Reader Questions Answered

Penny Stocks or Forex for the new trader

I had an email come in with a set of questions from one of my newsletter subscribers yesterday.

Two weeks ago yesterday, I began my venture into learning how to day trade. Expect to start in Penny Stocks &/or Forex. Here’s my Q’s…

1. Which one do you suggest I try first, Penny Stocks or Forex? Penny Stocks I’ve studied the most already.

2. How do I open a paper account, (to practice what I’ve been studying about Penny Stocks) the same Broker I plan to open my actual trading account with later, or somewhere else?

3. I like what I see at Peter Leeds web site… the list of Brokers he recommends, (as choices for opening our 1st trading account) and system he’s developed for picking stocks he recommends to those who subscribe to his newsletter. What do you think of his expertise?

Any suggestions for helping us get started, are greatly appreciated.

Let me start with the last question first. I don’t know Mr. Leeds, nor am I familiar with his website, system for picking stocks, or his newsletter. As a result, I cannot speak to his expertise or the value of what he does.

When I am confronted with questions like this my standard response is that you need to make sure whatever product or service you’re contemplating investing your money and/or time in is what you need right now to either further your trader development or to improve the efficiency and effectiveness of your work developing trade ideas and/or managing positions. Way too much money and effort are invested into things which don’t fulfill those criteria. This is largely because the person in question hasn’t taken the time to build up their foundational knowledge and worked through the process of understanding how they need to approach the markets and their own trading. Helping them do that is the major driving focus of what I am trying to do with this site and my various educational efforts.

Getting back to the other two questions…

Penny Stocks vs. Forex
I cannot tell you penny stocks or forex is better. Both have their strengths and weaknesses. A major factor in the decision, though, is time. You won’t be able to trade penny stocks outside exchange hours, so if that is something important then you’ll have to go with forex. On the flip side, there are only a limited number of really tradable currency pairs, so if working with a broad array of potential trading vehicles is important for your strategy, then penny stocks would be the better choice.

One thing I would note here is that penny stocks tend to attract low-capital traders because of their lower cash requirements. This is not a good reason to opt for penny stocks, though, because their lower liquidity tends to mean higher bid/ask spreads than in higher-cap stocks and commissions have a higher negative impact on a smaller account than on a bigger one. You will likely find if you are a very low capitalized trader that transaction costs in forex are smaller.

If you’re new to trading, my advice is to pick one or the other. Working on learning two quite different markets when you’re trading to develop your knowledge and skills will be problematic.

Picking a demo platform
In an ideal world, you’d go with the demo platform of the broker you plan on trading through when you go live. That said, part of the demoing process is also finding a broker whose platform you like. Also, if you’re planning on doing an extended period of demo trading you may be constrained by the time limits that some demo platforms have.

The Basics

What do you trade and why?

A question came up on Trade2Win recently on a new thread. It asked the question of the membership, what do you trade and why? In many ways this is a fundamental question that every trader needs to have a strong answer to in order to be on the right track. So to that end, let me address it for myself.

I have traded just about everything you could think of a retail trader trading. Basically, it’s about finding good opportunities. I’m primarily a technically driven trader who operates mainly in the swing to position time frames, so I don’t need to have the narrower focus of someone who trades in the shorter time frames.

That said, stocks and forex are my two main markets.

In the case of stocks, that’s what I came up following. Back in the 80s when I got started it was still the main market available to retail market participants. I didn’t have the funding to effectively play in the futures market (there were no mini contracts back then). Also, when I read [easyazon-link asin=”0132825244″]How to Make Money in Stocks[/easyazon-link] it really resonated with me in terms of approaching the market. The strategies I use to this day have a foundation in what I learned from that book.

I got active in forex in the early 2000s. This was as online trading was really starting to develop and I was covering the forex market professionally at the time (as I am today). I liked that I could trade at any time of day or night, which you couldn’t really do in other markets at that time. I also liked how technical the forex market was. It suited my trading orientation very nicely.

These days my #3 is stock indices. I go through periods where I will lock in and fairly actively trade the likes of the mini S&P 500 futures. It’s very much a market conditions and available focus sort of thing, though.

What about you? What market(s) do you trade and why?

Trading Book Reviews

Book Review: Buy and Hedge

[easyazon-link asin=”0132825244″][/easyazon-link]While it may be generally classified as an investing book [easyazon-link asin=”0132825244″]Buy and Hedge[/easyazon-link] by Jay Pestrichelli and Wayne Ferbert could easily be classified as a trading book because of the way it advocates the use of options. I’ll leave the reader to classify it for themselves, though, based on their own definitions of the two terms.

In a nut shell, the philosophy of Buy and Hedge is that any positions one takes in the stock market (and we’re really talking long-only here) should be hedged. Individual hedging is best, but portfolio hedging is also considered acceptable by the authors. Options are the favored tool to accomplish that hedging.

About the first half of the book puts forth the reasoning and justification for hedging. Mainly it comes down to reducing the volatility of your returns. The authors make the statement that the one thing you can control in the investing process is the risk. I’m not totally comfortable with putting it that way, but I get the point they are trying to make.

The second half of the book is focused on options and option strategies which can be used for hedging purposes. In fact, the authors go so far as to recommend strategies (though not necessarily in all cases) where no position in the underlying security (stock, ETF, etc.) is held – the position is totally created with options. This is probably something that will make traditional investing advocates a bit uncomfortable.

It should also be noted that the authors don’t have anything against a straightforward index approach. They just think that it should incorporate a hedging element.

All in all, I think [easyazon-link asin=”0132825244″]Buy and Hedge[/easyazon-link] is a worthwhile read for those who favor playing the stock/ETF market from a longer-term position perspective.

Make sure to check out all my trading book reviews.

Reader Questions Answered

CANSLIM and market trend

I received the following query from a Trade2Win member the other day.

I was just re-reading the example strategy part of your book. I know you said it is inspired from CANSLIM. O’Neill generally advises staying out of the market if it is in a bear trend. Do you generally find this affects your strategy. Do you have to leave it for another or do you find it still works fine possibly with less candidates?

My personal experience with stock trading in general, and CANSLIM-related strategies in specific, is that the overall trend of the market is a major influence on the performance of most individual stocks. I think most experienced traders would back me up on this. Also, there’s been a lot of talk lately about how much more correlated individual stocks have become to the indices of late, so it would seem these days the O’Neill suggestion should be taken even more seriously.

While it’s certainly true that strong stocks will tend to outperform the market no matter the overall conditions, there’s an aspect to CANSLIM which needs to be accounted for here. The stocks identified tend to be high beta names, meaning they tend move move more aggressively than the overall market. That’s great when the market is rallying, but it can be a killer when the market’s moving the other way.

Trading Book Reviews

Book Review: Laughing at Wall Street

[easyazon-link asin=”0312657854″][/easyazon-link]Books by successful traders and investors seem to be eagerly consumed, and with a title like [easyazon-link asin=”0312657854″]Laughing at Wall Street: How I Beat the Pros at Investing (by Reading Tabloids, Shopping at the Mall, and Connecting on Facebook) and How You Can, Too [/easyazon-link], I wouldn’t be surprised if this one by Chris Camillo is as well. Camillo’s claim to fame is running $20,000 up to $2 million in three years trading the stock market. The book describes his methodology for doing so.

It should be stated that the author’s approach to the markets is not dissimilar to the one suggested by Peter Lynch in [easyazon-link asin=”0743200403″]One Up On Wall Street[/easyazon-link] many years ago. Lynch, who was the wildly successful manager of Fidelity’s Magellan fund, suggested using what you know to invest in the stock market. Camillo takes the same approach, though brings modern developments like Facebook and online forums into the discussion. The book does a good job of describing the thought process which needs to be at work and how one needs to go about things.

The major wrinkle the author introduces here is the use of options. This is where we really go from this being an “investing” strategy based on identifying mis-valued stocks to a “trading” one which employs leverage, albeit a fairly simple one based strictly on plain vanilla long call and put positions. Of course its takes considerable aggression to increase an account 100-fold in three years, especially when working on a valuation type basis where positions aren’t entered frequently and take time to make the big moves. This is no day or swing trading strategy. The author looks for the moves to take 6-9 months or longer to unfold.

The aggression goes beyond just using options, though. Camillo takes on position sizes which would leave most traders in a cold sweat – like putting half his account in a single option. His doing so, however, is rooted in the way he funds and views his trading account. It is truly risk capital only, totally separate from his long-term investing funds. His concept of OPM is one worth thinking about for many new, low-capitalization traders. I venture to say, though, that even in this case it takes a certain mentality to be able to risk the loss of half one’s account in one single trade.

My biggest gripe about the book was the author’s constant sniping at Wall Street professionals throughout the book (he also tears into both technical and fundamental analysis, though his strategy would clearly be classified as the latter). The point was made plain enough early on that individuals can take advantage of things overlooked by the pros, with which I fully agree. There was no need for continued pot shots through the rest of the text.

The other issue I had was the failure to include a discussion of the impact of volatility on option prices. I’m on the side of those who don’t think options trading needs to be nearly as complicated as some tend to want to make it, but those thinking to trade them should understand the volatility influence. Camillo discusses intrinsic value and time value, but in his description the latter includes volatility. It could be said, though, that given the length of hold period and the types of moves he’s after, it’s not really a major issue.

Those two complaints aside, I do think [easyazon-link asin=”0312657854″]Laughing at Wall Street[/easyazon-link] is a good read. It provides support for the ability of individuals to do well in the markets and offers up an interesting concept in the author’s concept of Other People’s Money (OPM). The strategy requires work and effort, and perhaps the risk-taking aspect would need to be adjusted to individual tolerances, but overall the approach is a very reasonable one.

Make sure to check out all my trading book reviews.

Trading Tips

Volatility Changes Across Markets

A recent blog post got me thinking about where volatility stands now compared to where it’s been. Here’s what I found for stocks and the dollar. Both of the charts below is a weekly which includes two measures for viewing volatility. Normalized Average True Range (N-ATR) measures average period high/low ranges (You can find articles I’ve written about N-ATR at Trade2Win and TASC). The Band Width Indicator (BWI) measures the distance between the Bollinger Bands, which is standard deviation of closing prices.

Dollar Index
Here we see that while volatility has certainly fallen well off from where it was during the worst of the financial crisis, it hasn’t quite got back down to average levels from before then. It’s worth noting, though, that volatility heading into the start of the problems in 2007 was ridiculously low. I don’t expect to see it get back to those kinds of levels.

S&P 500 Index
Volatility in the stock market, however, has now fallen back to about the same levels it was at during the middle of the last decade. This is something very important to keep note of because N-ATR tends to be low turning sustained uptrends, but rise into market tops.

Trading Book Reviews

Book Review: Trading on Corporate Earnings News

[easyazon-link asin=”0137084927″][/easyazon-link]If you’re a stock market trader I think you’ll want to pick up a copy of [easyazon-link asin=”0137084927″]Trading on Corporate Earnings News[/easyazon-link] by John Shon and Ping Zhou. It’s a book that’s focused on short-term options trading, but which could have a fair bit of value to non-options traders and general market watchers as a whole. The authors are a pair of PhDs (Shon is an academic, Zhou a portfolio manager) who really get into the numbers about what stocks do around earnings announcements. It’s interesting and potentially quite useful stuff if you track stocks at all.

Don’t worry about the PhD thing, though. This isn’t an academic paper. The language is very easy to read and there isn’t a bunch of Greek in the text. What they have done is incorporate a considerable amount of academic research (7 pages of references) about earnings forecasts, price performance, and related subjects into a pretty well done discussion which features loads of visuals.

The book starts off by taking an in-depth look at earning surprises, including empirical evidence of how they are distributed and how their patterns have tended to change over time. It then moves on to look at how stock prices react to earnings surprises. I outlined some of their results in Some Numbers on Stock Market Earnings Reactions. The rest of the book focuses on options trading strategies.

By the way, there’s nothing too complicated about the option strategies, so even if you’re not an experienced options trader you shouldn’t have much problem following along with the discussion. There are lots and lots of examples provided and explained. I would have liked to have seen some empirical data on the performance of the strategies outlined, though.

Short-term options trading is not my personal thing, and I was well aware of the different types of options strategies that could be employed for the type of trading the authors discuss in this book. Still, I found it a very worthwhile read for the information presented on earnings estimates and how the markets react to earnings releases. It’s information I could very likely put to use in other ways in my market analysis and trading. From both perspectives I think it’s a good read.

Make sure to check out all my trading book reviews.