Changing trading strategies with changing markets

Traders with a single trading strategy all suffer the same fate – they only profit at times that suit that strategy. No matter how successful a particular trading strategy is, it will not be successful as market conditions change.

As a result, traders are faced with the choice of using a single strategy at particular times, or trading several strategies across varying markets.

Types of trading strategies

Day trading strategies typically fall into two categories – trending and ranging. Trending strategies are ones where the trader aims to profit on a sustained move in a single direction, taking advantage of higher highs or lower lows. By contrast, ranging strategies are used when markets fluctuate between support and resistance levels, with traders opening long trades when a price hits support, and short trades when a price reaches resistance.

Trading times

The time that you trade will impact the way that you trade.

Typically, market opens are very volatile and can result in large moves. Consequently, this is an opportune time to cash in on sustained movements with a trending strategy. A simple way to quickly identify a potential trend is to monitor the candles at the market open: looking at a 5 or 15 minute chart, often there will be a larger candle at the market open, and one of the following candles will be an inside candle (with a price range that occurs within the range of the previous candle). After the inside candle appears, traders should watch the subsequent candle – if it closes above the inside candle, it may be a signal of an uptrend and if it closes below the inside candle it may be a signal of a downtrend.

The lunch hour, in any market, is generally a quieter period, excluding if unexpected announcements are made at this time. This is a result of decreased trading volume, which leads to smaller price moves and more of a ranging pattern. Traders will be more likely to benefit by opening trades at established support and resistance levels. However, as there are lower trading volumes and there might be less liquidity at this time, it is a good idea to focus on trades that have a high probability of success.

Volume often picks up after lunch (usually any time after 1:00pm in your market), and this can result in breakouts of lunch-hour ranges. If there is a breakout, this can be a good time to follow the trend, though the risk of false breakouts means that losses should be exited quickly.

Different markets

For longer-term traders, it is also important to examine whether markets are trending or ranging before choosing a strategy. If we look at a chart of the Wall Street stock index from February 2009 to October 2011, we can see a clear uptrend from the March 2009 low to the April 2010 high. From April until August 2010, the index ranged between 10,719 and 9,626. Then, from August 2010, the index trended up until May 2011, before dropping and then settling between a range of 11,714 and 10,439.

A trader wanting to profit on trends would have done quite well in the two up-trends, but would have lost many trading opportunities in the periods of volatility and the resulting ranges.

Being able to trade both trends and ranges successfully will allow traders to profit more steadily than those proficient in trading in only one style of market.

Keeping a share trading journal

Since the advent of online share trading, people have been able to trade more independently. When previously every trade you made would be actioned by a broker, who would then keep records, now traders can buy and sell through online platforms.

And, although some of these platforms may record your trades, your profits and losses and your running total, there are a number of reasons why it is beneficial to maintain a separate trading journal.

1.       Historical record

Over time, your journal will offer a historical perspective of both your winning and losing trades, including trading patterns you may not have realised you had, and this can be valuable in preventing future mistakes.

It will also show the profit and loss of your individual trades, and their accumulated effects to date, allowing you to measure your share trading performance.

2.       Planning

Along with providing historical information, a good trading journal should also record information on your plans for each trade. This makes it more likely that you will consider each trade before entering it by setting parameters for where you want to enter, your risk-reward ratio, and how you will manage the position while it is open.

From a historical perspective, it will also offer another aspect for evaluating what was successful for you and what wasn’t.

3.       Future trading

Being able to evaluate your trading performance in detail can help you develop your trading skills and change your habits, so you make fewer mistakes and more winning trades. This can also make you feel more in control of your trading – your profitable trades will no longer feel random, and you will no longer get so attached to losing trades, which is an important part of trading psychology.

Your share trading journal

A good trading journal should consist of the following:

1. A chronological list of trades including dates, times, opening and closing prices, profits and losses, and a running total of your account balance.
2. A printout of the charts you used to determine the trades, noting down your entry and exit prices, your stop losses and your profit targets.
3. Your reasons for entering the trade including

a.       Fundamental – “there is a company announcement coming out today that, based on the company’s balance sheet, I believe will be negative and will result in the share price falling”

b.      Technical – “the share price has reached a support or resistance level”

c.       Sentimental – “market bullishness has been very high for months and it is no longer supported by fundamentals or technicals, so we may be approaching a reversal”

Also, if you use a variety of trading systems, it is a good idea to keep a journal for each one. Although it might be extra work, combining different trading systems in a single journal will incorporate too many variables for you to accurately measure what works and what doesn’t.

Evaluating your trading system

Once your journal is established, a formula for calculating the expected returns of your trading system is:

Expectancy = [1 + (Average winning trade/average losing trade)] x Percentage of wins – 1

So, after twenty trades, if the value of your average winning trade was $250, your average losing trade was $150 and 60% of your trades were winning trades, your expected returns would be 60% of your initial investments.

Expectancy = [1 + (250/150)] x 0.6 – 1

Expectancy = 2.67 x 0.6 – 1

Expectancy = 0.6 = 60%

So, for every dollar you invest, you could expect to receive an average return of $1.60.

Conclusion

Once you have a system in place, recording your trades in a trading journal will enable you to calculate your expected return over time. If your expected return is positive, you can confidently execute trades according to your system. Keeping a journal will also record whether the expectancy of that system changes over time. If it does, you will be able to determine why more easily, and will be better prepared to take advantage of the additional profits, or mitigate the additional risks.

Five forex trading myths

With over USD4 trillion in trading volume a day, most people have heard of the forex market. And, most of them have probably heard a few myths about it.

Following are five common myths about forex trading – by knowing these myths, traders can often avoid unnecessary frustration.

Myth 1: Forex is a way to get rich quick

The expansion of the retail forex market has resulted in an influx of new forex providers and new advertising. Consequently, you may see advertising that claims that people with relatively little knowledge or experience can make a profit.

Although some may benefit from beginners’ luck, getting rich quick is very rare. The traders who make the most consistent profits over time are those who have trading systems in place that outline their rules for entering and exiting trade, their risk management strategies, the markets they trade and even the hours they trade.

Myth 2: You can win every time

No strategy is successful 100% of the time, and waiting to find one that is will lead to a trader watching from the sidelines or entering the market with an inflexible strategy that will not adapt to new conditions.

Accepting that not all trades will be winning trades is an important part of trader psychology, and being prepared for this is an essential part of your risk management.

Myth 3: The more pairs you trade, the better

Yes, a trader may make a profit by trading one forex pair. Logically, one might assume that he could make ten times more profit by trading ten forex pairs. Unfortunately, trading a large number of pairs is more likely to result in losses, as it leaves a trader’s attention divided between several trades. Choosing one or two pairs to start with will increase a trader’s chances of success as he will be more able to stay up-to-date with the news on those currencies as well as their price patterns, and will, as a result, be more likely to find potential trading opportunities as well as exit losing trades quickly.

Myth 4: The more complex the strategy, the better

Traders often start with a simple strategy, and they make a small profit. Then, they take more variables into consideration, tweaking their strategy again and again to try and increase their returns.

However, instead of determining whether a market is trending or ranging, this results in the trader attempting to determine exact reversal points. And, often this only results in more trades, rather than in more profits. As even successful traders may only make slightly more than they lose, if a strategy works, stick with it, and those profits will add up over time.

Myth 5: Placing a stop is risk management

Risk management and money management are two of the most important aspects when it comes to trading success. However, often the only risk/money management that traders use (if they use anything) is a stop loss.

Risk and money management do not only consist of placing stop losses, but also comprise setting limits for the amount of capital you risk on a single trade or over a certain amount of time. This helps determine your position size, the placement of your stop losses and limit orders, as well as how many trades can be open at a single time. Ignoring risk and money management will result in overall trading failure, even with the best strategy.

Conclusion

It is essential that traders research what forex trading involves. Although a lot of this comes with experience, new traders can increase their chances of success by educating themselves on the various myths around the forex market. By developing strong trading strategies that include risk management and money management, these myths can largely be discarded.

Hedging currency risk in trading

The top ten stock exchanges in the world account for 65% of global stock exchanges by market capitalisation. They span the US, London, Germany, Japan, Hong Kong, Canada, Spain and Brazil.

In contrast, the entire Australian share market only counts for 2% of global share markets.

Consequently, anyone considering trading stock indices or shares who doesn’t come from one of the larger markets will probably consider trading internationally. However, although international trading opens opportunities across a wider range of markets, it also makes your portfolio vulnerable to currency risk.

What is currency risk?

Currency risk is the risk of the exchange rate turning against you. For example, if you were an Australian trader who wanted to go long on the FTSE100, not only would you be taking on the risk that the FTSE100 would fall instead of rising, but you would also take on the risk that the AUD/GBP forex pair would move against you.

Let’s say you bought a mini-contract on the FTSE 100 on August 25, 2010 when it was at 5100 points. A mini contract is worth GBP2 per point movement so, as this is a short trade, you will make a GBP2 profit for every point the index falls, and a GBP2 loss for every point the index rises (these figures exclude the dealing spread and any other charges).

On September 30 you closed your trade at 5600 points, making a profit of GBP1,000.

On September 30 the GBP/AUD exchange rate was 1.6300. So your GBP1,000 profit would have been a profit of AUD1,630 when converted into Australian dollars.

However, the exchange rate on August 25 was 1.7435. If you had made your profit then, it would have been AUD1,743.50. Consequently, you lost a potential AUD100 in profit.

An AUD100 loss of potential profit isn’t that bad – you still made nearly AUD1,750 in actual profits. 

Currency risk gets more serious when you are in a losing trade, and the exchange rate also moves against you.

Let’s say that you decided to go long on 1,000 Barclays shares on July 29, when they were priced at GBP220 each. On August 10, they hit a low of GBP162.50, losing you GBP57.50 per share, or GBP5750 in total.

On July 29, when the GBP/AUD was at 1.4811, this would have been a loss of AUD8,516.32. On August 10, when the exchange rate was 1.6056, this loss was AUD9,232.20.

Hedging with forex trading

The most common way to hedge currency risk is to take a position on the forex pair concerned in your other trade.

The trades above both involved the GBP/AUD. In the first trade the pair fell, and in the second, it rose. If you had predicted the direction the pair would move, you could have made a trade on the pair to offset any losses incurred as a result of the changing exchange rate.

Locally-denominated assets

However, the difficulty in hedging by trading forex is that you will need to be able to make judgements about the expected movements of a currency pair, as well as the expected movements of your shares.

A simpler way is to trade in locally-denominated assets.

In the conventional share market, it can be difficult to access international shares, as few are often listed on domestic exchanges. Consequently, international shares are often traded through derivative products, like CFDs.

A CFD is a contract that allows you to trade on an underlying asset without actually owning it – instead you just make a profit or loss as its price moves. Good CFD providers offer CFDs on a range of markets, like forex, options and commodities, as well as international shares and stock indices.

And, one additional benefit is that a number of CFD providers are now offering CFDs denominated in the local currency. This allows you to trade on a number of global markets, without worrying about currency risk.

IG Markets, for example, has a number of mini-contracts available on global stock indices, which are valued at AUD1 per point movement. By contrast, the internationally-denominated mini-contracts have varying values per point movement, in AUD, USD, GBP, EUR, HKD, CHF and more, which makes it more difficult to calculate your potential profits and losses.

Conclusion

Currency risk is the risk of the exchange rate turning against you when you trade in international markets. As trading shares and indices already carries the risk of adverse price movements, many traders choose to avoid international markets and the additional foreign exchange risk. However, this can be managed, either by trading forex, or by using a broker who offers locally-denominated international assets.

Four fundamentals of stock value

Investors can attribute a share price to four basic factors – the price-to-book ratio, price-to-earnings ratio, the price-to-earnings-growth ratio, and the dividend yield.

Price-to-Book Ratio

The P/B (price-to-book) ratio represents the value of a company if it were to be taken apart and sold today. This is good to know because while the growth of some mature industries may stall, their assets may still hold value. The book value of a company includes anything that can be sold, including equipment, buildings, land, and other investments. In purely financial companies, the book value can fluctuate with the market as these stocks tend to have assets that go up and down in value. In contrast, industrial companies tend to have a book value based on physical assets, which depreciate year after year according to accounting rules.

In either scenario, a low P/B ratio can protect you, but only if it’s accurate, and an investor may need to investigate the assets contributing to the ratio.

Price-to-Earnings Ratio

The P/E (price-to-earnings) ratio is the most scrutinised of all four ratios. Although a stock’s value can go up without the P/E ratio rising, the P/E ratio is generally what causes it to stay up, or fall back to earlier levels.

The reasoning behind this is simply that a P/E ratio can be thought of as how long a stock will take to pay back your investment if there is no change to the business. For example, a stock trading at $50 per share with earnings of $2 per share has a P/E ratio of 25, meaning you’ll make your money back in 25 years if nothing changes. The reason stocks tend to have high P/E ratios is that investors try to predict which stocks will enjoy progressively larger earnings, which will result in a shorter payoff period.

If this fails to happen, the stock is likely to fall to a more reasonable P/E ratio. If it does manage to increase its earnings, it will probably continue trading at a high P/E ratio.

Investors should note that they should only compare P/E ratios between companies in similar sectors and markets.

Price-to-Earnings-Growth

Many investors also use the PEG (price-to-earnings-growth) ratio, as this incorporates the historical growth rate of a company’s earnings and can assist investors in forecasting future growth. The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-on-year growth rate of its earnings. The lower the value of the PEG ratio, the better deal you’re getting for the stock’s future estimated earnings.

By comparing two stocks using the PEG (in the same sector) ratio, you can see how much you’re paying for growth in each case. A PEG of 1 means you’re breaking even if growth continues as it has in the past. A PEG of 2 means that you’re paying twice as much for projected growth than you paid for a stock with a PEG of 1. However, using the PEG ratio to predict future growth is speculative, as there are no guarantees that growth will continue as it did in the past.

Dividend Yield

Dividend-paying stocks are attractive to many investors, as even when share prices fall you still get paid (perhaps not as much as when the share price was higher, but it’s better than nothing). The dividend yield is the annual dividends per share divided by the share price, so tells you your return on your investment. For example, if a company’s shares are trading at $20 and they pay a dividend of $1 per share, that is a 5% return on your investment ($1/$20 = 5%).

Inconsistent dividends or suspended payments in the past could mean that the future dividend yield isn’t dependable. Also, dividends can vary by sector, with some industries being quite generous while others reinvest their earnings to fuel expansion.

Conclusion

Each factor has too narrow a focus to be an independent measure of a stock. However, combining these methods of valuation can help investors better evaluate a stock’s value. Although any one of these can be influenced by creative accounting, the more tools you add to your valuation methods, the easier it will be to pinpoint discrepancies.