13 - Tips for Traders

Friday, 27th May 2016 08:47 - by David Harbage

While most that has been written in the previous twelve articles surround sound long term financial strategy, there is undoubtedly scope for more nimble active investors to add value to a long term portfolio by making astute trades around the edges of the core investment plan.

The writer concludes this series of articles by listing a few favourite suggestions for the reader to consider and potentially investigate further:

1. Get to know a limited number of companies (according to the amount of time at your disposal) really well, across a number of different industries (to learn more, and take account, of varying business models). Read the company’s own announcements (from its own website, and other journalist’s reports from sites such as LSE), but try to assess the wider market’s perception (from the financial press and broker reports) of the particular industry and the specific business’ strengths, weaknesses, opportunities and threats. Write down this SWOT analysis, and a brief summary of the resultant rationale for choosing to own the stock (based on both fundamentals and valuation). As any new information (trading update, acquisition or management change) arises, so the investor can have a better appreciation of the likely impact on the worth of the business – by anticipating, for example, a change in sentiment (perhaps from a leading opinion-former) when a particular threat arises or has been removed - to the share price.

2. Besides the business, the prospective investor should acquaint him or herself with the trading pattern for the stock, and note any substantial changes in ownership - be they directors or institutions (stakes over 3% have to be disclosed to the stock market, and therefore the wider public). Fund managers will have carried out detailed analysis of stock exchange listed businesses and, while opinions will always vary on the outlook, a reasonable level of credence can be attached to their views and actions. Even more so, trading activity on the part of directors (all, irrespective of value, such bargains have to be reported to the wider market) can be indicative of a company’s progress or health – given their intimate (essentially inside) knowledge of their own businesses.

3. Some traders will be followers of share price charts (sometimes called technical analysis) and, while the writer would favour fundamental assessment of the appropriate value of a business, there is undoubtedly some measure of worth in evaluating human financial behaviour (one might say ‘gut instinct’) – especially surrounding short term share price movement. With the benefit of hindsight (looking at graphs), it can clearly be seen that marked changes in direction (‘breakouts’) occur – and not simply just in response to a piece of meaningful, valuation-changing news. The emotive over reaction, on both the up and downside, is a regular feature and can provide opportunity to the person taking the other side of such a trade.

4. Determine a short term (let’s call it a ‘fair value’) target price, equally based on the SWOT analysis and the recent trading pattern of the stock. And place a longer term target price on the shares, more heavily based on the fundamental assessment, but also to deliberately discard any shorter term trading pattern and incorporate one’s view of the company’s medium term future. The longer term horizon and target may well be 3-5 years away and, while the short term (say 3 month) fair value target may not take account of any anticipated wider movement in the market, the longer term target probably should incorporate the investor’s expectation. For example, if a 30% decline in the overall stock market was anticipated, one would probably not invest or add more monies to equity at this point in time.

 5. There is no hurry: take your time in making investment decisions (be it big asset allocation calls, subsequent tweaks or in individual security trades) and don’t rush to implement. Invest gradually, rather than on a single day, across various assets and in individual securities. Pound cost averaging (beloved of advisors’ recommending monthly savings schemes) suggests this strategy will limit the possibility of investing too much at what might turn out to be - with the benefit of hindsight - the wrong time.

6. Taking profits is a useful discipline, per the old stock broking adage “leave a bit for the next investor”. Booking a partial profit, for instance, by perhaps selling half of a holding once it has doubled in value – even when the fundamental attractions remain in place – can have logical merit. Setting a ceiling on the proportion of your portfolio that you wish to commit to any one stock (for example 10% might be appropriate), in order to retain disciplined portfolio diversification, is another. Similarly, placing minimum/maximum guidelines on each asset class (as well as an ideal initial allocation) provides the opportunity to reconsider the current mix – if one asset should particularly outperform and another has been weak. It may be that one alters the ideal asset mix (and the parameter guidelines, of say 10% each side of the ideal) based on a change in fundamentals or, alternatively, the investor carries out trades to move back, or closer, to the original allocation. On balance, the writer would choose to allow the ‘winners’ to appreciate further, (by minimising profit taking) but, by contrast, be more aggressive in disposing of the ‘losers’ within a portfolio’s asset mix or individual securities.

7. Finessing transactions: place price limits on shorter term trades – both on buying (contingent, on future price, orders) and selling (stop orders) – to control and potentially improve resultant prices and, in the case of disposals, limit the downside risk. This is largely a policy for traders, seeking short term gains, based on being comfortable with making judgements about how they view fair value and anticipate likely progress in a stock over the course of the next few hours or days. Online brokers typically provide a range of contingent limit or stop orders, at no additional cost; this is an area of competitive advantage (ideally, before signing up to one particular institution) well worth exploring – both in terms of adding value to investment returns and in managing or minimising downside risk.

8. Be mindful of early or late (in the working day, so 8am and 4.30pm for the London stock exchange) trading patterns, especially in smaller company or illiquid stocks, and those making announcements (companies or brokers) which have the potential to impact share prices. Be wary of prices on particularly volatile trading days (such as when the closure of futures and options occur), major economic announcements are made (such as job numbers in the US) or when a significant overall movement occurs (be it up, or down, in the market). This often leads to exaggerated price changes, via artificially wide spreads between the offer and bid quotes, which traders may utilise (for example on a weak day: buying a high beta (market-sensitive) FTSE100 constituent late in the trading day in the hope of selling it early on the next working day when a more normal market resumes, but may be to the disadvantage of a more typical serious investor.

9. One other consideration, insofar as early prices are concerned: the market will be aware of almost all valuation sensitive news, and adjust the first real (that can be dealt) prices or volume (size of order accepted) accordingly. This includes big FTSE100 constituent companies that are making the news – where it may take three or four minutes, after London’s normal 8am opening, to see prices settle and become established. But it also applies to newspaper ‘tip’ articles or other media speculation and broker recommendations; market makers will have made some adjustment to take account of anticipated investor action, if only by widening the spread between the bid and offer prices (because the market maker does not want to get caught out by a sudden flow of buy or sell business).

10. While, as mentioned in the first suggestion, it is good to get to know individual company stocks well, it is important to retain a ‘head over heart’ perspective and distance oneself from any emotional attachment. This becomes important, as ‘falling in love’ with a stock (and only seeing the positive part of that company) may hinder the investor’s ability to make a disposal - upon any deterioration in short term prospects or perhaps, more simply, in acknowledgement that the valuation has become stretched.

11. It may make sense to employ two deliberately separate stock market strategies – one for long term investment, and another for trading. Investors may wish to consider using low-cost Exchange Traded Funds for their long term asset allocation calls, and use a portfolio of individual company stocks to capture favoured shorter term themes or to maximise trading opportunities. Retaining a discipline is critical in such circumstances, because too easily the short term stock specific ideas can take-over the longer term investment plan – with a consequent hike in the overall risk-reward profile. After ‘banking’ a profit, there should be no pressure to find another prospect for reinvestment of the proceeds; in the absence of an immediate idea, it may be prudent to move some of the short term monies back into the long term ‘pot’.

12. Beware a lack of diversification in your investment portfolio. This could be evident in one or two industries or areas of geography dominating, an overwhelming bias to Value (apparently undervalued stocks) over Growth businesses, a portfolio of solely defensive business activities with little or no cyclical (economically sensitive) stocks. Or vice versa. While the selections may reflect the investor’s predilection (and, as such, see no need for change) one can easily underestimate the extent to which markets correctly ‘price in’ likely economic outcomes or future trends. The ‘bottom line’ is that the active investor should not become prejudiced in their view and remain alert to other opinions and the extent to which market movement or drift can leave an asset mix or security specific selections looking too exposed.

David Harbage

26 February 2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.