Trading process - a technical perspective

Introduction

I am adding additional detail to the post of “my trading process”. It is a significant post as I am sharing more details of my thought processes using actual trades this week.

It shows my decision process of entering a trade aligning technical with fundamentals with efforts to arrest the volatility and uncertainty of the environment.

Technical analysis has been disputed as some kind of black magic by some fundamentalist.

It is certainly not a science. But it does help to tell the short term psychological and sentiments with volumes, price movements and money flow. It is an important tool at least for my investment style.

It is not a perfect system. Many times, most reasonable technical system will work although I am not a fan of black box with mechanical process and using computer algorithms to automatically execute trade.

Discipline is key part of the system. Most system will work at least 50%. If you combine it with fundamentals and options hedging, you increase the probability of winning in a trade to 70-80%. That is also the reason I believe it is hard to be a very short term trader or day trade as you can factor in the edge you add to the trades with fundamentals and options.

No system that produce 100% or even 90% consistent success. There is a huge element of probability build into every trading process. Key is to identify information that is relevant and make decisions base of knowledge ( technical, fundamentals, sentiments ) and experience.

Premise

Below are some key premises to the trading process:

1. Fundamental is key to long term direction of the stock
2. Shorter term, the direction is influenced by market sentiments, crowd psychology and thus technical indicators is a necessary tool for entry and exit.
3. The process is kept as simple as possible. There is no need to extended and highly complicated analytical tools. Most simple indicators widely available in the market will do the job nicely. The main task is to use them logically for the decision process
4. Market swings to overbought and oversold. It gets extended inevitably from time to time. Efforts are expended to identify these tops and bottoms and ride on the swing. Having said that it is not fruitful effort to try to catch the ultimate top and bottoms
5. Market swings has an uncanny conformation to certain wave patterns. Fibonacci Retracement ( Fib Ret ) is my favorite. It works pretty consistent. But I find Elliot Wave too subjective and thus use it only sparingly. I will elaborate on this with examples later.
6. My key objective of the trade are:

-        Maximize gains or risk to reward ratio

-        Attempt to ride on the short to medium term swing as much as possible. At the same time, I want to stay on position that I am very bullish fundamentally without missing the big gains.

-        Minimize loss with risk control using options, good entry

-        Enhance the probability edge with options and fundamental background for the trade

7. Always trade with a plan. Many traders enter trades in reaction to a news, rumors or comments from friends and analysis resulting in over trading. Do not force into a trade rather wait for a trade to come to you. There must be technical and fundamental basis for entry the trade. Profit targets and time frame are identified. Primary exit and secondary exit are set. Also, it takes a lot of psychological and emotional fortitude or discipline to ensure that you execute the secondary exit. SE is a form of defense and risk control.
8. Trade in the direction of the trend. The trend is your friend. Trade what you see. Often the fundamental and technical can be totally misaligned.

Primary Technical Tools

Listed below are some primary tools used in the technical analysis:

For Trend and momentum directions

-        Moving averages : I use 20, 50 and 200 MA

-        Momentum indicators

o       slow stochastic

o       RSI

o       MACD

o       Volume

-        Candlesticks for directions and most often for reversal signals

-        Multiple time frame

Pattern Analysis

-        Fibonacci Retracement / Elliot wave

-        Classical patterns : saucer, head and shoulder ( or reverse ), double top, bull and bear flag

-        Support / resistance

-        Trend lines
-        Decide whether the trade is in a continuation, reversal or consolidation phase.

Options

-        Implied volatility

-        Spreads and open interest

-        Call / put and put /Call ratios

Most of these indicators are built into my charts. I have a weekly, daily and hour charts for comparison. I shall show how all the tools are used for the decision process using examples from this week trades in a logical and systematic fashion.

As with all traders, there will be mistakes. There will also be losses. Constant attempts are made to ensure losses are kept small. This is a very important part of the trading process. At the same time, I try to let winners run. Using options helps greatly in the risk control processes. It also helps to cushion the volatility.

This could be one way to deal to with all the big computer algorithm high frequency trade (HFT). Using a longer time frames and options to cushion the volatility. Day traders are especially vulnerable to the short term big swings which is becoming more frequent because of HFT.

Order of analysis

1. Determine the fundamental basis for the trade. Align it with the overall market directions. If the overall market is bullish, I will be more bullish bias on trades and vice versa. Fundamental will be the key driver of the direction of a trade LONG term. I have seen it too many times during the Asian crisis, dot.com bubble, credit crisis in 2008 and currently the sovereign debt crisis. It will pay off big time.

If you were able also to latch on the fundamental of such as AAPL, BIDU and Gold, you will be rewarded multiple folds.

Often you may be right fundamentally, the stock can go against you up to 50%, 61.8% and 78.6%. I will elaborate on this later in some examples. The key is to identify the reversal at the right time frame.

Trade in the fundamental direction will yield a much higher reward. It gives a very important edge.

Once the fundamental direction is determined, start the technical analysis. Move on with the next order of analysis

1. Determine the Trend

1. Use multiple time frames to determine the trend. Examples

                                                    i.     If the weekly is bullish, it means  the stock will be up for a few week.

                                                   ii.     If weekly bullish and oversold, a longer term top is near. Daily calls for direction over the next few days and hourly for the direction in the next few hours.

                                                 iii.     If the stock is in the overbought or sold, there will be limited upside an downside to the price

                                                  iv.     Trade in the direction of the longer time frame. Align the short time frame with the longer time frame. If it is weekly bullish, enter the trade upon a daily bullish reversal. 

2. Use trend lines / support and resistance

                                                    i.     Draw  the trend lines.

                                                   ii.     Identify another cycles of ups and downs in times of time if any.

                                                 iii.     Draw the support and resistance lines

                                                  iv.     Determine current direction is an impulse move ( strong direction ) or just a corrective move ( a relief rally or temporary correction). In other words, determine where it is in a continuation, reversal or consolidation phase.

                                              

2. Identify the pattern

-        Pattern analysis is used to identify the phase of the trend. Commonly used technique to do this is Elliot wave. But I feel that it is too subjective. Often, when it is wrong, Elliot Wave technicians will explain it with wave extension, complex wave, irregular waves! I am usually confused. Probably, I am not an expert in this area.

-        I have seen Bob Prechter, a major practitioner of Elliot wave has been wrong for so many years. If you follow Bob in 2000, where he forecasted gold to go down, a period of deflationary pressure, civil riots and a depression, you would have missed the run on the stock market from 2002 to 2006. You may say he is too early but he clearly expected the events to happen in 2003-2006 which happen to be a mini boom because of Greenspan loose monetary policies.

-        However, there are uses for Elliot wave at times although it is subjective. Just do not try to be too precise and wait for confirmation. I use Elliot wave simple to determine whether current phase is impulse or corrective. Also, I can roughly use it to determine a potential top or bottom. Roughly, I try to determine whether it is wave 1-5 or A-C. 

-        Classical patterns can be also used to decide whether there is a possible breakdown or reversal. It is important to note that classical patterns always need confirmation. Also, this can be subjective but it is certainly clearer than Elliot Waves.  Example:  a head and shoulder is not valid until its neckline is broken. Often it is a still a lagging signal.

-        Momentum indicators ( Stochastics, MACD  and RSI ) will give confirmation on the patterns whether there is a breakout, a change of trends. Keep in mind that momentum indicators are very short term. It is used only in line once the trend and patterns are established.

-        The combination of classical patterns with Fibonacci retracement, candlesticks reversals signals, multiple time frame, momemtum indicators and a “subjective” view of Elliot wave will give me a powerful idea of potential reversals. It will be even better if there is volume confirmation.

At this stage, it sounds mumbo jumbo. I hope it will be cleaerr once I give examples of some of the trades I made this week. Also, I believe that over time with more examples I will be able to improve and be clearer on the process.

From the above process, I construct a portfolio of longs and shorts from my watch list. It depends on the market sentiments. If it is bearish bias the longs will overweigh shorts. The reverse will apply if the overall market is bullish bias. Bias of the market is determined from the analysis of the broad indices. Currently, the QQQ has broken its short term bearish trends and thus it is time to add more longs to technology counters.

Options are used to hedge the trades. Bullish trades are hedged bycovered calls and dynamic collars. Bearish trades are hedged by synthetic puts,covered puts and reversed collars.

Stocks are entered on an individual basis based on their directions, fundamentals and relative strengths to the index. It is interesting to note that even in bull market there are always stock that can be shorted. Also, in a bearish market there are bullish trades.

Presto! You have now a hedged and diversified portfolio. To me, this is superior to many of the diversification processes generally taught and also hedging using SPX puts, or inverse ETFs. The only set back is that this requires some maintenance.

Practical Applications

I am going to give a few examples using some of my actual trades executed in the  last 2 weeks.  I entered a number of trades. Only 1 of them needs adjustment so far. I will go into details a few including the one that I need adjustment and exercise my secondary exit.

STD

Fundamental:  Europe is in a crisis.  Problem in Greece is not going to be easily resolved in the near future. Problems should continue to escalate until some real change has incurred not just politician coming out to reassure the market.

This crisis is dangerously similar to 2008 where Lehman’s CEO and Bernanke came  out to reassure the market that everything was fine. The market collapsed a few weeks later.

Technical: Stock has dropped almost 30% in about one month and rallied from $7.15 to 8.26 in 4-5 days. I expect this rally to be short lived.

How do I watch out for the reversal?

First price hit the upper channel resistance on the daily chart. Although the MACD and RSI are showing signs of positive turn, the overall directions of all the oscillators ( MACD, STO and RSI ) are down

More important, is the hourly chart.  When it hits the retracement of 50%, I started to watch it very closely. When the MACD, RSI and STO turned negative I initiated the trade.

1. Trend – it is down. Weekly oscillator is definitely down with no signs of recovery.
2. Daily timeframe : it is bearish as long as it is not breaking the channel
3. Hourly: At 50% retracement, it is a common Fibonacci retracement level. Sometimes it goes to 61.8% and 78.6% maximum. At 50% the oscillator turn, the trade was initiated. It was actually executed when I was exercising in the gym. When I was back, I was actually losing a little money. Immediately, I initiated the SP option.

Trade:

Sell  1000 STD at 8.2

Sell  Dec 7 SP at 0.65.

PE : Let the Dec 7 SP goes ITM and be assigned. ROI : 22.4 % for 3 months.

SE: If stock goes above 9, bull a long call and roll up the SP to 8.

So far the trade is going in my favor. I could be wrong. Over the weekend there is the European Ministerial meetings. They may come out with a huge bold bailout for Greece and all the countries in trouble. But the probability of a long term solution is low. If I am wrong, I will exercise my secondary exit and will continue to manage the trade to lower profitability or a slight loss. This will be illustrated with my trade on CRM

Earlier in the week when the European banks were falling, a trader in Vancouver asked whether I should add to my shorts. I told him to wait although I was bearish as it was greatly oversold.On Friday, I added on to my shorts.

CRM

With the depressing market recently, I am targeting many of the stocks with very high market valuation. These will be the stocks that will fall most in a bear market. NFLX is already one of the victims. So I shorted, LNKD, PCLN, GMCR and CRM. I am negative on all of them because of the high valuation. I cannot understand how LNKD can have a PE of over 1200 and a coffee shop seller has a PE of over 105. These are bubbles that will burst on a negative turn on the market

On Tuesday, everything seems to be falling apart. CRM hourly shows signs of breaking down.

Price on daily chart seems to be hitting resistance.

The signals I ignored on the weekly was MACD and STO were very positive. Weekly charts were negative.

On Tuesday, Sept 13^th I shorted CRM at 124.

Also, sell a Oct 115 SP at 5,12.

My primary exit is to let the SP be assigned.

My SE is to add a short call when it hits 128 and show signs of breaking up.

On Sept 15, when CRM hits 129, I exercised my SE. QQQ turned short-term positive too on Wednesday.

I bought a Nov 135 C and roll the Oct 115 SP to Oct 120 SP reducing the cost of my short.

Longer term, this trade is still very manageable. It is my belief that I will exit the trade with a small profit or just a minor loss. Currently, the stock is very much over bought. It will probably go up to 140 and I shall monitor the overall market to see if it turns long term positive. If so, I will need to reverse my bias for this position from negative to positive. This can be accomplished safely through just adjusting the options.

All the other shorts are doing fine. You can see the PCLN, GMCR and LNKD are showing negative technical signs - hitting resistance, negative on daily and hourly, etc.  Unless the market sentiment changes substantially positive, I should make money from all these trades.

Bullish trades

I bought HD, SINA, AAPL, BMC and AMZN in the middle of the week as the Nasdaq turned positive.  I shall not elaborate on all these trades. Try going through the charts on the multiple time frames, patterns, and trend lines, you should be able to get similar results. The SE should be easily determined. 

Also, I bought quite a few shares on the miners on Thursday - GDX, AUY and GG. Also on Thursday I rolled my calls on SLW which went ITM. The decision was made by a very consistent process.  It was a very interesting signal which I shall elaborate when I have time.

So far, no adjustment needs. I should be able to end positively on all these positions.

Concluding remarks

I will continue to illustrate these further using the same technical methodology and trading process when I enter the trades on the blog.

It is getting late now on Sunday now. I guess I need to retire now to get ready for an interesting day tomorrow.