My Trading Process

"Money itself isn't lost or made - it is the transfer from one perception to another: - Gordon Gekko in Wall Street 1

  

My trading process is relatively simple. It consists of a few major steps.

1. Determining the fundamentals
2. Align the Technical with the fundamental
3. Decision on the trade structure defining the hedge and exit points.

I outlined my trading methodology in Jan 2009 and subsequently added options to my strategies in October same year.

Over the time there various models written on how the processes were deployed.

After the above analysis, I need to make a decision entering the trade.

Let me discuss the above process in greater details.

1. Fundamentals

 Deciding on the fundamentals is basically examining the drivers for the stock. It could be positive or negative. Normally, I keep a certain percentage of my trade in negatively bias trade as a hedge.

The process filters down from the macro economic environment, to the  industry drivers and to the individual company’s management, product, earnings, debt, cash and growth. In many of my blogs, I have outlined  the process and thus I am not going to elaborate here again.  Many times it can be a very specific fundamental opportunity and it is best discussed with specific stock.

2. Technical

Many times I was asked whether technical trumps fundamental or vice versa. I am firmly on the camp that fundamental trumps technical. Technical basically measures the short term investor sentiments through the price actions. Psychology and emotions are a major part of trading. More often, psychology is more important than maths, perception is more important than reality.

Technical analysis is an art. I consider a good technical system if it gives me 70% accuracies. Also, it can only predict short term directions. On the other hand, if the fundamental analysis is correct, given enough time, the stock will align with the analysis.

So while I love the fundamentals, I will wait for the technical to agree before I enter a trade.

 

So what are the technical indicators?

 

The key strategy is to stick to the primary trend. The trend is your friend. Ride the trend as far as you can but never hesitate to execute additional protection once it breaks the primary trend. A simple way to see the trend is to draw a straight line on a few points during the last few months and determine whether it is sloping up or down. Sloping up means bullish trend and sloping down bearish trend. 

I can say that any reasonable system will work fine. There is no need for too many indicators or a complex system.

I use a combination of MA, slow STOCH, MACD and William %. These are lagging indicators. More important are the leading indicators – price actions, patterns, support / resistance and candle stick for short term movements.The leading signals will give the initial signals and often confirmed by the lagging signals.

It is easier said than done to follow the trend. Often it means buying when it goes up and selling when it goes down.  It is counter intuitive.I understand the need to buy low and sell high.  Most of us are tuned to try to buy on dips But sometimes the dip never come and we missed the train totally. Striking a bargain has its role but once the trend is clear, jump onto it.  The market has a way to leave you behind.

Many times the reality is different from your perception.  It was said that the irrationality can last longer than you remaining solvent. So many times it is totally contrary to the fundamentals.

I saw the whole housing bubble a full 2 years before it collapses. I short FNM, FAE, DHI and all kinds of housing stocks. I took losses a couple of times until the big collapse finally came. I finally got to take the ride. Even then, I got out too early.

We are undergoing a gold correction now. I see gold bulls complaining "it ann't fair, it can't continue; the fundamentals are too strong for this to happen etc" . But it is what is is. I got out of 90% of my juniors and collared everything on Jan 5. I protected most of my gains. You can be sure I am getting back again but not until my system tells me to go ahead. It will not be too late.

Another factor is that we tend to second-guess our technical analysis. Once you have determined your system, stick to it. You have to trade almost mechanistically. You will be wrong at least 20% of the time.

But the key to make money is to know when to lose money. I had said that risk control is the holy grail of trading. If you control your risks, the profit will take care of itself.

 3. Decision on trade structure: defining the hedge and exit points

First step is to take action. Do not expect to be right all the time. Once the fundamental and technical aligns, make a decision and execute the trade. If you expect to be right all the time to make the trade, you will be right eventually but you will miss the trade.

 My favorite structures are:

1. Most often, I start with a covered call or married put and moving to a collar when needed. Less often,  I may  start with a collar. There are times I start with just the stock.
2. On the negative bias trades, I may start with a covered put ( short stock + short put ) or a synthetic put ( short stock + long call ) and moving to a reversed collar when needed.

Most people knows how to trade bullish but seldom short the market. For me, I keep a certain percentage of short trades as a hedge to my overall portfolio.

The above covers 80% of my trade structure.

For the other 20%, I venture on Calendars, bull puts and even straddle and strangle. These are more speculative trades.

I seldom use double diagonals, Iron Condors or Iron Butterfly as a trade. But sometimes during the adjustment process,  the whole structure evolves into such trades.

Adjustments;

This is the interesting part. Like technical, it is an art but there are certain principles that I follow.

a. First, do not adjust when the trade is working. You will over trade if you do.

When the trade goes wrong, the adjustment process kicks in.

I use options for adjustments and hedge. Many people use options to leverage. Contrary to common practice, I use options primarily for adjustments and hedge.

b. Determine the DNA of the stock. Is it a volatile stock?  Does it gaps often? What is its possible directions and potentials? Has it got dividends?  From here you get an idea on what kind of trade structure to use and determine the primary exit ( if you are right ) and secondary exit ( if you are wrong ).

c. Below are situations I make adjustments. I am using example of a positive bias trade. Similar principles can be used for negatively bias trade.

-        Do not place a short call in front of earnings. You may limit the profit. If you need to place a short call in front of earnings, make it OTM and longer term.  Following the same principle, I will convert a covered call into a married put just before earnings by buying back the short call and adding a protective put

-        When the stock is reaching resistance or showing signs of resistance, add a short call.

-        If you are not sure of the resistance but feel that the trend  is slowing down, add a OTM short call and probably longer term

 Adding puts

Adding put is a difficult decision. I have to confess that I lose money on my puts 70% of the time. It is a necessary evil and insurance to control my risk. I am losing money to make money.

I add puts when:

i.                 It breaches support and primary trend. Often, if it breaks down, it will break down further and FAST.

ii.               In front of earnings, add a protective put especially for volatile stock. It is not worth the risk without the protection. If the protection is just to go through the earnings, I will add a short term put and take it out after the earnings. Normally, I add a ATM put. But if I am not so bearish, I may add an OTM put.

iii.             Protect my profit. If the stock has gone up considerably and I have made good money, it is often prudent to add a protective put if you want to continue to ride the trend but not sure it will pull back. A stock that has gone parabolic will pull back aggressive. Thus it important to implement the protection. If you intend to get out, an ITM SC may also do the same job.

Often if the trade continues to be bearish, maintain the put until near expiration date. Because the long put is deeply ITM, it will have a high delta and low extrinsic. So there is less worry about theta decay. You can put in additional protection only when it is near expiration.

You can sometimes reduce the cost of the protective put by:

i.                adding a front month short put to the long put making it a bear put calendar. Once it is confirmed bullish, remove the long put. You will still lose money but compensated by the short put

ii.              convert the long put into a bull put by add a short put at a higher strike price.  You do this  adjustment only if the trend is clearly bullish.

I have to say that adding put is a critical task. You will have no regrets if you go through a situation like 2008 again.  Warrant Buffet had said about successful trading. “ Rule no. 1 – do not lose money. Rule no. 2 – see rule no. 1”

If it shows support, remove the put or sell a SP below to reduce cost. Eventually, when the trend clearly reverses, take out the put.

Keep your hedge – unless the trend is so clear. Even so, more often, just apply a small OTM short options in case you are wrong, you have time to adjust it down.

Taking losses

I take small losses. If you look at my trades, 20% are losses. When I decide to take smaller losses, the percentage of losses will increase to 30%.

There are times I adjust to the stage that I make money. But sometimes it is not worth the effort especially when the fundamentals have changed. I can still make money. But it requires a lot of effort and time. It may take many months. The capital may be gainfully deployed on other trades.

Also, when I feel that adjustment process is out of control and it is difficult for me to recover, I rather take losses, get out and enter the trade again.

Summary

My key objective is the “catch and latch” to ride onto a trend using the various options to turn volatility and time to my favor. It is not an easy task. You can do it with a clear and discipline system. As any surfer knows, it takes skills and experience. Beneath the wave, there are coral reefs that could kill you. While surfing, at least you must determine the directions based on the long term fundamentals and  short term technical indicators.

It is difficult to do it with pure directional trades without options. You need to maintain the balance while the wave are going up and down. Options act as stabilizer during the process. My experience is that without options,  the market will whipsaw on you until you are confused.

The core of my profit will come from the ability to ride the trend. But also, in a stagnant trend, I will make money. I will only lose money if the trade goes seriously wrong in the other direction. Even in this case, the losses are limited by the options.

I wish I could be right all the time. But this is not the case. In my trade analysis last year, I was 80% right.  I suspect that I will have 10% more losses this year as I reduce the percentage loss on my trades.