Understanding Trading Risk
Stockscores.com Perspectives for the week ending March 4, 2012
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In this week's issue:
We are close to finalizing this year's Stockscores Training courses, I will be teaching classes in Vancouver, Calgary, Toronto and Montreal this spring. If you have recently submitted a request for information form regarding our courses and Mentorship, you will receive the details as soon as they are finalized.
The courses will be done differently this year. I will be teaching two programs, one for Investors and one for Active Traders. Each program will start with one day of live training in a class room to establish the important basic skills. Then, each group will work through weekly assignments over a three month period to learn and practice the more advanced skills. Each week, I send the assignment out by email and students work to learn that skill, asking me questions by email where necessary.
I will also teach a small group of aspiring active traders in the Mentorship program. I work one on one with people who want to make a career out of stock trading over a six month period. Students must apply and I only take 10 students at a time in the Mentorship program.
If you let us know your interest by going to this page, we will send you the time, location and pricing details as soon as we have them. If you have already submitted this form you do not need to do so again, we have you in our database.
This week, I want to discuss two types of trading, how they are similar and how they are different. Hopefully, I can change some misperceptions about what it is to trade a stock rather than take the long term buy and hold approach.
I think that most people consider day trading to be a high risk way to approach the market. Day trading aspirations with the wrong approach can be very risky but it should not be that way. To help explain, let's first examine a good day trade set up from this past Friday.
Each morning, I look for stocks that are trading abnormal volume and then apply my trading strategy rules to find those few stocks that each day give a good trade set up. FMCN gave an entry signal early in the Friday trading session because it was trading abnormal volume, running up quickly, formed a short pennant pattern consolidation and the broke to the upside at the green arrow. That trade ran higher for the next half an hour before giving an exit signal at the red arrow.
Let's first discuss position sizing and the reward for risk concept. The blue, horizontal line on the chart is the entry price, $25.93. The red line is the stop loss price, $25.70. If we buy at $25.93 and plan to sell at a loss of $25.70, we are taking $0.23 a share in risk. That means that buying 1000 shares has a risk of $230, plus commissions and slippage.
This stock marched higher quickly and gave an exit signal at $26.85. That was $0.98 higher than the entry which provided a profit of $980 (again, before slippage and commissions). This gain was about 4 times the risk taken, meaning it earned a reward for risk of 4 to 1.
Buying 1000 shares will cost $25,930 but my broker gives me 3 to 1 margin for day trades. This means I would have to put up 1/3 of the total cost of the trade, or just under $9000. With a profit of about $900 after commissions, this trade earned a 10% gain on required capital. All that in less than half an hour.
Let's turn to a position trade on Royal Bank (T.RY) that I featured in my daily newsletter a couple of months ago. Here is the chart:
In this case, the entry signal came at $50.90 with a stop loss at $49.05 for a risk per share of $1.85. To take the same amount of risk as our day trade example, we would have to purchase 125 shares for a total cost of $6400. If the trade failed to work and we got stopped out, we would lose $1.85 on 125 shares or about $230.
This trade has worked, the stock has been moving higher over the past two months. There has not yet been an exit signal and the stock is currently sitting at $56.40, a gain of $5.50 per share. That gives us an unrecognized profit of $685, about 11%.
When holding a stock overnight, I can get margin of 2 to 1 so I would only have to put up $3200 to take this trade. Margin thus doubles the percentage return to 22%.
The percentage gain on the T.RY position trade is better than for the day trade on FMCN but the reward for risk on FMCN was better. T.RY is currently sitting at a reward for risk of 3 to 1 while FMCN was a 4 to 1. More importantly, it only took half an hour to make the gain on FMCN.
The problem with the FMCN trade is that it takes a lot more time and expertise to execute that trade, day trading is a fast moving pursuit that requires a high level of trading skill.
What is important to note is that the day trade was no riskier than position trading a large banking stock like Royal Bank. Since we size our position based on the risk of the trade, we essentially take the same amount of risk on all trades.
The source of risk is not the stock but the trader. Any trader that loses all of their capital does so because they fail to manage risk effectively. When you use margin carelessly you can wipe out a lot of your trading capital very quickly. Leverage is a double edged sword.
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I have created a video to explain the rationale behind this week's picks and how I found them. You can watch the video on YouTube by clicking hereBack To Top
1. GA
Good break out of a lengthy trading pattern with abnormal volume supporting the break. Support at $4.15.
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2. ALSK
Gapped up on strong volume on Friday after better than expected earnings, the stock fizzled out in to the close but I think it still has potential to move next week, watch it for a move up through $3.50 as a sign that it is worth considering. Support at $3.
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3. SYA
Another strong gainer on Friday which saw some selling pressure in to the close. Still a chart that is showing optimism and excitement about the company's prospects. Support at $9.80.
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4. SFLY
Shutterfly bought a component of Kodak's business and the market seemed to like the news. This caused the stock to break up from a rising bottom and trade heavy volume. Support at $26.75.
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References
Get the Stockscore on any of over 20,000 North American stocks.
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See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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