Documentation > Tutorials > Trading Strategies

Trading Strategies - getting 'Sophisticated'

Generalities

By now, having got this far through the tutorials, you should be pretty convinced that active trading on your own behalf, doing your own analysis, is very much the right thing to be doing. The previous page talked over the physical activities involved in using StockWave™ — i.e., how to create a trade using the application, communication with your broker, and so on. This section is devoted to helping you becoming a sophisticated trader or investor, i.e., someone who can use all of the tools available to him with skill, so that in the longer run, a greater return will be possible than by simple reliance on others, or on naïve strategies.

Despite the multitude of data processing algorithms, the insistence on the probabilistic approach, the reliance on sound scientific techniques, the extensive tutorials, the critiques of much of what passes for wisdom in the investing world — the user may simply shrug his shoulders and say:

It is just gambling, at the end of the day — and I do not want to do this, no matter what the encouragements are...

This is a view which we quite understand and can sympathise with, but it misses the point — whatever you do with your money, is a 'gamble,' and the so-called experts are unlikely to have any better skills at trading than you have; what is more, trading strategies can be developed that lessen risk.

The question you must ask yourself is what your overall goal is — and this goes a lot further then simply 'making money;' you have to decide what your attitude towards risk is. Once you have gained certainty here, then the real capabilities of StockWave™ will become apparent to you. When we considered the trade creator, it may have seemed a little complicated, perhaps overly so, with the capability of handling several different kinds of trade, and in any combination. This is quite deliberate, and indeed, the whole point of this application — the trade creator allows the user to create combination trades with tailored risk profiles, so that in theory, you can make a profit whatever direction the market moves, and with as little or as much exposure as you feel comfortable with.

Where should you begin?

Start simple; in the case of what to trade, start with the indices and the blue chips, then perhaps move on to mid-caps, small-caps, and foreign stocks; anything which is liquid — just take value where you can find out.

For the case of what types of trade to make, you can start paper-trading stocks, then move on to the leveraged derivative based products; once you understand these, you can work on developing your own strategies. Buying stocks is not good value in the UK because of the charges involved, so we do not recommend it, even though it is the easiest to understand. In the beginning you will likely be using single trades only, and so it is a good idea to use stop-losses with these; later on you will be capable of creating your own hedged and leveraged trades.

Be active, but don't trade too much; once a week is good enough. Work out beforehand where the danger zones for the share price are, and work out what your response will be should the price get into these zones — make a plan and stick to it; it is very tempting to chase one's losses, or to hold onto a bad position for too long — when it goes against you, best to take it on the chin; think about what went wrong, then get onto the next trade. Conversely, when you have made your profit target, close out your position; don't get greedy, leave something for the next guy.

When using the analyzers, try and work out whether there are going to be any likely external events which will distort the movements, i.e., what we have termed trend-breaker news events. A good example might be company reporting dates — if you are hoping to keep open a position through a report date, you may find the price takes some large unexpected kicks.

Have your broker's phone number programmed into your mobile phone. Alarms will normally be sent via email; you can also get periodic updates on your (estimated) position. Know what you have to say to close out your position, especially if you have several trades running simultaneously as part of some composite trade.

Detail

So much for the generalities, let's talk about specifics.

First of all, make sure you've done your analysis — i.e., have tried various things, and found some analyzer that you are happy with. From its predictor you will be able to gauge the basic direction of the share price — you will discern an up, a down, a neutral, or perhaps a turning point. From this qualitative information you can choose which kind of trades make sense, i.e., which ones are most likely to be profitable; take these trades and experiment with them on the trade creator. If you see an upward trend then buying CFDs, up-bet spread bets or the buying of call options is the obvious thing to do; if you see a downward trend then you do the opposite. If you decide to look at an option trade then you should experiment with the strike price, and also look at the 'double opposite' trade — e.g., if you think buying a call is the basic trade to make, then you should also look at selling a put. Remember that selling options has limited profit and unlimited loss potential, buying options is the opposite — the maximum loss is the price of the option, the premium.

If you use spread bets, make sure you use the daily type — these are settled against the share price on the day, and have small spreads; they also usually have automatic rollover potential, if you want to do multi-day trades.

Once you have decided on a basic trade you should then consider protecting yourself against losses, or on increasing the profit level; this may involve adding another trade to the basic one, changing the parameters of the original trade or arranging a stop-loss with the broker. Iterate between increasing profits and adding protection to the trade. Once you are happy, then make your trade; print it all out, then phone your broker. Try and get email confirmation as well.

The goal here is to find a combination of trades with good expected profit level and a risk level, i.e., a maximum loss level or a loss probability that you are comfortable with. When you place the trade an automatic trading alarm will be set; this will warn you if your trade is going seriously off track.

StockWave™ will also alert you when you have reached your stop-loss limit, target profit level or maximum running time; these limits act as circuit breakers — the idea behind them is to encourage the user to close out his trades in a timely manner; taken together these values set a 'box' around the trade — i.e., when one of these values is reached or exceeded, the user should close out his position, whatever he thinks may happen in the future.

However, sometimes if a trade is doing well, you may think — 'Why should I close out the position, when I am doing so well? I am losing profits here!' or if you are doing badly you may think — 'I'll just give it a little longer, maybe it will turn around.' These are foolish attitudes, if you hold on too long, then it will turn against you eventually — and the chances of you choosing the exact moment of maximised profit are very small indeed; conversely, holding onto a losing position is psychologically comforting, as until the position is closed, the loss has not been realised. You must accept that with all the analysis in StockWave™, or even the world — from time to time, you will get it wrong; it will just go against you — in these situations you must learn to take it on the chin, and get on to the next trade. Holding on, hoping it will turn around, is a mug's game (it's also how the spread betting firms make their profits).

The reason for having a maximum running time is simply because we have to accept that as it ages, your analysis becomes less and less valid; after a while you will get to a stage where it has no predictive value whatsoever, and so if you hold a trade open for too long, you will eventually find yourself in a zone where you are trading without any supporting analysis; this we are strongly against — all trades should be based on some underlying piece of analysis.

If you really think there is more profit in the trade; close out your current one, do some more analysis, then re-open a similar trade — chances are you won't!

Getting the most from the Trade Creator and the Auto Trade Searcher

Trading can be a complicated business — all the possible choices just confuse us, options are particular problem — options prices are laid out in a large table, inspection of which in no way tells us what trade to actually make. Again StockWave™ comes to the rescue — by learning to use the trade creator and the auto search we can narrow down our search quickly to a handful of good looking trades.

The first thing we need is to do is assemble a representative set of probabilistic analyzers — try and get a range of methods, sampling detail level, parameter choice and level of pre-processing; when assembling these we should be looking for the emergence of corroboration and the range of extreme cases. Also it would not exactly harm you to check the news file and calendar for any exceptional events.

Now we go to the trade creator, the basic operation of which should be well known to you by now — you select an analysis and experiment with trades which you manually enter; this is a very good way to learn about the basic payoff profiles for the common trades, but entering information by hand and manually experimenting is a bit too time consuming — luckily we have a secret weapon which comes to our rescue — the auto search.

The auto search can take up to twenty initial trades as 'seeds' for our search and exhaustively evaluate the payoff parameters for each up to a depth of six trades; you choose any combination of spread bets, CFDs, plus call and put options with varying strike prices; if you are not interested in a type of trade just leave the pricing box blank.

To use the auto search — fill in the prices for the trades you want (get the prices from LIFFE, CBOE or your broker; these Web sites can be accessed directly from the stock chart for our stock of interest), press SET and then press START. That's it!

On the left hand results pane you will see the trade summary results fill up — you will see the best (and worst) twenty-five results for each category of profit probability, loss probability, expected profit, maximum profit and maximum loss.

The auto search is pretty fast, but when you start getting to a depth of four or better, and are using greater than say twelve seed trades, it will start to slow down; you can of course pause or stop the search process at any time — once you have done this you may examine the results.

First things to look for will be the trades with the highest expected profit and highest profit probability; select a trade by clicking on it then right-click for further options; click on 'Load to trade creator' and the trade will be sent back to the trade creator, where it can be inspected in detail.

From the trade creator views we can find out what the trade is and look at its payoff profile — you may see something which is familiar to you; it also helps you get acquainted with the strangely named options strategies — and this is not purely of academic interest; some brokerages allow you to execute known combination trades for single-trade execution costs.

Look at a few trades which interest you and make a shortlist of these; now you can try varying your analysis as well, or make enquiries with your broker. Ideally we would want to get a trade which has high expected payoff and capped losses — the precise trade-off is a matter for the user.

Issues when using the Auto Trade Searcher

Equivalence

In searching for trade combinations we use the fact that 1,000 CFD shares, £10 per point spread bets, and one option contract (if the number of shares per contract is 1,000) are equivalent. We do not bother with stock trades due to the stamp duty involved.

Costs

Trading costs are usually included in our calculations — these are a very important factor in our overall profit measures; typically the user will enter representative values for these, but when doing our search across different types of trade it is very hard to be accurate, for example — options trades may or may not have a flat fee, may or may not charge commission, but do not have stamp duty (unless you exercised the option), and no daily financing rate; spread bets have no stamp duty, or commission, but may have a daily financing rate; CFDs have no stamp duty, usually no commission, and usually a financing rate — you see where we're going with this...

You can stick in 'likely values' if you want, but since it is unlikely to be very accurate in practice we would suggest that you simply set all the costs to zero, identify likely trades as per usual, then, if you actually want to make the trade, get the costs from a broker and subtract these from your expected profit figure. You should also ask the broker about any expected dividends, as these will alter the options valuation.

Odd things you might see
- '100% profit probability,' but with a rather small expected payout
  
  This can happen — professional traders are always looking for this — it's called arbitrage, and is that 'Holy Grail' of investing, the 'sure thing,' the 100% profit likelihood — free money. Unfortunately, for a small investor like yourself — limited to delayed prices (you should now understand why real-time options prices are always expensive) — the opportunity is now likely to be long gone by the time you identified it, plus when you add in accurate brokerage charges, the likelihood is that it never existed anyway. Oh well.
- The payoff profile looks crazy
  
  The trade searcher can look at a huge number of trades; this is going to happen, and...is good. Note that it is to your significant advantage to be looking for profit in places where the rest of the investing herd is absent.

The markets

What is a share or stock?

Bonds, gilts and commodities

Derivatives, futures and options

How to trade

How to analyze chart data

Trading strategies