came up with numerous ways to predict the outcome of the battle. It began as a game to pass time with, but with so many people voicing their opinions, humans seek to find a "winner" among so many voices by putting their wealth into stake. The one who had predicted the outcome correctly, takes the golds. The one that had the most golds by the end of the war, is the "ultimate winner".

At this time, three breeds of players were born. The first breed of players analyzed the biology of the animals, all the way to the type of food they eat, the type of training they underwent, how built was their warring knowledge, the weapon or style of fighting they adopted, and even, who was the commander of the troop fighting that day. These are the Fundamentalists.

Another type of people took records of historical battles that were fought, and then analyzes the probability of the outcome of the next battle using various statistical methodologies. They analyzed the wins, losses, deaths per day, slays per day, number of militia per day, and so on. They also believed that the outcome of a battle was highly determined by the number of supports they received. The more supports they got from the backlines, the more strength they have in fighting. These are the Technicians.

The last breed of players do not perform any specific types of analysis, but stake their golds by listening to what the Fundamentalists and Technicians say. They made decisions on hearsays, analysts recommendations, and some even made themselves acquainted to the animals to get "Insider News". In times of analyzers' indecision, they were the ones who will build speculations around the outcome, and profit from the other undeciding players. These are the Speculators.

Up to this point, I guess my readers would have already figured out that these two animals are none other than the bulls and the bears. Although the war had ceased centurions or even millenia ago, being having nothing left to kill the boredom, humans have made the war go on among themselves. And that, after taking many years of evolutions and reformations, had ultimately created today's stock market.

There are three reasons why I share this story with my readers.

Reason No.1,
We must realise that most of us here nowadays are the bulls and bears who fight each other in the market. If we are working for the companies that participate in the stock market, then we are the 'animals' that have replaced the bulls and bears from centurions ago. Knowing this, do you still want to continue to work for your company indefinitely, or try to get out of the "Rat Race"? Do you want to be the 'animals' or the 'players'? Think again. :-)

Reason No.2,
In the quest of obtaining Financial Literacy and becoming a Sophisticated Investor, we must first know the game that we are playing. The rule of the game is straight forward. It depicts only bull and bear, nothing else! The market goes up, goes down, or goes sideways (when the winner is undecided). It is for us (investors) to place our 'bet'. So, is it complicated? :-)

Reason No.3,
We must determine what type of players we are. Are you a Fundamentalist? Technician? Or a Speculator? This will determine the style we play the game.

Fundamentalists
You will spend most of your time looking through Annual Reports and published media reports, and analyzing reported profits, cash flows, net assets, and other Financial Information that you can find. Other than that, you will also perform certain background checks, and keep abreast of the latest market news to form your investment decisions.

Technicians
You will spend your time looking through charts after charts, studying Technical Indicators to find stocks that would potentially trend upwards or downwards. You will also look at other statistical analysis such as Volume Analysis and also Candlestick Patterns. You will neglect most of the market reports on the belief that all relevant supply and demand information will ultimately be reflected on the chart itself.

Speculators
You possess excellent communication and interpersonal skills, and have excellent Economic Power. You would have a vast number of network hubs to connect you with the experts in the Investment World. You make use of the information you gather from "Insiders" and also Sophisticated Investors to decide on which investments to undertake.

Whichever school you choose, you will have only one ending in mind - becoming a Sophisticated Investor (SI). An SI would make informed investment decisions utilizing a mixture of all three schools listed above. It's just a beginning that we choose to kick start our game with!

I am a Technician. What are you?

Discussion 1: Kick DCA Out Of The Game!

Whenever I had a discussion on this topic, it would almost inevitably triggers my memory of an interesting conversation which I overheard between a stockbroker and his client. It was around May 2008, when the Malaysian economy was heading towards downtrend. To make the matter worse, I was unexpectedly out of employment and on the road.

I was having my breakfast at Mc Donalds alone that morning, and was delighted to overhear this conversation, hoping to get a good tip on the market to make my ends meet. The stockbroker recommended his client to buy a stock that its price was trending downwards at that time. I was a little surprised to hear that. The conversation followed on like this:

"Isn't that stock (price) dropping currently? Why would you recommend me to buy that?"
"Yes, it is, that is why you need to buy it. It's cheap now."
"What if it heads down even further?"
"Then we Dollar Cost Average (DCA) them. When the stock (price) comes up, you'll earn a lot that you'll come thanking me at my foot."

I then shoke my head, and continued my morning coffee.

To me, the idea of buying a blue chip stock that pays handsome dividends every month, and then DCA them when the price goes down, is already as old as dinosaur.

Now I'm assuming that most of you readers would have already known how DCA works. For those who do not, it's a mechanism to lower your average cost per share by buying up more shares when the price is trending downwards, and then selling them when the price goes up.

Illustration (i)
Investor X puts aside RM100.00 every month and invests in Stock ABC, regardless of the price of the stock. Every month, as the price drops, he would stock up an amount of shares equal to the worth of RM100.00. In month 5, he sold his portfolio for RM0.35, and made RM282.50. Obviously, he's practicing the DCA technique.

The question I would ask to any practitioners of such technique would be, "When you accidentally put one of your feet into a quicksand, would you quickly pull your foot out, or will you put both feet in, and then wait for helicopter's rescue?"

Most of the time, investors just do not realise that they are putting another foot into the quicksand when they pump more of their hard-earned money into the stock. All they do thereafter is to pray hard to the sun and moon that favourable news (helicopter) will come along and the price will go up, not realizing that the helicopter might not even come for them after all!

Let us take a closer look at the situation:

Illustration (ii)
When investors look at the portfolio in this manner, probably they may realize something. As you can see, the investments in Month 1 and 2 result in total losses (totalling RM42.50). While Month 3 and 4 earns, these profits are then knocked off against the previous losses, bringing down the investment earnings to only RM282.50.

Well, let us see how a sophisticated investor (Investor S) would have approached this situation:

Illustration (iii)
Investor S would have the guts to own up his mistake and painfully departed with his loss. Therefore, he sold the stock which he had bought at RM0.50 in Month 1 at RM0.40 early in Month 2. He lost RM20.00 in the process. He then watches the stock from Month 2 to Month 3 for any signals of reversal in price trend.

Come Month 4, the stock price hit the low at RM0.10. He waited for a confirmation when the prices rebounded to RM0.15, and purchased 2546 stocks worth just a little under RM380.00 (RM200.00 saved in Month 2 and 3 + RM100.00 injection in Month 4 + RM80.00 leftover from Month 1). Assuming that he sold the shares at RM0.35 (the price Investor X sold his portfolio for), he made RM486.60 from this trade, after deducting the earlier RM20.00 loss.

So what are the differences?

• Return on Investment (ROI)
• Absolute Returns (RM)
• X - RM282.50
• S - RM486.60 (72.24% higher than X)
• Percentage (%)
• X - 70.63%
• S -  121.65%
• Payback Period
• X - 5 months (or more! if the price doesn't go up and continue downwards for say 12 months?)
• S - 1 month
• Opportunity Profits
• S could use the remaining funds on hand (RM280) to invest in other stocks to earn short term returns, while waiting for Stock ABC to recover.
• X has all his liquid funds tied up in Stock ABC. If Stock ABC does not offer dividends or offers low dividends, then these money will not be working for Investor X during the tied up periods.

With this understanding in mind, it cringes me when I hear brokers, fund agents and alike speak so majesticly on DCA. Very often I hear mutual fund agents persuade their clients to place a certain amount of money in the fund every month, often automatically deducted from their salaries, on the catch that when they retire, they will have access to a huge amount of money. What if there is an economic crisis when they are 55 and the funds' value are slashed into half by that wave? >.<

To be successful in stocktrading as well as other financial instruments, the DCA concept is the only one concept that should be kicked out, dumped, and completely deleted from the investors' memories. In comes Technical Analysis to complement your Fundamental knowledge in the quest of becoming a successful Sophisticated Investor.

Thank you for reading, and happy investing!