The Ten Commandments of trading

A beginner’s guide to succeeding in what is likely to be a volatile, and potentially lucrative, year.

PORTFOLIO POINT: Making money in equities during 2012 will mean having to stick to the rules.

In a market that has as much direction as a drunken housefly, 2012 does not bode well for buy-and-hold investors without a high tolerance for risk.

One day we have unprecedented central bank lending and a series of successful sovereign bond auctions in Europe, the next we have an S&P downgrade and disagreements over Greek haircuts. One day we have positive lending data from China, the next we have the state-owned media predicting a Chinese New Year credit crunch (see Enter the dragon).

Economic indicators, market sentiment, broker guidance and technical charts are all over the place and while there are plenty of people making calls on how the year will pan out (see Alan Kohler’s Don't risk it on the ASX and my Twelve predictions for 2012), they’ll be the first to admit that nobody has a crystal ball. As Chinese philosopher Lao Tzu supposedly said: "Those who have knowledge, don't predict. Those who predict, don't have knowledge."

Yet one more or less indisputable truth is that in the absence of a clear direction, this year’s market will be a trader’s market, with volatility expressing a wide distrust of both downwards and upwards movements. And with volatility – compounded as it will likely be by less volume and liquidity, thanks to the many people who’ll spend the year sitting in cash – this also means greater swings. So not only will we likely have more up days following down days and vice versa, but higher ups and lower downs as the seesaw moves.

Source: Australian Securities Exchange, January 13, 2012

The good news, however, is that if you’re willing to adjust your tactics and can spare the time, effort and brokerage, a trader’s market can be a wonderful place. Obviously, this comes with a much higher degree of risk – and this is why at Eureka Report we tend not to advocate it as a sensible strategy for most retail investors – but if you’re able to reasonably predict daily or weekly direction, whether of a stock, an equities index or a currency pair for instance, then you can do quite well.

Obviously a warning needs to go in here: do not try day trading unless you’re willing to treat it like a profession; but for those who are ready, willing and able, or who just want our take on it, here are my Ten Commandments for trading:

1. Thou shalt have no other investment gods before thee

Beginner traders will invariably come across books, courses and experts that claim to have a golden formula for predicting the market, usually to do with some form of technical analysis (see the Second Commandment below). The first question to ask is why are they sharing these secrets with you? Unless that reason is to either sell books or create a self-fulfilling prophecy that they themselves can trade on, then they’re probably being disingenuous.

The hard truth is that there are no magic formulas. Further, you’re the one responsible for your money and as such you’re the only one who truly cares. Investment gurus – whether in the media, the seminar industry or a brokerage or financial planning firm – can spout all the wisdom they want, but nobody is giving you an easy way out and even if they wanted to, nobody is infallible. Even Eureka Report!

Nonetheless, learning from others is an essential part of being a good investor or trader. The trick is to know who to listen to and how to put their guidance into context. First, make sure the experts you listen to and the advisers you use understand Australian markets and are licensed to operate in Australia. The Australian Securities & Investments Commission can help you in this regard (see its consumer advice website MoneySmart).

Respected organisations such as the Australian Securities Exchange and the banks also offer investor briefings from pre-selected organisations and experts. Mainstream media outlets tend to cite the research and analysis of more trustworthy sources as well (though this is of course not always the case). But better still, join a membership organisation such as the Australian Investment Association, the Australian Shareholders Association or the Australian Technical Analysts Association to learn from like-minded traders on who they read and listen to.

Most of all, be a shopper of investment advice, not a true believer, and take what you can from as many sources and experts as possible but don’t rely on them for all your decisions. Ultimately, you have to have a good feeling about the investment decisions you have before you make them and you also need to know that you’ve weighed up the pros and cons.

2. Thou shalt not rely on technical analysis alone

Technical analysis (ie, charting) is one of the most common methods of market trading, used both by snake-oil salesmen on late night television and the most sophisticated hedge fund investors on Wall Street. By all means, sometimes the most commonly cited “rules” of technical analysis can have an uncanny knack of predicting a near-term movement, whether that is measured in hours for the currency markets or days for the equities market, but if it doesn’t make rational sense then it’s not a truly reliable indicator. Again, whether it’s admitted or not, the phenomenon of self-fulfilling prophecy is probably to blame in many cases.

But rather than just rely on intraday candlestick charts, head-and-shoulders patterns, cup and handles, the Elliott Wave or trend lines and triangles, you should back up your indicators with real-world fundamentals, whether that’s economic news in the case of markets, or company figures (balance sheet, profit and loss, outlook) for stocks. Technical analysis can be a useful tool for traders to use, but it shouldn’t be the only tool.

3. Thou shalt not use leverage thee cannot afford to lose

There are many who say you should never borrow to invest. Clearly those people don’t own a home. Borrowing to invest (gearing) is fine and it can also be very tax-efficient, but you need to not just be certain of a conviction before you leverage your bets, but be certain that you can afford to repay the leveraged loses if your conviction doesn’t bear fruit.

The worst stories we heard out of the financial crisis were of those who had not just lost their savings, but had built up grave and unrepayable debt due to falls in the market. And considering that many of them were retired or near retirement, those stories weren’t just unfortunate, but tragic, especially so if the collateral they used to obtain that debt was their family home. Leverage for investment is a classic double-edged sword. It can magnify your gains, but also magnify your loses.

4. Thou shalt use stop-losses and close-off thy trades regularly

It is possible to set stop-loss orders on a variety of financial instruments with a variety of brokers. And if you can’t do it with the instruments you trade, or the company you trade with, then you should seriously consider changing.

Stop-losses are essential if you wish to trade, or if you wish to go on holidays and don’t wish to close-off your trades. In order to limit your downside it's inevitable that you'll limit your upside through the costs involved, but trading is about small, accumulated results, not the once-off wins you see in the movies. Setting buy-stop and stop-limit orders are also a sound idea; the former to prevent you from spending too much in accumulating an instrument with a rising price; the latter to discipline you to quit while you’re ahead and sell as soon as you’ve obtained a pre-defined profit.

As for the second part of this commandment, to be a good trader you need to be a healthy trader, and that includes sleeping at night. Close off your trades on a regular basis – whether that’s daily, weekly or otherwise – so that you don’t have to lie awake wondering what will happen to all that money you made when New York opens.

5. Thou shalt only trade in highly liquid markets and instruments

Don’t be the idiot who makes an all-in bet on bamboo futures or Shady Mining Limited only to find there’s no counterparty to your trade. While I’m a big a fan as any of exotic markets and small-cap companies, these investments are for long-term, carefully researched, assiduously scrutinised buying and holding – just like venture capital is in the off-market world.

Generally speaking, you should limit day trading in the Australian equities market to ASX 50 stocks if you want to be sure about volume and liquidity. ASX 200 companies are generally liquid enough for most retail investors, but intraday liquidity in even the biggest company can dry up, leaving a day trader high and dry (albeit, hopefully saved by a stop-loss limit). As for overseas markets, Standard & Poor’s, among others, provides indices made up of blue-chip, highly liquid companies. These are useful whether for index trading (see No looking back now: ETFs ready to take off) or for working out a list of foreign companies that are liquid enough to consider.

In terms of currencies, only major pairs should be entertained – not things like the Bolivian boliviano versus the Central African franc. As rule of thumb, if you don’t read about it in the daily newspaper, don’t trade it. Common, high-liquidity pairs include AUDUSD, AUDEUR, USDEUR, JPYAUD, JPYUSD and USDJPY.

6. Thou shalt use hedging

Some people like to think of short-selling as some kind of satanic voodoo, but it’s one of the most common ways you can hedge your bets. Short-selling of course has its own particular risks and you should never engage in it unless you’re certain of what you’re doing and are trading in a highly liquid market or instrument (see above), but when used judiciously it can form a sensible part of your overall portfolio.

The other primary way to hedge your bets is through simple diversification, whether that’s of asset class (ie, cash/bonds/shares/property), market (Australia/Europe/US/emerging Asia), industry (mining/banks/retail/capital goods), strategy (small caps/large caps), stock (BHP/RIO/FMG) or risk profile – a topic that I’ll be writing about in the future. Finally, diversification and hedging in the equities market can be achieved through using derivative instruments such as options, warrants, convertible bonds and futures in addition to an underlying common stock security or index product.

7. Thou shalt know the reliability of thy trading platform

Like wine, shoes and suits, cheap brokerage can often mean a cheap experience. There are definitely good online brokerage accounts available at a reasonable price, but these won’t offer a full suite of services nor will you enjoy the support of a team of traders, analysts and advisers. As such, if you’re placing a large order you won’t have anyone sweating in a room in Martin Place or Collins Street making sure the trade is filled. You may find yourself instead inadvertently moving the market and either being unable to execute or unable to get a good price (see setting stop-limit orders above).

More importantly, you should know and understand the reliability of your trading platform, broker or provider, as well as your legal recourse should things go wrong. There was no equivalent to Lehman Brothers in Australia, but there was Opes Prime and Storm Financial.

8. Thou shalt use a demo account

Paper or dummy-trading, where no real money is used, is an essential learning tool for even the most experienced investors when entering a new asset class or new market conditions for the first time. There are many software platforms on which you can test your theories – technical or fundamental – before actually putting your cash on the line, and several online brokers also allow you to test the water through paper trading. The ASX, meanwhile, runs regular sharemarket games, which are free to join and have generous cash prices if you're any good. Other sharemarket games and simulation opportunities are advertised by various industry participants from time to time as well.

9. Thou shalt keep a record of all thy trades

Record keeping is not just for tax and financial accounting, but also for learning. Better still, go to the newsagent and buy a journal in which you can not only record your trades, but also your thoughts and feelings (yes, feelings!) as you make them. This will be essential reading in the years to come as you learn not only from your mistakes, but about your psychology and cognitive biases.

Journal and record keeping also allows you to learn more about technical analysis in a real-world environment if that’s what you want to do and it’s surprisingly easy with the computer software (much of it free) that’s available to investors. Most online brokers will have built-in record-keeping systems, with some features that work automatically.

10. Thou shalt never stop learning

It's essential that you keep educating yourself as you keep trading. The markets are an ever-evolving system and economics is not a physical science with immutable, fundamental laws. Indeed, the markets and economic theory change continuously in response to political, environmental, technological, cultural and scientific developments. A successful trader using successful strategies 100, 50, even 10 years ago would not necessarily succeed in today’s market.

Read widely too and don’t just rely on one source – even if it’s Eureka Report. The more widely you read the better, although of course there’s always the risk that if you just read without distilling and critiquing that reading you’ll be like a leaf in shifting winds.

Don’t just limit yourself to mainstream financial or economic literature either, nor to the best-seller list in the bookstore (for an alternative view, see our contributors’ favourite books here). You’d be amazed too how much insight you can gain by reading books and periodicals from fields such as politics, international relations, science, computing, culture or philosophy.

Be aware of your own inherent biases, opinions and preferences, too – whether they be political, cultural or otherwise (see Tom Elliott’s Trading Psychology 101 for more on this). If you don’t like an opinion you read, ask yourself why it’s annoying you and always adopt the position of devil’s advocate on your most cherished beliefs.

If you follow this and the other nine commandments, you’ll be well on your way to a better trading experience and, hopefully, a larger trading account.

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