Sample chapter from

SHARE TRADING: AN APPROACH TO BUYING AND SELLING

Daryl Guppy © with editorial assistance from Dr Alexander Elder. This extract copyright 1996/97.

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PRIVATE TRADERS: AN ENDANGERED SPECIES?

© Daryl Guppy

Where do you stand as a private trader? Are the odds against you so overwhelming that you ought to stay clear of the market unless you have a minimum of $100,000 or more? Unless you are prepared to loose $50,000 you have no place in the market, or so you are told by fund managers eager to manage your money.

You do have distinct advantages as a private trader. Starting with as little as $2,000, or better still, $6,000, you can use these advantages successfully so you can live and work anywhere in the world. You can control your own time and answer only to yourself. Success has many rewards, but getting there takes skill and care.

Dr. Alexander Elder, author of Trading for a Living, helped to edit this book. He is a successful New York private commodity trader because he concentrates on managing risk. Every morning before trading he sits in front of the quote screen in his office and says: "Good morning, my name is Alex, and I am a loser. I have it in me to do serious financial damage to my account today."

Daryl Guppy is a successful private trader because he understands the risks he faces in the market. Every morning, after he has downloaded the previous days data, but before he looks at a chart, he reminds himself: "This Guppy is shark food unless I am careful."

TRADER OR INVESTOR?

Everyone wants to make money, but the way you preserve your cash and put it to work depends on how comfortable you are with taking risks.This comfort factor determines what investment markets you enter and how long you stay in them. The techniques you employ in investing and the time frame for these investments flow from your temperament.

The comfort factor is a major influence on the investor's approach to the market and collectively it plays an important part in determining the way the stock market moves.

The level of uncertainty you are willing to risk is a factor that keeps most people out of the stock market because they feel more comfortable buying real estate as an investment. Despite the massive devaluations of property over recent years, people still see real estate as a sound investment. Bricks and mortar have a solid thunk to them that a share certificate cannot match. The real estate people point to the rental income stream, while ignoring the maintenance costs, and confidently predict that real estate prices will start to increase and go up forever. Comfort for these investors is reinforced because the property can be willed to their heirs or used as collateral.

This feeling of security through stability is much more important here than other factors. Temperament also accounts for the differences between the small landlord, the property developer, and the housing companies.

Stock market investing attracts people who are a little more adventurous - those prepared to risk a little more uncertainty than the real estate investor. Although an increasing number of people are forced into the market by proxy through compulsory retirement and superannuation funds, only about 21% of the population of Australia voluntarily invest in the market. Even then, the number who invest directly in the market, as distinct from investing with a mutual or market fund, is smaller again - under 13%.

For these investors rental income is replaced by dividend stream. Capital gainsseem to be guaranteed over time through such popular methods as dollar cost averaging where the same amount is invested each month irrespective of the stock or counter price. There is a pride of ownership, no matter how few the shares we hold, in successful companies that manufacture familiar brand name products. Sound stock or counters can also be willed to your heirs and used as collateral.

Investors in the financial markets enjoy substantial peer group support. What makes the environment apparently more adventurous than real estate is the feeling that paper burns more easily than bricks and mortar. Portfolio values move up and down more frequently than property values. Unless you have enough income to live without drawing on your investment capital you may suffer that nagging feeling of something insubstantial that allows your neighbor to sneer at your paper holdings while he happily pats his brick wall. You smile back weakly and hope that Warren Buffet lives up to his reputation. For whatever particular reason, fewer people are comfortable with exposure to the financial markets.

It seems that everybody talks about property, but only a few discuss investing in the market. Such a discussion is more likely to be limited to your broker or remisier, and perhaps a few very close friends. The peer support group is smaller and your investments are at the mercy of violent forces discussed daily in the media. In comparison, property values offer a rock of stability.

The greater level of uncertainty attached to share market investing brings with it a sense of adventure. Not all investors have the self-confidence to tackle this adventure and many are washed out of the markets when conditions move against them. Unable to stand the strain of substantial, if temporary, dips in value, their reactions help to set up or emphasize market moves. Understanding these reactions is part of the traders advantage.

TRADING THE MARKET

If investing in the financial markets is an adventure, then trading the markets is a jungle survival course where even the butterflies have teeth. Trading is a more pro-active process appealing to people with a more active temperament.

It has none of the apparent advantages of either real estate or investment shares. Ownership is sometimes so fleeting that you are out of the position before the confirmation of trade arrives in the mail. Capital gains are the sole objective although they are never assured. Dividend income is a bonus. Only good money management religiously practiced daily lets you hang onto the gains.

It is unlikely that the trading stock can be willed to your heirs because by the time the estate is sorted out, the market will have changed. Depending on the technique, the portfolio can be used as collateral with your broker. Your bank manager is more likely to show us the door.

With uncertificated holdings, there is a leap of faith into cyberspace. If paper burns more easily than bricks and mortar then what hope is there for a 'bit' of computer data? Everybody sneers at the trader's quixotic holdings. You smile weakly back and hope that your trading plan lives up to expectations. Traders do not look for variations on the stable capital or income aspects that real estate or market investors prize.

Trading is uncomfortable for most people who must face up to the absolute inability to shift the blame for wrong decisions onto someone else. Wannabe traders often pile in when the price nears its high, and bail out much later than is consistent with good money management. These behaviors help set the character of the market and better traders can use this to advantage.

Trading is made more uncomfortable by the lack of peer group support. If property is usually the subject of after-dinner chats, and to a lesser extent investing in the market, then talk of trading is, perhaps best kept for a confessional. There are very few private traders, so contact and support is via small groups, select publications and Internet providers like CompuServe.

Does this make trading an exercise in bravado and every private trader a 'greed is good' demon like the fictional trader, Gordon Geko in the movie Wall Street? There are many like this who become market victims.

TRADING DISCIPLINE

You have to deal with stress and a huge potential for self doubt. Because trading so often takes profits from being out of step with the crowd, you need a level of self discipline that is not dependant upon the approval of your peers. Private trading is a lonely business that requires strength of conviction and of character. Anybody can open a trading account, but only those who have the right temperament, or who can develop it, will feel comfortable and succeed.

The path from startup to survival, on to prosperity and beyond is difficult. This book is written with the benefit of hindsight. If you believe becoming a trader and acquiring the traders skills is worth the effort then take from this book anything that you think will help you. Much of what is said about stocks also applies to non-equity markets - futures, currencies and options. Where information only applies to stocks it is noted.

By learning to watch where the big money - the smart money- is moving you can take advantage of opportunities. You are only a loser when you trade on institutional terms. You should not slavishly copy institutional trading methods and assume they will work for you.

The person on the other side of the trade is not necessarily smarter. The institutions and their traders have a market edge that is created by their size and their ability to withstand losses. The institutional trader can survive on narrow margins because of the high dollar volume.

The private trader has no size by comparison and his ability to withstand losses is very limited, usually because of capital size. Good margins are necessary from each trade. These are perceived weaknesses, but they can be turned into strengths by properly using the advantages he has.

ADVANTAGE, PRIVATE TRADER

The first advantage is the advances in technology that are providing us with the means to flatten the playing field. More powerful computers, better software, and better electronic data supplies are closing the gap between the professionals and the private trader. A gap will always be there, but it will be narrower than in the past. You can take advantage of this because it allows you to participate more easily. Information flows more freely, more rapidly and at less cost.

The same information can be used simultaneously by many people and everyone can make money in the market. The institutions might trade news, but the mechanism of the trade is price. Private traders have access to price data at a reasonable cost. A desktop computer with technical analysis software can now number crunch the data with as much ease as the professionals. Using first hand experience trading from the remote parts of the Australian outback, Chapter 3, Electronic Trading Tools explores the way the handicap has been reduced.

Information, or price data alone is not enough to give traders an advantage. The institutions approach the market differently. Like all sharks, they need to eat a little bit very often and must move all the time. You are not under this pressure so you have greater flexibility in deciding when to enter the market and the risk you are prepared to take on.

Your advantage is that you can take your time in establishing trading as a business. The progress from startup to survival is usually spread over years. While you still have your day job, there is no pressure to trade as the sole means of earning your living. The danger is this can bring complacency and many fail to move beyond dalliance.

Time is a luxury that no institutional trader enjoys. Successful private traders use the startup period to build the discipline, and the capital, needed for trading survival.

These advantages may appear trivial, but they give the private trader an edge. Most novices squander this edge and are blown out of the market. This outcome is not inevitable, but avoiding it takes discipline, planning, skill and a determined interest in trading for profit.

WHERE YOU ARE GOING

Set Return Parameters

To prevent these golden advantages turning to dross you need to develop trading discipline by establishing suitable return parameters based on the minimum return on capital required for trading survival. Without cashflow you starve. Chapter 4, Benchmarks for Trading returns looks at the differences between traders and investors and the way this determines the type of returns each seeks from the market.

Institutional traders largely avoid small cap stocks. One of the reasons for this is that larger stocks have more liquidity and a better dividend stream. When they make large transactions, these considerations are important because moving big volumes can make waves. The small trader rarely makes a ripple on the market so our rules must be different. Once you have established the minimum level of cash flow required for survival you need to turn your attention to practical ways of obtaining it from the market.

Some practical approaches to determining reasonable return levels for different classes of stock or counters are explored in Chapter 5, Blue Chips -Hold or fold? This looks at ways to assess Blue Chip, small cap and speculative stock classes against cashflow requirements.

Specialise

Unlike the institutions, you cannot afford to allocate cash to every market. You must specialise. The one man band cannot play a symphony. As Roy Longstreet comments of a trader colleague in Viewpoints of a Commodity Trader, "His specialty is soybeans - only on the long side."

It is no good honing an edge on a sharp axe if it is locked in the woodshed. Like the institutions, you must select the tree you want to fell. Of course, the funds fell many trees, but as long as most of them fall in the right direction the fund survives. They have a very strong safety cage.

Private traders cannot do this. You must know which direction the tree is going to fall. Your safety cage is very flimsy. You must know the trend and anticipate its direction, or reversal, as accurately as possible. Near enough is not good enough because if you miscalculate and the tree we select falls on us, we sustain a lot of structural damage. Chapter 6, The Trend is Your Friend explores this concept and suggests ways to reveal the trend in a chart.

The area of your specialisation decides the market crowd you want to understand. You need to develop a measure of trend sentiment for your particular group. A private index fills the same role as the published market indexes, but it provides specific tradeable information about the market of your choice. Chapter 7, Your Private Index looks at the benefits of building and using this. This is your research department and it is the edge your trading business needs to survive and prosper.

The fact that you are removed from Wall Street gives you an advantage. American 'market wizard' Gary Bielfeldt trades bonds from Peoria partly because it is away from Wall Street. Like Bielfeldt you can learn to recognise the crowd from a distance. You can understand its motivation by looking at yourself. Your instinctive reactions, multiplied a millionfold, are those of the crowd. By recognising your own instinctive emotions, you can discount them, and so look at the market crowd more clearly. Greed and fear are such powerful enemies that it is much better to have them on your side.

Once you understand the role crowd psychology plays in setting price you can decide how far you want to go. Armed with risk parameters that are distinctly your own, and equipped with clear targets for return on capital, you can confidently walk a mile with the crowd. As a private trader, you have the time to make every decision a good decision. You have the opportunity to see the crowd from a detached viewpoint. How to use this major advantage is the subject of Chapter 8, Walk a Mile With the Crowd.

Selected Tools

Like a burglar crouched in front of a safe, you need the right tools to crack the combination. Surprisingly, the tools you use to crack the market safe are much the same as the tools used by the institutions. Your trading edge lies in selecting the right tools and using them in the best way. Every burglar has his private MO. Every private trader needs no less. Your safe is in the stock market office and we look at how point and figure charting can be a useful safe-cracking tool.

Fully armed, fully informed and equipped with the necessary discipline the guppy enters the sea along with the sharks. Any fool can enter the market. A guppy that stakes out the middle of the sea is instant fishfood. As a private trader, you must find your own corner from which you can dart into the melee for a few moments before withdrawing without being bitten or eaten. You are not big enough to hide technique behind bravado. The tactics you use depend on the corner you hold. Chapter 10, Enter the Fool - Not considers how an entry and exit technique should be linked with stop loss tactics.

Linking the theory together in a practical way is the subject of Chapter 11, Putting it all Together. Specific monitoring and management techniques are discussed, along with some trading tactics made possible by electronic transactions. This is the day to day activity of a private trading business, from evaluating trading opportunities, to fine tuning the placement of orders and making an exit with discipline.

Things Can Go Wrong

No matter how successful you are, you are going to make mistakes. The institutions make them frequently, but as a small trader you cannot say " Wait a minute. Hold everything. A $350,000 loss? Why, that's nothing," as Nancy Goldstone does in Trading Up. Taking a loss and recovering from a loss is serious business for you. Unlike the institutions, your very survival depends on your ability to recover. Losses threaten your prosperity and have a greater potential to destroy your business.

The threat of catastrophic risk looks over your shoulder at every trade and casts a shadow on the screen. Risk is real and Chapter 12, Protecting Profits considers how it can be controlled in small stock trading accounts. The 2% rule is the core of money management, but managing profits can further add to risk. This chapter considers how money management applies to small accounts. The next, Six to Twenty-One explores three money management models from a startup capital base of $6,000 to a safer $21,000. The way you manage your profits plays a bigger part in your long term success than just winning trades. This chapter explores in detail six approaches all subject to the same series of trades.

Not a single one of us trades perfectly from day one. Getting better at the job is only part of the solution. Even when you develop enough discipline to stop the bleeding, there is still a fair amount of old blood on the floor. Running your account into the ground is not the end. It is an opportunity in rather ugly wrapping. If you cannot take a loss, but if you can live with it for a while, then your only choice is to trade your way out. Chapter 14, When Trades go Sour looks at some ways to really make you and your capital sweat.

Trading provides seductive distractions for the private trader. Not so for the institutions who are able to contract them out. For you, the search for the Holy Grail of trading - the perfect system for finding profit through price differences - is very seductive. Like watching garbage on TV, the pastime has its place, but it must not become an end in itself. The institutions can pay a team of computer nerds for years on end to develop a propriety trading system because their traders are still trading. When you get waylaid by the search, too often your trading stops.

Chapter 15, Waylaid by the Holy Grail considers how this search can help, or hinder us.

As private traders you stand on the shoulders of giants, dragging your errors behind you. When you understand that you are not like institutional traders then you take the first step towards survival in the market. The next chapter, A Guppy Among Sharks, explores those differences.