How to Lose Money When Trading: Part 2
Define your strategy - Knowing your fundamentals, part I.
Over the years I have both heard and lived by many different trading rules. The very first mistake I made was falling for this “rule”: “ A chartist (short for person using technical analysis when trading) does not care about fundamentals…”
Not knowing fundamentals is one very certain way to lose money. If you (as short term trader) don’t know that your company will release “earning report”, you will be in for a big big surprise. You may end the trading day with a super profit in a stock to see it be blown away on opening next days as earnings have been released after trading hours. If you for some reason are using leverage (broker puts up the money for most of the shares) you can be forced to close your position losing absolutely everything.
Not too long ago (2013-2016) the ebola virus spread killing thousands of people in Africa and several cases were reported in Europe as well. A hunt for a cure was initiated and billions flowed into the biotech markets. This was given. I put my bet on a few companies and got very lucky on Arbutus BioPharma (ABUS) formerly known as Tekmira Pharmaceuticals Corporation (TKM) doing a 3X in just a few months. After some research I knew Tekmira was one of the potential companies to release some “breaking news” and so they did.
As the Ebola threat increased, the disaster was all over the news. In one live broadcast I saw people being interviewed in Hazmat suits (full protection suits). I then instantly started to look for manufacturers as I knew there probably would be higher demand than supply pushing prices up (and thereby stock prices). My second bet was therefore on the US company Lakeland - yielding yet another great profit.
It is perhaps a grotesque example praying on others misery. But it is a perfect example why fundamentals matter. As money flow into the biotech sector it left other sectors causing otherwise good stocks to fall. The concept of “fixed” liquidity is perhaps the most single important knowledge I can teach you. Like every concept it has modifications and exceptions, but the general usage is very high. And the easiest way to explain the concept is to imagine a bucket of money. From this bucket all economic activities share the money. If some activity uses more money, it will be less for other activities. If interest rates are low, more money flow from banking and into stock market. The flow of new capital is the only way to sustain growth and at some point you reach a level were there simply is no more money. If the growth stops or even declines, money will flow to more lucrative sources. We can use the same concept for a single stock and understand that at some point there will simply be a lack of more investors to push the stock further up. There are several indicators to measure these relationships like RSI, volume, hausse etc. We will get to them all.
You have made yourself a small trading strategy and learned that you need to know the fundamentals. Where is the market right now? What company have I invested in? This knowledge will help you understand and interpret your results and enable you to work your strategy better. Let us say you invest into the chip maker AMD who recently (January 31st 2018) posted record results for Q4 (fourth quarter). If your read their comments and the results you would see that some of the result is due to the huge demand for graphic cards for cryptocurrency mining. What happens if crypto prices collapse? China already banned all crypto and Russia is considering the same… Or let us take another example. You invested into SnapChat (SNAP) at USD 26.50 and currently your stocks are traded at USD 13.50. Bad luck? Or is the fact that SNAP had an insane valuation on their IPO (initial public offering - when they got listed on Nasdaq) compared to most other companies? If you look at Facebook (FB) and SnapChat (SNAP) you can easily understand why FB is far easier to capitalize. If you look behind the numbers you will also see that FB keeps growing user base, while SNAP struggles.
With a minimum of fundamental knowledge you can add elements to strengthen your strategy. This can be elements like:
I will not sit in stocks that are about to publish economical reports (Q’s).
If you're more advanced you can:
I will put automatic stop loss 1.5% under current price (stock will be sold automatically if price hits 1.5%) on the day results are published.
By doing this you reduce your risk substantially. Furthermore, it forces you to pay more attention to the stock(s) in your portfolio. Like cash is king. Knowledge is too.
Define your strategy - Knowing your fundamentals, part II
So far I have tried to make you understand that you need to know some minimum fundamentals like: in what part of the cycle is the market (are you investing in a bear or bull market)? What is the core business of my stock (know your stock)? I have mentioned that there is a level of liquidity in the market and that if it flows into one sector another may lose. In this decade my two favorite sectors have been technology and biotechnology. I have also followed raw materials as the ever growing human population and increase in living standard is putting its toll on resources. For instance have the salmon farming company Marine Harvest (MHG.OL) gone from NOK 10 to NOK 163 in just 9 years. After some correction I am very sure that fish production will continue to be good investment for the next few decades.
As a trader, opposite to an long term investor, you jump in and out of stocks. You seek short term profit. Where the long term trader would avoid investing in dieing businesses, you as a trader may still be active, but the general advice is leave it. Staying in trending sectors and industries will save you a lot of risk. There is a lot of investors that lost money on old video store chains, and many that made a fortune on Netflix. Being a big brand is no guarantee for success. Large corporations are in need of large cash flow and if this dries up they are in huge problem. A good business may overnight become a nightmare. The last proof of this is the oil industry which took a hard hit when oil plunge from USD 100 (Brent crude) in the summer of 2014 to USD 35 in the winter of 2016. Why would you try fight a falling oil price investing in oil shares. The answer to this is usually lack of knowledge and the fact that hope is stronger than common sense. To buy shares is easy, selling is hard.
Earlier I pointed out that the liquidity is just shifting from one thing to another. When banks lower their interest rates making saving in banks less attractive, money goes into the stock market and vice versa. If money goes out from one sector in the stock market it usually flows into another sector. The huge fall in prices of oil took its toll on oil shares, but at the same time it was a boost for the airline companies that now could lower their running costs. While oil prices were plunging from summer of 2014 till beginning of 2016, the Norwegian Air Shuttle company (NAS.OL) went from NOK 180 to NOK 380. As a trader you need to utilize these fundamental movements. Trading oil related stocks (except shorting) when oil prices fall would require extreme precision and picking, while you could pick almost any airline company and do very good in the same period.
Depending on the amount of capital you are trading with you should define your main sectors. A good advice is to make a table and just write scores for each sector as you see it. You can use news sources, your gut feeling or technical tools like hausse indexes that are found @ StockInvest.us. Hausse indexes are one of my personal favorites and in short term it simply measures the relationship between buy and sell signals. Too many buy signals increases risk heavily, while the opposite happens if there is too many sell signals. Hausse indexes can be made from a long range of both fundamental and technical signals. The table below is from Stockinvest.us and was copied the day before -3% fall in the US markets.
As a trader you can utilize this information in the way you play your risk. There is no contradiction in having financial sector in your strategy as one of your main investing areas and reduce your exposure when hausse indexes are high for this sector. I will get into more details about working with high risk in later chapters. I also need to mention that there are hausse indexes for all time periods - even including intraday.
Bit by bit I hope you are now able to see how your strategy is picking the stocks for you by the method of elimination, and also keep in mind that if you follow a strategy the results derive from the strategy. A wise man once said: How can I change something if I have no clue what I am doing wrong?
Define your strategy - Knowing your fundamentals, part III
By now we understand that liquidity flows and a small but very good proverb comes to mind: “Follow the money”. It is one of the oldest of and most basic principles; the path of less resistance. It is widely used in marketing and referred to in the bible as greed. If it is easier and safer to make money by placing them in the bank (high interest rates), money will flow out of stock markets into the saving accounts. If it is easier to make money on technology sector than industry sector, the money will flow from industry to technology sector, and for stocks to rise they will need a constant supply of new cash.
A contradiction is that stocks with no seemingly fundamental reason, like huge earnings or agreements, do huge gains in short periods. Example of this is stocks like Tesla [TSLA] and Snapchat[SNAP] which both operate in deep red, burning investor's money like crazy. There is far less resistance in beliefs than cold hard facts. If enough people believe that a stock is a good buy it will go up. Very often there is huge and professional marketing apparatus pushing news after news to shape the investors mind. There is no point in fighting such stocks with short selling. Until the day they find their tipping point, you should stick to simple but powerful proverbs like “Follow the flow” or “Let the trend be your friend”. The tipping point for stocks like this, where they go from gainers to losers, can often be seen in the content of the news. In the end they will be more and more desperate and often not even related to the business itself. This will often be backed up by the major players who will do the famous pump and dump. In pump and dump brokers start heavily recommending the stocks, boosting it while the major players sell their stocks. In other cases the brokers fire up the stock doing some larger purchases (often when liquidity is lower than usual) and then off-load all stocks while you think the stock is on the roll. You should therefore keep an eye on news, insider information and shareholder structure. The market is two-faced and the same is with the owners. They often say one thing while doing the totally opposite. Since the beginning of 2018, Snapchat [SNAP] has been rolling out their new changes to their application. These changes have (as of Feb 15th, 2018) gathered more than 1 million signatures from users who wanted to revert it back to the old design. However, the CEO Evan Spiegel, claimed the design is there to stay and that it will benefit both users and the company (income). Nevertheless, new records shows that on the 14th of February, 2018 the same Evan Spiegel sold more than 2.65 million of his own shares for a value of more than USD 50.1 million. Other insiders, like Director Mitchell Lasky been selling 25.000 stocks every single week since November, 2017. Why?
In stock trading it is very much about the future. When you're buying or selling stocks you're doing a prediction. You either predict it will go up or that it will go down and place your bet. Companies that got high evaluation are either making good yearly profits or there is a belief that it will do very good yearly profits (predicted). The evaluation is often measured by price-to-earnings [P/E] , price-to-earnings growth [PEG] or price-to-book [P/B] which in short term look at the value of all the company's assets. I would not claim it as a necessity to know these definitions unless you're doing a value trading. There is simply too many variables included, like type of industry, the maturity of the business etc etc. Neither do the stock market pays daily attention to it, but sooner or later it will have an effect. No company can run endlessly in the red. There is only a limited amount of capital and investors trust. Some of the worst news that can hit you if you're not prepared: when a company is issuing new stocks, this can take 5-20% of your profit or increase your loss in minutes. It is very seldom that companies can get more money without offering some sort of rebate. I may be very wrong, but I believe Tesla will be such company, asking the investors for more and more money to support the dreams and visions of Elon Musk. It may work very well, even be smart, in bullish markets, but can be totally devastating if the bear is roaring.
In your strategy you should be accountable for the fundamentals. If your focus is the financial situation of the company, you will use the methods mentioned above. You can, for instance, have in your strategy that you will not invest in companies that have P/E higher than X. Again you will see that the amount of stocks to select from will be reduced, and hence your strategy will pick the stocks for you. If everything gets very confusing and you just like to follow the market you can use the beta coefficient. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. You may find this strategy boring in your pursuit for quick wealth, but remember the phrase “easy come, easy go”. Even following a Beta-strategy will not make you safe. Let me show you a recent example:
If you invested in the company Apricus Biosciences Inc. [APRI], that has a Beta of only 0.26 (low risk), you would have seen a -67.40% loss on Friday, Feb 16th. 2018. The huge loss came after the company got a rejection to start marketing its topical erectile dysfunction (ED) drug Vitaros from the Food and Drug Administration (FDA). In this case APRI closed @ USD 3.12 on Thursday and opened @ USD 1.07 on Friday. No stop-loss in the world would have helped you.
It is important to understand that this is an exception and special case. If you follow a Beta strategy you will be more right than wrong as long as the market is in a upwards trend. Only way to reduce all risk is simply by not investing in stocks at all. It is also worth mentioning that APRI is a high risk stock both fundamentally and technically (based on daily trading volume) and with defined risk level in your strategy you would have never bought APRI in the first place.
Define your strategy - Before we move on
As earlier established, you should base your trading on a strategy that takes into account your financial strength (size of portfolio), your desired level of risk, the segments/sectors you like to trade and so on and so forth. With a good and well defined strategy you will not have to “find” stocks, they will be found for you. The 2.800 stocks at NYSE will be reduced to maybe as little as 10 stocks fitting your criterias. The next parts will focus more on which of the 10 stocks to select, and for this we will use my favorite tool - technical analysis. But before going there - some last thoughts about fundamentals and strategy.
It is easier to become a good trader if you understand that you will do bad decisions. In fact you will most likely lose money before you make some. The main point is that you have to learn from it. Buying is easy, but selling is hard. No matter what you think, emotions will come to play. Greed and fear are written in stone. If your picks are done by a defined strategy, at least you know you have to change the strategy. Changing yourself as a person is close to impossible. Why would you select high risk stocks if you're an impulsive person? Playing high risk stocks requires true dedication and emotionless decision making. Even after 20 years of playing the stock market I still have not managed to transform my personality enough to play the “high ball”. My most common mistakes are entering too late and leaving too early in runners and selling too late in stocks that do not perform or drop. Knowing this, I made a decision that I would never play more than 1 high risk stock at the time, and it should always be less than 20% of my total portfolio.
Information is found at many sources, but always ask yourself who can benefit from the information/news. An article written by Forbes is no guarantee against false or misleading information. They will write and publish anything that sells. Often news companies are fed with information that has a very specific intention. In politics there are shitpacks and the exact same applies for the stock market. Reports are “bought” from scientists and published. Lobbism activities in politics are just the same as in the financial world. Why would Elon Musk and SpaceX wait with launching the heavy lifter with a Tesla onboard until just before Tesla released the worst quarter (Q4) numbers in the company's history? Coincidence or a brilliant move by Mr. Musk? By continuously pushing all kinds of news Tesla avoids the deep main questions like what to do when they run out of cash? According to all logic and number crunching it is not a question if, but when. As an investor and trader you should ask yourself if you should go all in or portion your risk. The upside in Tesla is huge, but there is no free lunch. Tesla is also one of the most shorted companies in the world when this is written.
I have mentioned pump & dump a few times so far in the text. Pump and dump comes in many shapes and colors, but the intent remains the same. Pump up the stock, then dump it. If a stock suddenly starts to get a lot of recommendations without any big fundamental changes ongoing - a bell should start ringing. Some famous broker sees a “possible” potential. Vague articles with a lot of scenarios that give huge profits get published. Figures are just great. Suddenly the volume starts to move, somebody is buying large quantities. Brokers issue an alert to their smaller clients. XXX is moving and the potential is very good. Stock really starts firing up. 5%, 10%, 20%, up up and up. The smaller day traders jump in just to see the air go out and stock to fall back to start or even to red. There is no loyalty. Money talks. As the proverb says: “If something sounds too good to be true, it usually is.”
I often see attempts of stock pumping on stock related forums. Users saying that “news” will soon come, or rumours on a potential deal. Since large companies often require large volumes to be moved, these attempts are often towards minor companies with low daily trading activity. For many years biotech stocks have had hot “pump” cases. A very typical pattern for such stocks is long period with very little trading - then huge price spikes, where stock afterwards goes back to vegetative state. In most cases it is “penny stocks”.
If you are aware of this type of behaviour you can do a lot of good trades. I often post possible runners on our twitter account https://twitter.com/StockInvestUS asking the followers to keep an eye on the volume.