Equity markets are heading into mid-year with lackluster gains. While few investors have been thrilled with this year’s performance, it could be much worse. We have yet to see a significant correction, equity markets remain within a few percentage points of all-time highs and volatility remains low.
Many clients have been asking: What could change? Or put differently, what could lead to a more severe market correction? So, I figured it was time for my annual look at the market risks that keep me up at night. While there’s a long list of things that could go wrong, here are four that I would focus on for the summer.
- Ukraine. There’s no way of knowing how events in Ukraine will play out, but what’s clear is that for now, the market is paying scant attention. Even during last week’s sell-off, market volatility, as measured by the VIX index, never got above 14. An escalation in Ukraine-related violence and more sanctions against Russia don’t appear to be priced into financial markets and would both likely lead to increased selling.
- Europe. With many of Europe’s former problem children enjoying all-time low bond yields, it seems a strange time to worry about Europe. However, while bond yields have dropped, risks remain. Sovereign debt levels continue to climb; growth, while improving, remains anemic; and the currency zone is flirting with deflation. Outside of the economic risks, there are growing political risks. The European parliamentary elections may illustrate just how much damage has been inflicted on the region’s main political parties. For example, while economic conditions in Greece have improved – from abysmal to merely poor – the political situation has not. The government is teetering, with a razor thin two-seat majority.
- China. My base case scenario is a modest deceleration in the Chinese economy. So far, while the country’s economic data has been weak, it has conformed to that scenario. That said, the Chinese government is attempting a difficult balancing act: slow down the real estate market and credit expansion without cratering growth. A sharp and unexpected drop in growth would not only pose a risk to China, but with China as the world’s second largest economy, it would pose a risk to the global economy as well.
- U.S. Bond Market. Why worry about interest rates with bond yields at six-month lows? Because, as everyone experienced last May, with rates at these levels, bond prices can reverse violently and abruptly. I would focus on two near-term and interrelated risks related to the bond market: a change in Federal Reserve (Fed) language and aggressive selling of bond funds by retail investors. Year-to-date, investors have been piling into bond bunds. However, even a subtle shift in the Fed’s tone could quickly change that pattern. The risk of retail outflows is heightened by the fact that many recent bond buyers are desperately seeking yield rather than committing to the asset class. A turn in rates could produce a quick turn in flows.
To be sure, I do expect equities to move higher over the course of the year. But as I’ve discussed previously, given last year’s extreme multiple expansion, 2014 was always going to be a more difficult year for stocks. Any of the above could quickly turn a difficult year into a bad one.
There are thousands of companies listed on stock markets and picking which stocks to trade can be confusing, especially if you are new to stock trading.
In this blog, we will guide you through the share selection process.
This blog will discuss how to start picking companies.
Start with the time horizon
The longer the period that you want to hold a position, the more detailed the analysis has to be.
This is because when you look at a longer time horizon, you need to make sure that there are solid fundamental reasons why the price of a share will continue rising – or falling, and this requires detailed analysis. For a short-term time horizon, you will only be looking to take advantage of short, quick price movements, and so such a detailed level of analysis is not needed.
Choosing a time horizon can depend on how much time you have. If you have a lot of time to trade and watch price charts, then you can trade on a shorter term time horizon.
If you only have an hour a day, or a week, to dedicate to trading, then you would be more suited to longer term trading.
At the end of this lesson, you will be able to choose which kind of analysis you want do.
Picking your stocks – start simple
If you're new to trading shares, it's best to start simple. Rather than diving straight into riskier, companies that have a small capitalisation, or obscure start-ups, try your hand at trading big, well-known companies.
These stocks are very liquid, meaning it's easy to get in and out of trades at the price you want. They’re always in the news and there’s plenty of research material available.
It may be a good idea to watch their price for a few weeks before committing any real money to the market. A demo account can be great for this.
Go for what you know
Once you're ready to begin stock-picking, start with something you know.
If you've worked in a particular industry, you will have useful background knowledge that will help you understand what issues are important for a company.
Even if you're a regular customer of a company, you might find it easier to understand their business model than a company that you do not know.
Being able to witness first-hand when a company's business is slack, or when its product range seems better than usual, can help you start thinking about whether now could be a good time to trade its shares.
Don't forget about shorting stocks
Remember too that choosing a stock to trade is not only about working out which one you think will rise in value – traders can make just as much profit by shorting a stock – selling it to profit from its anticipated price decline – as they can from buying one.
So if a company strikes you as a disaster waiting to happen, you may have just spotted a trading opportunity.
Pick a sector
Many professional traders decide which stocks they are going to trade through a top-down process of elimination. To start with, pick a sector or an industry that either has good growth opportunities – to buy stocks – or may look like they could be in trouble – to short-sell stocks.
Certain industries tend to perform better or worse in certain economic conditions or can be disproportionately affected by external events.
During an economic downturn, for example, retailers, holiday companies and restaurants tend to suffer as consumers are less willing to spend. Consumers may, however, flock to discount retailers, fast-food chains and voucher companies, pushing up their stocks.
There are also certain goods and services that people will need however well off they are. For example, defensive sectors, like pharmaceuticals or waste-collection, will tend to at least hold firm during a downturn.
Weed out the best companies in that sector
Once you have settled on a sector, you need to start looking at many different aspects of the various companies in that industry and find one or two you believe will present the best trading opportunities.
How you do this takes us back to our original point about time frames – the level of analysis you apply will be very different depending on how much time you have and how long you wish to hold the position for.
Where to find the information you need
There are numerous resources to help you with your research.
For fundamental analysis of a company’s performance and prospects, read its quarterly and annual financial reports.
You can usually find these on the Investor Relations section of a company's website.
There are also regulatory bodies in each country that require public companies to file their financial statements for public viewing.
If a company is listed in the UK, for example, it will file its earnings and other announcements with Companies House, whose website you can search.
For US-listed companies, you can search the Securities and Exchange Commission (SEC) website.
For a mix of fundamental and technical analysis, you can also use a stock screener – a software program or online subscription service that helps you pick stocks based on a range of criteria that you can customise.
Fundamental traders could, for example, customise the program to compare companies based on their sales, profits and any of the other yardsticks listed above.
One example of a free stock screener is YCharts, that is available in English. Alternatively, you can simple enter "free stock screener" into Google.com.
The first step to trading the news is to make a news trading schedule. First you identify news sources that might help you.
Newspapers, such as the Financial Times, or specialist websites, like Bloomberg, are a good place to start if you want to know when announcements are expected and how they might move prices.
These sources will also give you a broader view of the market and wider economy, give you a feel for what to expect from news announcements and how much their expectations have already been 'priced' in to the market.
News feeds
You can also subscribe to a news feed. There are two basic categories of news feed: those publishing news in real time, and those publishing in near time. Near-time feeds usually report news with a 5- to 30-minute delay.
The smaller the delay, the more you pay for the feed. Prices for news feeds also vary depending on what issues or asset classes the feed focuses on and the volume of news that is included.
Plan your daily trading schedule
You should plan your daily trading schedule one or several days in advance.
Make a note of what news announcements are expected that week and decide which ones will be most important for the assets you trade. Use this information to plan on which days and times you will trade. Then you plan each trading day according to the news that will be released.
See below for an example of what a daily trading schedule might look like – this schedule was for March 20, 2013:
Planning your trades
Once you have a schedule for each day, you can then plan your trade for each news release with the following steps:
Step 1: Analyse analysts' expectations
Analysts will form an opinion on the results of an announcement and how it could move prices. This is usually a major influence on market behavior following an announcement, when traders compare them to the actual result.
When analysts publish their expectations, usually the price of an asset will adjust accordingly – the expectation becomes 'priced in' to the market.
If the actual results are very different to the expected results, then the price is likely to rapidly move and traders open and close positions to adjust to the new information.
Using analysts expectations, you can then build scenarios for when the news is released.
Step 2. Build possible scenarios
Once you have the analysts expectations, you then prepare for different scenarios so you can respond quickly when the real figures arrive.
There are essentially five scenarios you need to prepare for – when the figures are:
- Exactly as expected
- Slightly better than expected
- Much better than expected
- Slightly worse than expected
- Much worse than expected
You can use a table to determine what the market expectations are and then what direction the price is likely to go in once the news has been released. For example:
News Type: Unemployment figures
Analysts expectations: Good – Better than the previous month
Once you have done this preparation for each news piece that you wish to trade, you have a clear outline of what could happen, for whatever scenario. Once the news is released, you can act accordingly.
Of course, this is only a guide. There is never a guarantee that the same event or circumstances will produce the same response every time.
Step 3. Observe the current market conditions
Now that you have your trading scenarios, you should see what the current market conditions are – is the market trending or ranging?
This will help you when you decide which strategy you will use to trade the news.
For example, markets that have been ranging can offer excellent trading opportunities, because the release of important news can cause the price to break out of the range. You would therefore look to use a breakout strategy for this kind of market.
Keep in mind the costs of trading
Another important issue you need to consider is the fact that the cost of trading can go up when news is released.
For example, most of the time, brokers often widen their spreads on forex currency pairs and CFDs just before the news is due, to reflect the extra volatility (and therefore the risk to the brokers) that is expected.
However, some instruments are charged at a fixed commission, such as shares and futures.
To understand how news can affect the volatility of prices, you need to consider how other traders prepare for and react to its release.
Before the release
In the case of news that is pre-scheduled, some traders stop trading just before an announcement and close any positions that they have.
Others decide to keep positions, or open new ones, but use tighter stop losses.
As there are many traders and institutions closing and opening positions just before the news release happens, you find that there is an increase in price volatility, as buy and sell orders become processed.
After the release
As soon as the news is released, there is another surge of activity.
Traders pursuing news trading strategies now enter the market, increasing the volatility.
Meanwhile, other traders get stopped out and automatically exited from the market – remember that stop loss orders are orders to buy and sell – and so this increases the price volatility further.
Automated trading increasing the activity further
You should also bear in mind that a lot of trading is now automated and is most often used to employ "high-frequency trading" – lots of small trades that flood the market with activity causing volatility.
Observing the increase in activity on a chart
You can observe the increase in activity directly on a chart.
This following chart shows you one scenario, where there is increase in activity in price action for the EUR/USD currency pair, on a 1 minute chart, on March 14, 2013:
Increase in price action on the chart explained
In the chart above, important economic data was due to be released at 12:30 on this day – the exact moment of the release is shown by the black vertical line.
The area highlighted in blue, at number_1, marks the time from 12:20:00 to 12:29:59. As you can see, only very short candlesticks formed during that time – price volatility was relatively low.
The Average True Range (ATR) indicator, which measures price volatility, is shown underneath the chart.
Up until 12:29, the ATR indicator also showed that volatility was low. However, at 12:30 – the exact time that the news was published – the price volatility, shown in the green area at number_3, showed a significant increase and the ATR indicator reading suddenly increased sharply, shown in the red area as number_4. This volatility increase continued until 12:41, before dropping down again.
This shows you the typical price action around an important news release.
Volatility is usually determined by the importance of the news
Ultimately, how much volatility and when it increases depends on how much importance traders attach to it.
Generally, if traders consider a piece of news important, then volatility is generally expected to increase significantly.
How long the effects of news last
Some news events only affect volatility and prices in the short term. Others may trigger the beginning of a new long-term trend.
Before you place a trade, decide how long you think a news event will affect the market you are trading. This will dictate what time frames and charts you use.
To trade the initial momentum immediately following a news release, a tick chart and the M1 time frame are usually the most suitable.
If you wish to wait and see how the price was affected first, it is often better to use a 5-minute chart or – if you believe the news is highly significant – a 15-minute chart.
If a news event has a longer-term impact on a market – for example triggering the start or strengthening of a trend – you may decide to use 1 hour charts after the news has been released.
Collecting and analysing trading data
Before trading a strategy on a live account, experienced traders will thoroughly test a strategy on a demo account and determine whether it is profitable over a sustained period. When they start trading that strategy with real money, they will continue to record their results and constantly monitor them.
This collection of data is a trading journal.
The easiest way to record the data of your trading activity is using a spreadsheet. This allows you to very quickly analysis a lot of data to get useful information.
The image below demonstrates what such a spreadsheet may look like:
What trading data should you record?
You are essentially looking to record as much information as possible for every trade that you take. The data you are looking for is everything that will help the performance of the strategy and more importantly, the kind of performance that can be expected in the future.
Time and date of each trade
This is especially helpful information to find entry points when looking back over your charts. You can find the exact market conditions at the time when you entered your trades. There may also be certain times when the strategy either works well or breaks down completely – recording the time and date will highlight these periods.
The financial instruments being traded
Keeping track of the financial instruments you choose to trade with will help you determine profitability for each instrument over a sustained period of trading. Not all financial instruments behave in exactly the same way, some assets have different spreads or costs of trading and so not every asset will work under your strategy. It is essential to record what you are trading in order to cut the unprofitable asset classes from your trading strategy.
Entry, stop loss and exit prices
Recording these makes it much easier for you to check and verify each trade when looking back over your trading results and your charts. It will allow you to determine information such as risk to reward ratios and the initial risk that can safely be traded with the strategy, as well as analyse individual entries.
The results in pips, percentage gained and cash values
Recording your profit and loss will allow you to get a more accurate picture of whether the strategy is worth pursuing. As well as monitoring the profitability of the strategy, you will also be able to assess the strategy’s risk to reward results and whether trading the strategy, in reality, produces the same risk to reward as expected.
Turning the data into useful information
Once you have collected this data, the next step is using it to provide meaningful information. The amount of trades taken is a huge factor. For example, results based on 10 trades are nowhere near as valid as results based on 100 trades. The image to the right shows how this may look like in a spreadsheet. The following is the information that you are attempting to attain:
Overall profit or loss
This should be shown as cash value and ideally pip value as well.
Distribution of wins, losses and breakeven trades
This helps to determine the ratio of winning versus losing trades. It also helps traders decide exactly how much of the account can be risked on each trade and determining the overall risk to reward that can be taken using the strategy.
Average risk and average reward
The average risk to reward is vital so that expectations can be more aligned with the reality of the performance. This can have a positive impact on your psychology when trying to follow the strategy closely.
A trading journal is a record of all your trading activity. It is important to keep an accurate record of your trading results, because they allow you to assess the overall performance of your trading decisions and how effective your strategy is.
This information can prove critical, especially when you start to experience negative trading results. During these times, the confidence of a trader can be shaken, especially if there is no clear reason as to why their trading results are poor.
Questions that can arise during these times are:
- Has the system stopped working?
- When should I stop trading with this system?
- Should I just keep trading despite losses?
Not having the answer to these questions can lead to a fear of losing trades. This can further lead to traders making common mistakes, such as revenge trading (taking too many trades to get the lost money back, without a concern for the strategy) or deviating from your trading system in an attempt to avoid further losses.
To avoid this, you can use your trading journal to look over previous results and find out if anything unusual is happening in your trading. For instance, you may believe that you have been sticking to your system, but in actual fact, you have drifted away from your system without knowing.
Analysing your trading journal also allows you to identify certain trades that you may have been taking in less than optimal market conditions. For example, you may notice that even though you were sticking to your system, there could be a particular time of the month where these trades resulted in losses. You may have then found that this is because of a regular news release that affects the market and results in the trades taken at the same time being losers. You can then continue with your trading avoiding the time of that news release.
Only by keeping a record of your trading activity will you be able to go back and make this judgement.
What to record in a trading journal
There are many things that you can record in your trading journal and everyone has a different preference. However, as a general rule of thumb you should try to incorporate more than just data. The following is a general overview of what you should include in your trading journal.
Recording your data
For the journal to serve its purpose, it is important to record the correct data: This includes a record of all the trades you have taken, and an indication of how those trades have performed on an individual and overall basis.
Many traders use a spreadsheet, because it can be analysed easily. A spreadsheet can be used to find useful information such as the overall profit of a series of trades, as well as the profit of individual trades. This information can be used to produce an equity chart– a chart that shows the steady rise or fall of your trading capital.
When losses are occurring and doubts start to creep into your mind, a quick glance at an overall rising equity curve can restore confidence and keep you on track.
Recording your thoughts
It is possible that your judgement is affected by certain things going on in your life, which would be highlighted more clearly when going back over the journal. Recording your thoughts will also help you monitor your own personal development in trading as your experience grows. You can observe how your mindset matured and your discipline grew.
Visual screenshots
It is also important to actually take a screenshot of your entry and the exit. Not only can you see how well the system is doing by the journal data, but you can actually see how well you are adhering to the system or whether there are circumstances when the system breaks down under certain market conditions. You can also see if there are any particular market conditions under which the system works particularly well.
You will not remember how every trade happened, but by recording screenshots you can visualise exactly what you were seeing at the time, and without the emotional influence of being in the market.
There may be indications from a screenshot that you can use in order to find better entries or tweak your system.
Public journals
With the development of the internet, many traders are opting to record their trading activity in public journals. The advantage to this is that a trader can receive feedback, engage with other traders, as well as share and develop trading ideas. Many traders find this beneficial, because they can develop their trading skills and see the progression of others, as they go through the same hurdles when they begin to learn.
It can also be a good way to instil discipline to consistently recording your activity, because the interaction and feedback help you to maintain a positive attitude toward keep a journal.
What is scaling?
Scaling is a method of trade management that allows you to reduce potential losses and maximise potential profits, despite the fact that the future price movement in the market is unknown. There are two types of scaling: scaling in and scaling out.
Scaling in
Scaling into a trade means that when you enter the market, you initially enter just a fraction of the total position that you intend to trade and then observe how this initial market entry develops. If the trade works out as intended, then you can enter further positions in the market and take advantage of the price moving in your favour.
The following chart demonstrates an example of multiple entries as the uptrend develops.
The first position is entered when the market has shown a clear trend to the upside. A second position is entered after a pull back in the market and then started to continue on in the original direction. As the trade continues to go well, a third position is entered after a second pull back.
The benefits of scaling in
Let’s say that you wished to enter into the above trade with a standard lot. The trade will either win or lose, however by entering just a fraction of the standard lot, you reduce the total risk.
By breaking down this position into mini lots and only initially risking, say, 5 mini lots (half a standard lot) on the first entry, you will lose much less if the trade does not work out compared to if you entered with a full standard lot.
If the trade starts to go in your favour, such as the example shown above, then you can add to the position – for example, another 3 mini lots. If the trade continues to go well, as above, then you can enter two more mini lots.
Without scaling into the trade, you would enter the market with your entire position (in this case a full lot) which means that more would rest on your judgement of the trade being correct.
You can also add more than just the intended amount. Let’s say that the trade is successful and the initial position that you entered is now in profit. If you bring your stop loss up to the initial entry point, then you have taken any risk you had out of the market. This means that you can continue to increase the position size and keep adding to the winning trade beyond the amount that you initially intended to enter.
The risks of scaling in
The most prominent risk of scaling into a trade is that it can increase the overall exposure of your account, which is why it is essential to apply appropriate money management, that means only risking 1-2% of your trading capital on a single trade.
Even if the market is trending in your favour, there is always a danger of the trade reversing against you and the more positions you have open, the more you can potentially lose.
Also, as you enter positions while the trend develops, the later positions that you enter with may be closer to the end of the trend. It is advisable to be cautious when you are getting into a trend that has already been established for a while, as demonstrated in the chart below.
Scaling out of trades
Scaling out is a similar concept. Let’s say that you have a total position of one standard lot in the market, and the trade is in profit. You may have reached your initial profit target, but it seems like the market could continue to go in your direction. In this instance, you can close some positions to take profit and leave some positions open in order to take advantage of potential further price movement . By doing this, you maximise your gains by locking in the profit you have, while still having a position to take advantage of further price runs. You can see an example of this in the chart below.
The chart above shows a winning trade was scaled out as part of the position was taken off at each stage of the upward move. The first exit was taken out of the market once the initial move upward had finished, leaving two further positions to take advantage of the continued upward trend.
This technique reduces your overall profit, because of course you would have made more if you had left the entire position open for the duration of the entire upward move. However, scaling out protects the profit you have. For scaling out to work well, the market needs to be trending.
