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 6 : Does It Make Sense?

Having read a few articles that I have contributed solely on Technical Analysis, most of my readers who are new to investments might be feeling a little 'high on the horse'.

Halt! Read at least THIS Discussion before executing your big time plan!

Just hours ago (as I'm writing this article), my mentor and I attended a Market Chat organized by Hong Leong Investment Bank. There, I bumped into one of my old friends, who was also an ex-student of my mentor. I found out that she has been visiting my blog recently and is very interested and geared to start managing her own investments portfolio.

"I can't read figures, and I don't like reading figures. I like graphics. I like pictorial diagrams. Technical approach breathes new life into my dreams of getting rich."

After the course of Market Chat, we met again at the lift. She excitedly said this to me,

"I couldn't understand a thing of what the speaker said just now. It was too technical for me. I don't care of the market outlook or if the economy crashes. I don't know what GDP, MGS or QE are. The most important session of the evening is at the last moment when he shared with us the list of recommended shares that will outperform the market this year. But as you said, I will go back and read the charts first before doing anything."

I then asked her to read my next article (which is this Discussion) this weekend before reading the charts.

As I have mentioned in Discussion 2, a Sophisticated Investor (SI) would use a combination of both Fundamental Analysis (FA) and Technical Analysis (TA) in determining whether to confirm or dispel an investment decision. I don't recall asking my readers to neglect FA!

Every investment has to make sense. I am using this strong word here - sense. 'Making sense' is a phrase that I have shunned using for months after gotten into an ugly conflict with my superior in my previous employment. While I don't know why many people find it offensive with this phrase, I understand that many people don't like hearing it. Well, reality sounds harshest when it is closest to the truth. The 'making sense' part in investments refers to FA.


FINANCIAL FUNDAMENTAL

For investors, the Financial Fundamental of the stock's underlying company must be strong.

Imagine your target company's debt equity ratio is 200% (debts twice the equities) and is having millions of negative cashflow from Operating Activities (OA). In addition to that, you realized that the company is underperforming industrial average by at least 20% for 3 years in a row! Key management personnel are changing almost on a bi-annual basis.

I can't sleep at night if I ever invested into this stock. This investment just doesn't makes sense. Ask yourself, "Who would've wanted this stock?" This means that there is a high probability that the charts are only showing False Signals.

Most of the time, if I were to go long for a long period of time with a stock, I would shortlist to monitor a few companies with good OA cashflow and had a good equilibrium on capital management policies - an optimization of debt and equity. They must also be healthy on other useful financial statistics such as ROE, profit margin, and dividends policy.


MACROECONOMIC - FISCAL AND MONETARY POLICIES

Investors/traders should also know at least the basic of macroeconomic and how it plays an influence on the stock market as a whole. You need not to be as skillful an economist, but the foundation studies must be there so that 'you know what you are doing'.

Let's say your target company is operating in the Automobile industry (Cyclical Consumer Products). If the economy is currently experiencing high inflation and high interest rates, will you be investing into this company, even when the chart shows that there is a good setup? I will never do that.

In times of rising interest rates, many consumers will restrict spending. Borrowing costs would be high. Purchasing power is low. Cars would then be more expensive. Will they even consider buying a car right now?
At this moment, unless there are other good reasons supporting the chart readings, I would fire aggressive stocks from my hitlist!

On the other hand, I would be more interested in defensive sectors such as those in Food, Healthcare, and Cosmetics  (Non Cyclical Consumer Products). Cosmetics remain to be my favourite bet in an early bear :-). Think, no matter how bad the stock market is, ladies will never stop making up! :p

I might even consider to invest in bonds at this time. This is an excellent time to find a good bargain for fixed income securities. Bond prices are negatively correlated with interest rates. If interest rates are expected to drop in the future, bond prices will increase to maintain its attractiveness against other investment vehicles, such as stocks.


FLUCTUATIONS IN OTHER FINANCIAL MARKETS

To name two of the most important ones:

Commodities Market
If oil prices were to increase, I would be wary prior to investing in companies operating in Transportation. Investors/trading would have to research and see if the target companies have sufficient and reliable oil hedging policies in place. Jumping to invest/trade in one that has none, basing solely on the chart, doesn't make any economic sense at all.

Oil and Gas companies tend to make good progresses during these times. So, is it making more sense to invest/trade in these companies while oil prices increase?

Futures Market
For day traders, or swing traders, futures market is an important component to trading success. Futures market pre-empts the behaviour of stock market and acts as a good indicator to what your trading strategy would be, at least, in the early hours of the market. It makes no sense to start long in the stock market when the futures market shows declining figures!

Also, as the day progresses, the stock market would then most likely guide the direction of futures market. So, if the stock market progresses as a big bull, shorting in the futures market would seem similar to digging a hole, jumping into it, and then covering yourself up. There is no meaning for that person to stay alive after making such decisions. >.<


Investors/traders should also keep abreast of other financial and non financial information available on the media to base their decisions on. Every morning, prior to commencing my trading day, I would sit down with a cup of black coffee and scan through news via theedgemalaysia.com and thestar.com.my.

Other than that, I will also login to my trading platforms to scan through available investment and business news. I will also look into the futures index (FKLI), if I intend to trade on the 30 counters forming the KLCI index. If the futures market doesn't show a positive sentiment, I might even consider beginning my day by shorting the futures.

Knowing FA to pair with the deadly tools you learn in TA would further enhance your investment/trading profitabilities, even if your investment horizon is extremely short, such as intra-day trading. As a day, as well as swing trader, I always find FA very useful in helping me to determine a sensible tolerant level for stop losses.

Depending on your investment/trading preferences, your main approach could be either FA or TA, but in either approach, you must also incorporate a sufficient degree of the other school of thought. Never isolate the other!

Always make your investments/tradings as sensible as possible. Don't invest/trade in anything that doesn't make sense to you. As what Robert Kiyosaki always says in his books (unless you are shorting the futures),

"You make your profits when you buy, not when you sell!"