Den of The Lion Investor

Today, I’m sharing a few points that I got from Brandon Wendell a few months ago when he spoke at the Asia Trader and Investor Conference. Brandon is a former stockbroker, brokerage trader and hedge fund trader.

1. Fundamental Analysis
2. Technical Analysis
3. Execution
   1. Ability to execute at most favourable points
   2. Confident exits
   3. Conditional orders
   4. Automatic executions
   5. Three sided orders
4. Live data feeds
5. Risk management
6. Psychology
7. Trading plan based on your capital, time frame, risk tolerance and trading style

I think most of these terms should be quite straight forward. I will take this opportunity to explain more about conditional and three sided orders.

You will probably be familiar with the basic single order. This is the typical buy or sell order that you perform when you execute a single trade. This is also the only kind of order that most traders use.

There are a few other kinds of orders that help in automating trading and are used by most professional traders:

One Cancels Other

This is a type of order where either one of two orders will be executed. For example, if I already hold 1000 shares of SGX bought previously at $10, I might have two sell orders. One that is triggered at $9 and another at $11. The $9 is the stop loss order while the $11 is the limit order. Once either one of these orders gets filled, the other one will be automatically removed from the system.

If Then

This is a simple conditional order. If the first order is filled, another order will go live. For example, the price of SGX could be currently $10. I put in a “if” buy order of $9.50 and a “then” sell order of $10.50. If the buy order gets filled, the sell order at a price of $10.50 then goes live.

If Then One Cancels Other (Three sided order)

If the first order is filled, another two orders will go live. For example, the price of SGX could be currently $10. I put in a “if” buy order of $9.50 and two sell orders, one at $8.50 and one at $10.50. If the buy order gets filled, the two sell orders will become live. Once either one of the sell order gets filled, the other sell order will be removed.

Trailing Stop

This is a single order that will move in the direction of the order. For example, if SGX is trading at $10 and I have a sell order with a trailing stop of $1, the sell order will have an initial price of $9. If the stock price moves up to $10.50, the sell order will be moved to $9.50. If the price moves further to $12, the sell order will be moved to $11. A trailing stop is useful to ride out your position in the direction of the trend.

The pillars given by Brandon Wendell are very real and practical. There really isn’t any “secret” or “know-how” that can change a person into a master trader overnight. It is the application of all these pillars and real time practice that will gradually hone and improve your trading skills.

The next presentation after Steven Molnar was Peter Elsworth.

Peter Elsworth was a name unknown to me but he was supposed to teach us on E-Minis. Before Peter came on, Garry Kewish, a former president of Brian Tracy International, gave us an introduction on Peter and E-Minis.

Garry spent more than an hour telling us:

1. He is not really a trader.
2. E-Minis are good.
3. Peter Elsworth is the guru.
4. We can all make money from E-Minis.

There was a short part where Garry mentioned that E-Minis were better than options because:

1. Options have spreads of up to 20%.
2. 83% of options expire worthless.
3. Due to time decay, a 3-month option will lose up to 2/3 of the premium in the final month.

The introduction was getting a bit long and I was already very impatient when Peter Elsworth finally got up onto the stage. However, it got even worse.

Peter spent the next 30 minutes or so telling us why we should “invest” in his trading training package. Towards the end, I gave up and decided to go to the Metro sale happening in the adjacent hall to buy some stuff.

This was one presentation where I learnt nothing.

I didn’t know much about trading E-minis before Garry and Peter started, and I didn’t know any bit more when they ended.

A few days ago, I attended a preview of an options trading seminar conducted by Ron Ianieri. Ron was supposedly one of the best option traders in the United States. He is also the co-founder of The Options University, and has trained many new trader trainees.

Before Ron Ianieri gave his presentation, Adam Khoo came on to cover some fundamentals of options. He used an example of a property purchase to illustrate what an option is.

A simple definition of an option is that it gives you the right (but not the obligation) to buy or sell the underlying asset at a particular price. This price is called the strike price.

Most of you will probably be quite familiar with the many call and put warrants that are traded on the Singapore Stock Exchange. Both these instruments are examples of options with stocks as the underlying asset.

At the preview, we were given a nice little notebook which contained the 7 deadly sins of options trading. They are:

1. Not fully understanding the independent effects of time and volatility on your option.
2. Forcing a pre-selected strategy on every opportunity.
3. Not fully understanding the proper meaning of leverage as applied to trading.
4. Not fully understanding the foundations or building blocks of option theory.
5. Thinking that cheapness or expensiveness of options is determined by dollar cost.
6. Overcomplicating otherwise simple strategies.
7. Not knowing how to pick the correct option for the selected strategy.

Trading options without first understanding the mathematics behind it is a sure recipe for disaster.

I won’t be going into too much details about the technical aspects of options in this post. Instead, I will focus more on some of the strategies that I pick up from Ron Ianieri.

A) Stock Replacement Strategy (Bullish Play)

This strategy involves buying call options instead of buying the stock directly. The advantage is that a lower capital is required to get the same amount of exposure. You get leverage and if done correctly, your loss can also be controlled.

A rollup play involves selling your long call with a lower strike price while simultaneously buying a new call with a higher strike price in a 1 is to 1 ratio. This trade helps to lock in your profit with a credit which is money received.

B) Stock Replacement Strategy (Bearish Play)

This strategy is an opposite to the above strategy. Put options are used to get a short exposure instead of shorting the stocks directly.

C) Earning Monthly Income (Covered Call)

For this strategy, basically you just sell call options on stocks you own. This is a premium collection strategy and not a directional play.

D) Stock Replacement Covered Call

This is a combination of strategy A and D. This strategy is far superior to a basic covered call but the price of superiority comes at a potential cost.

Morphing

This refers to the switching of your position from one direction to another in just one trade. Example:

1. Buy a call.
2. When stock retraces, short the share.
3. Cover the short and then collect more profit on the upside.

And finally ….

The Big Secret

Most amateurs trade backwards. They learn a few tactics and then go out to find stocks that fit this strategy. Sometimes, they force a situation to meet their strategies.

Ron says that we should recognise the opportunity, and then apply the correct strategy from our trading arsenal to meet that scenario instead.

One strategy that I learnt from Richard Kang during the Asia Trader and Investor Conference is on the use of pivot points to create your trade plan. This is a very simple trade plan that doesn’t require much monitoring of real time charts.

Before I go into the plan, let me first explain what a pivot point is.

A pivot point is a technical price indicator that is derived from the numerical average of the low, high and average price. Here’s the formula for calculating the pivot point:

Pivot point = (Previous high + Previous Low + Previous Close) /3

This indicator is used to predict the price direction for the next time frame and also to calculate the support and resistance level. The formula for calculating the support and resistance is as follows:

Resistance 1 = (2 x Pivot Point) – Previous Low

Support 1 = (2 x Pivot Point) – Previous High

Resistance 2 = (Pivot Point – Support 1) + Resistance 1
Support 2 = Pivot Point – (Resistance 1 – Support 1)

Resistance 3 = (Pivot Point – Support 2) + Resistance 2
Support 3 = Pivot Point – (Resistance 2 – Support 2)

Depending on the time frame you are going to predict, the respective low, high and closing prices will be used for the calculation.

For example, if you use the day’s low, high and closing price to calculate the pivot point, it can be used to predict the next day’s direction. If you are using the week’s data, then the week’s low, high and closing price will be a prediction for the following week’s price instead.

Richard mentioned that he prefers to use the weekly pivot points when he is trading stocks as a day’s data might have too much noise. For my forex trading, I prefer to use the daily pivot points. Remember a day in forex is 24 hours - this is almost 3 times the trading hours for the stock market.

Now that you know how to determine the pivot points, let’s move on to the trade plan.

The trade plan is extremely simple. The closing price is compared to the pivot point to predict the price direction.

1. If the closing price is above the pivot point, go long for the next trade. Buy only if price dips and hits the pivot point. Conversely, if the closing price is below the pivot point, go short for the next trade. Short only if price rises and hits the pivot point.
2. If you are long (after condition 1 has been triggered), take profit with a limit order set at R1. Stop loss level is just below S1. If you are short, take profit with a limit order at S1. Stop loss is just above R1.

As you can see from the trading rules, this plan is very simple to execute. It is purely mechanical with not much inputs or judgements required. Let’s look at one example. These are the latest daily pivot points of EUR/USD based on Friday’s close, high and low.

High 1.5958
Low 1.5711
Close 1.5814

R3 1.6192
R2 1.6075
R1 1.5945
Pivot 1.5828
S1 1.5698
S2 1.5581
S3 1.5451

The closing price is 1.5814, which is below the pivot point of 1.5828. Therefore, I will be looking for a short trade for the day.

If the price goes up to 1.5828, I will open a short position with a stop loss near R1 (1.5945) and limit order near S1 (1.5698).

The risk/reward ratio is 127:130 which is roughly equal. If you think it’s not good enough for you, you can alwasy choose to skip the trade. As it turned out, this trade will result in the stop loss being hit with a loss of 127 pips.

Some modifications to the basic plan might be possible. For example, if the closing value is very close to the pivot point, you might want to use R1 or S1 as the entry level instead. If that is the case, the stop loss and limit order will have to be shifted.

Based on the same example, I will use R1 as my entry level. R2 will be my stop loss and S1 my limit order. One characteristic of using this plan is that you will enter into trades much less often.

Another way is to use the pivot point in conjunction with the technical charts to detemine the exit prices.

No matter how you tweak the plan, be sure to test it out to determine the best strategy for yourself.

A futures is an agreement between 2 parties to buy/sell a certain asset on a future date. It is typically used by people dealing in that commodity to hedge their position.

For example, oil might be trading at US$100/barrel now.

In the futures market, a company that uses oil in its daily operation might want to buy a 1-month futures at US$105/barrel if they think the price of oil is going up. Similarly, a company that produces oil can sell the futures to lock in their future selling price. The price of the futures will be higher than the current rate if people are bullish and vice versa.

This means that no matter what happens to the price of oil in a month, the company can (and have to) transact at the agreed price. Unlike options, for futures you are required to exercise your right when settlement comes.

The way the futures market work is that no actual exchange of product takes place. Rather, the price difference is used to determine the profit or loss.

In my example above whereby the company bought a $105/barrel futures, if price of oil goes up to $110, the company will be better off by $5/barrel than if it would have if it didn’t buy the futures.

If it drops to $95, it will be worse off by $10/barrel.

Futures are traded in contracts. Each contract will be equal to a certain quantity of the underlying asset.

There are futures for all sorts of things, from commodities to prices of financial products. It is also a leveraged product, which means you can lose your pants if you are using it for speculative trading and your trade goes against you.

CFDs would be another instrument which is very similar to futures.