Previous < Chapter 7 - Money Management
TAKING CONTROL OF YOUR TRANSACTION COSTS
If you subscribe to the technical approach to trading, you must fully appreciate that transaction costs are a significant consideration. This holds true for swing traders as much as day traders. The effectiveness of any technical trading system will always come down to your money management techniques, and the optimization of the entire trading strategy will depend on your ability to keep transaction costs to a minimum.
New traders should be aware that minimizing transaction costs means more than shopping for the best deal from discount brokers. Commissions represent an obvious real cost, but costs associated with inexperienced traders placing trading orders to their own disadvantage is often a much more costly factor. If a technical trader believes that market timing can be a profitable strategy - and certainly that is our expectation - then it would be prudent to ask questions about the manner in which we execute our trades. The rationale for a trade, whether it is rooted in fundamental or technical evaluation, is only a causal factor in what is the essential operative act – buying and selling securities.
It is important that every trader – and you are one if you follow the Stock Trends analysis effectively – knows the answer to this question: what does it cost me to make a trade? You should know the cost of a round trip ticket (buying, then selling) and make sure you have found the best avenue for meeting that objective. It is not enough that you have shopped for the lowest commission at a discount brokerage. In fact, you may find it more cost-effective at times to have a solid relationship with a full-service broker – especially in cases where you may be able to negotiate a better deal on larger transactions or when you don’t want to show your whole position to the market. Know what kind of stocks you will be buying and how many shares. Determine the commission structures applicable. When shopping for commissions, get the whole story. Are service charges built into the commission? What are they? Are there additional charges or limitations? Will the broker be willing to transact the total amount of shares over more than one day and still only charge one agreed-upon commission (instead of separate commissions on each trade)? Know the answers to these questions before you act. Know that you have found a relationship, either with a discount broker or a full-service house, with which you are comfortable. You need not be surprised or disappointed by this business relationship.
Beyond the engagement of a dependable brokerage, there can be some unwanted surprises for the uninitiated. The stock market can be unforgiving. Have you ever placed a market order and been unpleasantly surprised at the price it was filled? Have you ever placed a stop-loss order and seen your position wiped out by the most bizarre trading? In most cases, these situations reflect some level of inexperience in order placement. If you intend to trade stocks, it is a good idea to have a thorough understanding of the types of orders you can make. In this manner you are exercising as much control over the process as you possibly can.
A Market Order is an order for immediate execution at the best price available when the order reaches the marketplace. Because no price is specified, it has the advantage of nearly always being filled. For Buys, the order is usually filled at the lowest “Ask” price available when the order reaches the market. For Sells, the order is usually filled at the highest “Bid” price available. Sometimes, Market Orders will be filled by a series of partial trades at different prices if the best “Ask” or “Bid” sizes (i.e. the number of shares) are insufficient to fill the order. A Market Order will be filled, but the price obtained may be higher (if buying) or lower (if selling) than a trader would anticipate or desire.
A Limit Order is an order to fill a transaction only at a specified price (the limit) or better. Limit Orders are used by traders who have decided on a price (either precise or approximate) at which they are willing to buy or sell. Because the price is specified, there is no guarantee it will be filled.
It is a good practice to almost always use Limit Orders. Any time you go to the market you should demand the best price you can get. You do this when you shop for a new car, a new home, a new washing machine – even when you hire a plumber. Why should it be any different when you trade stocks? A Limit Order puts you in the driver seat when you go to market – at least to the degree that you establish a defined range for your trade. You have to know what you are prepared to pay. A Limit Order allows you to establish your price tolerance within a defined range. You may not get the order, but you will never be surprised and disappointed with your fill price. How would you feel with a buy market order fill at \$5.10 just because, at the time your order hit the market, there was a temporary imbalance in the order book, and the stock promptly sold at \$4.95 immediately after your trade? Why worry about a bad fill simply because market professionals are scouring for these temporary imbalances in illiquid stocks?
Avoid placing Market Orders. The only time you should place a Market Order is when you want to get out - and fast! Bre-X, Enron… you know what we are talking about here. It is a rare occasion to use a Market Order. See where the market is, and determine what you are prepared to pay. If the bid is \$5.25 and the ask is \$5.35, you can be sure that you would not want to pay much more than that range. Would you go to a department store salesperson, plop down a wad of cash and say: “Take what you want, I really like these shoes”? Of course not! You know the shoes are ticketed at \$100. You expect to pay \$100 and that is that.
The stock market is different in one important way: prices are fluid, sometimes erratic and unpredictable because there are so many participants – buyers and sellers – all lined up at the cashier at the same time. They are all ready to buy and sell the same shoes you have picked out. Obviously, you had better know the limit on how much you are willing to spend on that particular shoe. And if you are selling those shoes you had better know how little you are prepared to receive for them. Obviously, the more motivated you are to buy or sell, the more leeway you give. The market often moves quickly – bids and offers sliding in and out of the book. But the Limit Order forces you to make a decision about what you are prepared to pay. Give yourself a realistic price target. You may not be filled there, but at least you will be in an acceptable range.
Slippage is the difference between the price a trader anticipates and the actual, or “filled” price the market delivers. The bid/ask spread delivers some of this discrepancy - it is the fee the market exacts for the privilege of trading. Less liquid stocks will have a larger spread than actively traded ones – this is the cost of doing business in volatile stocks. Also, if a market is moving rapidly, prices may vary significantly during the delay it takes for an order to get to the market (even in this era of online trading, many of us will suffer the cost of failed technology).
The cost of not using Limit Orders to your advantage is also categorized as slippage. In some cases slippage is simply a variable of an imperfect market – a situation where you, the trader, are steps removed from the transaction. However, in this day of electronic markets, slippage has less to do with market inefficiency (or unethical practice) than it has to do with poor order execution.
Liquidity is an important ally of the trader. If a stock is actively traded, the spread between the bid and the ask will be smaller, the chance of irregular trading patterns are minimized, and the trader can conduct his business with more confidence that there will be little, if any, slippage. A highly liquid stock makes for a more efficient market. Conversely, a thinly traded stock is a den for erratic trading, steep spreads, and costly slippage. In the worst cases, they are canyons for ambush by professional traders waiting for the unsuspecting, naïve trader. Indeed, if a stock is illiquid, enter the arena at your own risk. If a stock is trading “by appointment only”, there’s no rush to get in. And if you must, be specific about your price objectives. Caveat emptor!
Stop Loss and Stop Buy Orders:
A Stop Loss or Stop Buy order is an order to sell or buy which becomes a Market Order when the price of a board lot of the stock rises or falls to a specified price. A Stop Loss order is an order to sell when the price of the underlying stock declines to, or below a stated (stop) price, and is used by traders to limit risk on their long positions. A Stop Buy order is an order to buy a stock when the price rises to a certain level and is used by traders to limit risk on short positions. Note that Stop Buy orders must always be above the current market price, and Stop Loss (sell) orders must always be below the current market price.
Stop Loss and Stop Buy orders are designed to limit losses (or protect profits) if the market turns direction against you. However, it is important to remember that Stop Loss and Stop Buy orders become Market Orders when the underlying stock trades at the stop price you designate. You will be filled at the next best bid (or ask) after that trade. So if your Stop Loss order was at \$5.00 and it is activated when the stock trades at \$5.00, you now have a Market Order that could be filled anywhere at or below \$5.00 depending on where the next bid is. It may be at \$4.95 or it could be at \$4.75 depending on how active the stock is. Discuss with your broker what the risks and limitations are on Stop Loss or Stop Buy orders. It may be advisable, and indeed in some cases a policy requirement of the broker’s firm, that you specify a price limit when entering a Stop Loss or Stop Buy order.
Limit Stop Order:
A Limit Stop order is a specialized type of order in which a Limit Order and a Stop Order are combined. Once the stop price has been hit, the Limit Stop order becomes an active Limit order. For example, a Limit Stop order specifying "sell 100 CM on stop 55 limit 53" becomes a Limit order to sell 100 shares at a price of \$53 (or better) once the stock sells at or below \$55. In contrast to a Stop Loss order, which becomes a Market order when triggered, a Limit Stop sell order may not be executed if the stock’s price suddenly drops below the limit price. The use of a Limit order as a rider to a Stop Loss order can prevent a position from being “whipsawed” or sold out by a Market Order on a sharp but short-lived decline in price. However, if the decline in price proves to be more than temporary or even becomes more significant, the loss on the position will increase, as opposed to being sold out immediately with a Market Order at a higher price.
A Day order is an order that expires automatically at the end of the trading day if it has not been filled. All orders are usually considered to be Day Orders unless otherwise specified. If you only get a partial fill on a Day Order, make sure you get it changed to a GTC order (see below) if you wish to complete the order. Be careful with your Day Orders - watch for partial fills.
Open or Good Till Cancelled (GTC) Order:
An Open or GTC order is an order (either to buy or sell), usually at a specific price, that remains in effect until the order is executed or canceled. To avoid unwieldy buildups of Open orders on their books, some brokers will impose time limits (e.g. 30, 60, or 90 days, or end-of-calendar month). Some traders should avoid GTC orders or alternatively, always put a time limit on their GTC orders so they are not surprised by a forgotten GTC order. A GTC order with a time limit or deadline is also referred to as a “Good Through” order.
All or None Order (AON):
An AON order is a Limit order to buy or to sell a security, in which the broker is directed to fill the entire amount of the order before it is accepted by the client, or none of it. An AON order differs from a Fill-or-Kill order (see below) in that, with an AON order, immediate execution is not required, but filling the entire amount of the order is required. It is an effective order when you want to hide your hand, since the order book does not show an AON because it is not really a buy/sell order – there are limitations (i.e. a specific number of shares must be crossed in a single trade). It can be a good buy order, but not so great if you are selling. If you have a good relationship with your broker and can negotiate acceptable commission terms on multiple fills, you may never need to use an AON.
A Fill-or-Kill order is an order that stipulates that, as soon as that portion of the order that can be executed is completed, any remaining portion of the order that is not filled is canceled. Normally, a Fill-or-Kill order is completed or canceled within a short period of time after being received by the trading desk. It is a rarely used type of order for longer-term investors, but sometimes useful to shorter-term day traders.
Knowledge of the marketplace is always beneficial – and certainly no less when going to the market with an order to buy or sell a stock. Using a discount brokerage service may go a long way to reduce actual commissions, but without the skill and experience of placing price specific trading orders, much of your “savings” in commission can be eaten away by clumsy trading practices.
It is unlikely many of Stock Trends’ followers, excluding investment advisors, have access to real-time quote services with “Depth of Market” bid/ask screens, but the market information provided by these services can be quite valuable. The Market-by-Order screen tells us a lot about the market for a stock. It itemizes the order book, allowing traders to see the actual bid and offer sizes at individual price points. This is important information even if you are not a day trader – remember that regardless of your holding period the onus is on the trader to get the best price possible. With the bid and offer sizes we can determine the supply and demand forces at work. Generally, a large bid size relative to ask size reveals that the demand side is stronger than the supply – a situation that generally pushes the price up. Conversely, a large ask size relative to the bid size reveals softness in the market, often resulting in a drop in price. Intuitively, we know that the interaction of supply (the volume of shares at ask) and demand (the volume of shares at bid) will push and pull stock prices. Knowing these levels is critical if a transaction is going to be executed efficiently.
What causes stock prices to change? Simply put: imbalances of supply and demand for the stock. As the appetite for a stock grows, both price movement and liquidity respond. As liquidity improves – that is, more participants are attracted to the market – traders have a better opportunity to move in and out of trades. Liquidity indicates interest. As liquidity grows, price volatility fades. But as imbalances in supply and demand grow, it becomes increasingly difficult to enter and exit trades at each price level. This induces more buyers and sellers to come to market. If momentum is weakening, aggressive sellers find liquidity at or below the inside bid. Passive sellers will offer at the offer price or even above the offer price if some upside momentum is present.
Are there better times of the day to trade? What are the best days of the week to trade? The answers to these questions will come with your own experience, although it is generally considered to be a more stable market in mid-week, as opposed to Monday or Friday trading. Some think it is best to buy on Tuesday morning and sell on Friday afternoon (take your profits and enjoy the weekend!). And for those interested in the long-term timing of their trades, Horst Mueller, a respected and entertaining Bay Street technical analyst, used to advise his brokers that, historically, the best day of the year to buy a stock is on the Tuesday of the third week of October, at 10:30AM. How’s that for calling the shot!
- Never chase stocks. With an imbalance of supply over demand, for example, sellers will have to meet the bid, while it still exists – before bidders are no longer willing to buy there. More experienced traders will lead the market, anticipate the next price level, and lead above the inside offer price as an aggressive buyer before chasing the stock into resistance. Let the market lead the way.
- There is nothing worse than getting trapped in a stock you want to unload. This happens when liquidity vanishes. Know the risk/reward of holding an illiquid stock.
- Trade execution has an important impact on your trading results. Stock-picking, while important to every trader, is actually of secondary concern to effective and efficient trade practices. Without trading discipline, knowledge of how to read the market book, and how to place orders into that book, a trader will fail. If it is not a humbling and painful encounter with heavy losses, it will most certainly be a slow but deliberate death. If you expect success in the market you must master your trading skills and remain disciplined.
- Know who the buyers and sellers are. Market makers lead the way in most stocks. Learn to read their intentions. Recognize who is dominant in a particular issue and monitor their trading closely.
- Never marry a position.
- Know why you are in a trade and when you will be out.
- Just as on the buy side, consideration for liquidity must be given when selling.
- Selling into a rally is desirable. Selling into volume assures a good result for your order.
- Don’t get greedy. Over the long haul, you will find that more often than not staying in a trade longer than your stop allows results in lost profits. Yes, there will be instances where a stock continues to generate returns after an exit, but it is best not to sweat these lost profits. Just as you cannot always hit the lows when you buy, you will not always sell at the high. The best traders understand this. They know that survival and success in the market come on increments of high probability trades. Each trade is merely a movement in your own symphony.
- It is easy for traders to exit too early on profits and too late on losses. Nobody likes to get whipsawed out of a trade, but to be successful in the long run, you must decide on a rigid set of rules to follow and follow them diligently.
- Success in the market will come at a graduated pace. Do not expect overnight success. If you have a good trade, do not deceive yourself into thinking you will continue to always have that kind of success.
- You must keep a positive attitude and a grounded commitment to sound trading practices. Patience will win the day.
- Experience, more than anything, will guide you through the market.
Next > Chapter 9 - Stock Trends Portfolios