Issue #302 03 April 2009

This newsletter is written on a weekly basis to help investors understand and learn the principles of market analysis for themselves. We don’t provide investment advice, but we do aim to provide a straight talking review of the market action over the previous days with a focus on how real life analysis techniques could be applied.

Editorial: And what if I am wrong?

Tom Scollon Chief Editor

Dare I contemplate that thought for a moment? But it has happened before and it could happen again. But remember success in the markets is not about being right or wrong – it is about unashamedly making as much money as possible but also as safely as possible. My experience is that there is an inverse relationship between risk and experience. That is I see inexperienced traders attempting CFD gymnastics with not even a skerrick of experience. Highly experienced and skilled investors measure and manage risk. This is what Mat Barnes is so succinctly enunciating in his article today. As markets climb higher we climb the risk curve. Take a look at the All Ords chart below for the last couple of weeks: click to enlarge I have postulated a possible scenario – for the point of discussion - although one just never knows! At the March low I considered the risks were still high. The market was at risk of going lower. And if I pick the bottom of the market I always feel uneasy as I feel literally dead lucky. But technically the March low had no consolidation of note. If you did not buy at the March low why would you buy in the last few days? Are you not buying up the risk curve? Be patient. If what we are seeing is a new long sustained rally – which I very much doubt – then wait for a pullback. We know they always come. Money is made not by buying at the exact low but by taking out the big chunk between the bottom and the top. We are nowhere near the beginning of the big chunk. You have not missed the bus. One of the beauties of wave fours is the bus has slowed down and we can board easily, with safety and then go for the nice long ride. Enjoy the ride Tom Scollon Chief Analyst

Fundamental Focus:Long Term Investing Dead?

Andrew Page

A lot of comparisons have been made between the current Global Financial Crisis and the great depression, and indeed there are many similarities. Unfortunately though, such comparisons seem to provide little scope for optimism, especially for the longer term investor. After all, anyone who bought prior to the crash in October of 1929 would have had to wait 25 years before their capital was recovered! Similarly long periods are quoted for more recent market crashes, such as the 1987 crash where it took 9 years for new highs to be created. So there is little reason to think that even if the market is close to the bottom, we will see a swift return to 2007 levels. But does this mean that people who were invested in the market prior to this most recent correction should abandon all hope? The long recovery periods that are quoted assume that all your capital is invested at the absolute high of the market. For those who had been regularly contributing to their positions in the years prior to the crash, their breakeven point will be well below that of the market high. This is because a significant run up is usually seen in the lead up to a crash. In the case of the Great Depression, the Dow advanced 244% in the 5 years prior to the crash, and 54% in the year prior. An investor who had been regularly adding $1,000 to their portfolio each quarter for 5 years prior to the crash would have seen their invested capital recover in just 7 years instead of 25. This still isn’t fantastic, but it’s a significant improvement in recovery time. Continued investment following the crash helps improve the situation further still. In the above example, had the investor continued adding $1000 each quarter, they would have seen a 42% return on invested capital over the same period. This is because we tend to see substantial gains from the low of the market. Following the low of 1932, the Dow rallied 63% in just one year. The annualized growth over the next 4 years was a massive 31%. Professor Jeremy Siegel, a noted expert in financial markets, has conducted some interesting research in this area. He has demonstrated that for the 7 largest corrections over the past 145 years, the market showed an average improvement of 24% in the year following the crash.Moreover, he noted that there was an observed 21.4% improvement per year over the next 3 years, and 18.4% per year over the next 5 years. Clearly, it pays to invest into the markets following a large correction. The worst thing investors could do at this point is to pull up stumps and walk away from the market. Indeed, investors should be looking to add to their portfolios, average down their entry prices and position themselves for recovery. It may well take the market 10 years to get back to 2007 levels, but that doesn’t mean you have to wait that long. Make the markets work for you Andrew Page

Foreign Exchange: Money Management as Your Trading Account Grows

Mathew Barnes

One of the reasons that traders tend to overtrade is that they are trying to make too much money, too quickly, with a trading account that is too small. During the online training sessions I run for new Safety in the Market students, I ask students to think about the financial goals they are trying to achieve from their trading during the year. For example, let’s assume you aim to make $100,000 per year from your trading. You have a $5,000 trading account, you will risk 5% of the account per trade and will aim to achieve a minimum of a 2 to 1 Reward to Risk Ratio. This means that your losses should be no more than $250 per trade (including brokerage) and your profits should be at least $500 per trade (after brokerage). I encourage students to focus on 10 trades at a time. It doesn’t matter whether you take those 10 trades in one day, one week, one month… Just take 10 consecutive trades, and focus on the results. I suggest that new traders aim to have 4 winning trades, 4 losing trades, and 2 “breakeven trades” out of every 10 trades they take. What does this mean for our trading account? Well, the 4 winning trades should return at least $2,000 (4 x $500). The 4 losing trades should lose no more than $1,000 (4 x $250). The 2 breakeven trades cost us nothing. If you can achieve this mediocre success rate of 4 winning trades out of 10 with a conservative 2 to 1 Reward to Risk Ratio, then every 10 trades would be worth $1,000 to you. This gives you a 20% return on your trading capital. Not bad. So to make $100,000 profit, you would need to take 1000 trades (100 x 10). We set our target low because if we know that 4 winning trades out of 10 will help us reach our goals, we don’t mind if the first two trades, for example, are losing trades, because we can see the big picture. Contrast this with aiming for 7 out of 10 winning trades – if your first two trades lose, you can start to panic, and take trades that you shouldn’t. You then need to ask yourself whether it is safe and reasonable to make 1000 trades during a year – after all, this equates to around 4 trades per trading day. The answer for most people is probably not. So we need to adjust the parameters of our trading system. Many traders will look to increase their risk size – and maybe start risking 6% or 8% or 10%, in order to get where they want to go faster. This is dangerous and can lead to serious depletion of your trading capital if you have a bad run. Or, they will aim for a higher success rate. While this is a good idea, the reality is it can take a few years in the market before you have the experience to be making, say, 7 winning trades out of 10 consistently. If you aim too high too early, you can find yourself disappointed, and “chasing” extra trades as you play catch up. I suggest students work out a compounding plan instead. For example, maintaining the same parameters as above, we know that every 10 trades are worth $1,000. So after 50 trades, we would expect our trading account to double in value from $5,000 to $10,000. We can now risk $500 per trade, which is still only 5% of our new trading balance of $10,000. Now every 10 trades is worth $2,000, so 50 more trades would see us at $20,000. By risking 5% of $20,000, or $1,000, each 10 trades should now be worth at least $4,000 to us, so 50 more trades would see us at $40,000. Risking 5% of $40,000, or $2,000, each 10 trades should now be worth at least $8,000 to us, so 50 more trades would see us at $80,000. 30 more trades from here would see us make $24,000, giving a profit of at least $99,000. So by increasing our position sizes as our account grows, you can see that we can still risk 5% per trade, still only require a mediocre 4 wins out of 10, and still make around $100,000 profit in 230 trades. 230 trades in a year is less than one trade per day – this is far safer and far more achievable than taking 1000 trades in a year. Remember too that 5% loss is our maximum loss, and 2 to 1 is our minimum reward. And we may well do better than 4 winning trades out of 10. In this case, we would achieve our final target well before 230 trades. The point is, we have a minimum standard to aim at, and we know that if we reach this standard, it is simply a matter of finding and executing 230 trades in a year. Having this rock solid plan in place will help to keep you from over trading, and help keep you focused on your goals. Trading is a business – treat it like one. Be Prepared! Mathew Barnes

Options Corner: The Greeks And Their Mystery Unveiled! – Part 12

Matt Baker

Welcome to Part 12 of my series on the Greeks. In this article and the one following we are going to focus again on choosing your Greeks but this time on the level of the whole portfolio, rather than just in individual trades. We started to look at this topic in Part 8 where we learnt how to select the Greek signs you want for individual trades. I would strongly suggest you go back to Part 8 first and review what I discussed there. Here is the link: http://www.optionetics.com/market/articles/20193 The first step in assessing the overall Greeks in your portfolio is to be able to see the Greeks of all your trades and the totals. Optionetics Platinum has this feature in the “Profit/Loss” page. Under Profit Tools, click Profit/Loss and at the top of the page checkmark the box “Show Greeks” and then click Go. The first issue to address is that sometimes overall Portfolio Greeks can be deceiving. For example let’s make the statement that when the market goes up, gold goes down. Of course this is not always the case, but a lot of the time this can happen. Let’s say that our two trades, to trade the overall market and gold, were positions in the SPY (S&P500) and GLD (Street tracks Gold ETF). In the example let’s say very simply that we had one Long Call on each, and each Call had a Delta of 50. SPY Delta 50 GLD Delta 50 Total Delta: 100 It would be easy to look at the overall Greeks here and say we have 100 Deltas. Most of the time the trader might analyse their Portfolio here and conclude that if the market went up, we’d make $100 per point, or if the market went down, we’d lose $100 per point. But this is not necessarily the case. If the overall market (SPY) went up, we would expect Gold (GLD) to go down and vice versa too! So in theory we are actually Delta Neutral here, that is if Gold and the overall market hold their normal correlations. But I’m sure we see the message here – we have to look at the different sectors we are trading and understand how they correlate with each other in order to truly analyse our Portfolio in respect to the Greeks. Another situation where the Portfolio Greeks can be deceiving is viewing them at different points in the expiration month. If we had 2 Theta positive trades open, for example one Calendar Spread and one short Put spread, and we were 30 days from expiration, we may not have a lot of positive Theta yet in relation to the risk taken, meaning it may not look like we have enough time decay in our favour. It could be tempting to load up more contracts and take more risk in order to get more positive Theta, but if we looked at the portfolio again with 15 days to expiration, Theta would look a whole lot different - a lot larger ! So it’s important to consider where we are in the expiration month, and know in advance how each Greek is going to change throughout the life of the trade. Part 13 will continue with DPGM - Dynamic Portfolio Greek Management, now that we have been introduced to some areas to take into consideration. Manage your Portfolio Greeks! Matt Baker