Business of Share Trading: From Starting Out to Cashing in with Trading

By Leon Wilson

Successful trader and best-selling author Leon Wilson knows how to make a living trading on the sharemarket. He also knows that because trading requires discipline, time and self-education, 90 per cent of those who attempt it will fail within two years.

In concise and clear language, The Business of Share Trading, second edition, shows how you can take control and profit from an active sharemarket portfolio. From developing a plan and financing your capital investment, to setting up a home office and keeping accurate records, this newly expanded edition offers step-by-step guidance to all aspects of running a successful trading business.

Updated to reflect the changes that have occurred in the industry over the past decade, the Business of Share Trading contains everything you need to know about:

• Fundamental, technical and combination analysis
• Dealing with brokers, data suppliers, ISPs and information sources
• Trend trading, break-out trading and reversal trading
• Trade entities and exits, position sizing and stop-loss management.

• Language: English
• Publisher: Wiley
• Release date: May 9, 2012
• ISBN: 9780730376316

Book preview

Part I: Basic principles and techniques

Chapter 1: A reality check

Before we race off and spend our hard-earned money on the best, flashiest whiz-bang software, sign up for a live data-feed and send off a fax requesting the latest Ferrari price list, we need to sit down and take a reality check. Most books dedicated to trading the markets only cover the strategies and processes involving the act of actual trading. In my opinion, this is of secondary importance when first starting to delve into the stock market and its potential. People first need to discover if they are genuinely compatible with the beast. You would not give a moment’s thought to becoming a professional fisherman if you suffered from chronic sea sickness, any more than you would become a high-wire walker if you were scared of heights. When it comes to the stock market, most people charge in head first, never considering the consequences and possible ramifications of their actions. An emotion called greed can be blinding at this point in time.

The sad fact is that most people are not psychologically or emotionally capable of dealing with the everyday rigours of the stock market. For these people, the chance of successfully surviving long term in the marketplace is virtually nil. In nearly all cases, this fact is usually discovered only when their trading account has a zero balance, or their partner is living back at home with Mum. People need to be brutally honest with themselves: strengths and frailties need to be evaluated fully prior to embarking on the journey. Ask your partner for his or her honest assessment of how they think you would manage long term. You must be realistic about yourself and your personality and, if appropriate, elect to place your money in a managed fund rather than cruise into the stock market armed only with delusions, misguided hope and an overzealous ego. The stock market does not have free trial periods or money-back guarantees. There are no medals for being the world’s fastest bankrupt. For accomplishing such a dispiriting goal with zeal and tenacity you will receive a small mention in the public notices, though it is probably not the recognition you are looking for. The mental torment of losing an entire life’s savings can be insurmountable for many people.

My intention here is not to scare you away from the stock market — quite the contrary. What I am endeavouring to do is encourage you to examine the stock market as it really is, and not as it is sometimes portrayed by those who have little factual understanding or real-time involvement with it. Looking at the stock market through rose-coloured glasses will be fatal to your finances. You have to be realistic not only about the market but, even more importantly, about your own personality. You and you alone will make all the decisions, and only you are responsible for them.

If you are indecisive or are unable to admit or accept you have made mistakes, then this is definitely not the investment path for you. The market will not wait for you while you make up your mind. It is not your partner’s fault if there has been an 80-point drop and you are still holding stock, any more than it is your broker’s. The responsibility for your market trading activities rests solely with you. This is one career where blame cannot and must not be allocated to someone else. If admitting to, evaluating and acknowledging mistakes is not really your style, then disaster is imminent.

People who survive in the stock market long term analyse their successes and their failures to the same degree. One is enjoyable, the other is not, but both must receive similar degrees of scrutiny. Read the following list and tick either ‘Yes’ or ‘No’ beside each character trait. If you cannot tick ‘Yes’ for all of them, or genuinely believe you can’t change your line of thinking to score a ‘Yes’, give it away here. Put your money in a managed fund and sleep easy.

Questions for you

Can you self-correct? Yes missing image file No missing image file

When mistakes are made, you are the one who must analyse where it all went wrong, and you are the only one who can implement the correct solution.

Are you disciplined? Yes missing image file No missing image file

Records must be kept for taxation purposes, a trading plan must be stringently adhered to, and comprehensive details of trading activities must be kept in order to evaluate current and past performances.

Are you self-motivated? Yes missing image file No missing image file

There is no-one to drag you out of bed on a cold morning and no boss telling you to examine the latest trading journal. If trading is to be your business, it must be treated as such. You have leisure time only when you are not required at the office.

Can you manage consistent failure? Yes missing image file No missing image file

All traders experience periods when nearly every trade entered turns against them. This is an unavoidable element of trading.

Are you confident? Yes missing image file No missing image file

Are you a person whose confidence can be easily sapped? Trading requires confidence in your own ability and the systems you have in place.

Do you have the ability to learn from others? Yes missing image file No missing image file

Reading books and attending trading seminars are the easiest ways to expand your knowledge base. If you are one of those people who reads two books and becomes an instant expert — yes, the dreaded ‘know-all’ — you must mark this question ‘No’. (Better still, ask your partner to answer this one on your behalf.)

Are you focused? Yes missing image file No missing image file

Every time the sun shines, do you spend the day peering out into space dreaming about the beach and your new surf rod? You must be very focused and single-minded when trading the market. You can worry about the latest tides and phases of the moon when your office is closed.

Can you manage stress? Yes missing image file No missing image file

The markets can cause plenty of this. For instance, the 2008 global financial crisis (GFC) caused incredible volatility and major price corrections. Your portfolio can be decimated in minutes and you must be able to act clearly and rationally in such situations, even if your heart is racing.

Are you a realist? Yes missing image file No missing image file

Both pessimists and optimists will eventually go broke. You must be realistic about the market and its present path, the appropriate actions you need to take and the income you can realistically expect to receive from your activities.

Can you leave your work at the office? Yes missing image file No missing image file

Even though as a trader you will work from home, treat your workstation as your office. You must be able to give yourself and your partner an opportunity to discuss issues other than work. Your partner should not suffer just because you had a lousy day at work.

Can you accept full responsibility for your actions? Yes missing image file No missing image file

Some people have a tendency to blame someone or something other than themselves for every disaster and negative occurrence that affects their daily lives. By allocating blame to someone or something else they delude themselves into thinking the onus of responsibility rests with a third party. If this is you, then you need to lose this mindset immediately. The upside is that you receive 100 per cent of the accolades when you get it right. Responsibility must be accepted as a full package when trading — you cannot pick and choose where liability sits.

Can you survive without people contact? Yes missing image file No missing image file

Trading can be the loneliest business on the planet. Do you crave people contact or need a hectic work environment and office chatter to function at full throttle?

Do you freeze or procrastinate under pressure? Yes missing image file No missing image file

If you have a tendency to freeze or procrastinate when the pressure is on, then give it away now. Trading is often easy and well defined by trading rules; however, things can and do go pear-shaped, and on a semi-regular basis. You must be able to act promptly and in accordance with your trading plan, regardless of what is unfolding around you.

For those of you who glossed over this checklist — or, worse still, skipped it completely — I am disappointed. The honesty of your self-appraisal today will be directly reflected in your bank balance tomorrow. If you think that this task today is too painful, then try to imagine how you will feel when it has all gone down the gurgler because your ego got in the way and you didn’t deem this process necessary. You will have to face reality at some point in your trading career.

All traders must face the inevitable. This is a condition of your rite of passage to successful trading. You can face it now or in the bankruptcy court later. It might as well be today, while all of your funds are still intact.

Now that you have assessed your own personality, you need to consider what you are up against — the dreaming that takes place when you initially discover this hidden secret called the stock market, and the mythical image sometimes projected of it. Many people initially imagine abundant wealth and suddenly feel all warm and fuzzy. Now, there is absolutely nothing wrong with feeling like this and looking up to the clouds, as long as your head is not among them. Dreams and desires are what drive people to achieve their life’s ambitions; they are the fuel of motivation. However, you cannot evaluate clearly if your vision is blurred.

Sharemarket participants

When people initially discover the stock market, irrational visions of abundant wealth immediately come to mind for many of them. They are oblivious to the blatantly obvious and their visions are unrealistic. The media always seems able to locate the latest market millionaire and his or her life of excessive indulgence, reinforcing the perception of incredible wealth ‘on tap’, and they make it sound so incredibly easy. Then we hear regular commercials on the radio telling us how, for just a few minutes a day, we can make more money than it is possible to spend. The delusion is now complete and we are hooked better than any fish. People such as Larry Williams, Warren Buffett and George Soros get regular attention from many within the financial world regarding their phenomenal successes, reinforcing many of our ill-conceived perceptions.

Now for the reality check. These professional traders are at the pointy end of the pyramid when it comes to stock market participants. All newcomers commence their education down at the base. The people mentioned above are the cream of the crop. Never confuse your current capabilities with your ambitions. Even later down the track, making a few successful trades does not qualify you as an expert. The market is brutal to anyone who has an inflated opinion of his or her trading skill, and it has the ability to humble even the very best of traders. Added to this, you need to consider the quality of traders you will have to trade against, including professional institutions and some incredibly proficient private traders. Traders in the class of Louise Bedford and Nick Radge will have come and gone and you will be totally unaware that you have been relieved of your funds until it’s too late.

Should you wish to survive and prosper long term, this is the quality of opponent you will have to contend with; remember that traders of this calibre are attempting to separate you from your money just as you are attempting to relieve them of theirs. Warren Buffett was once asked how he would define the stock market. His reply was something along the lines of, ‘Simple, it’s the transfer of funds from the amateur to the professional’! While you may dream of an abundance of wealth and riches — and, yes, it is quite possible — the reality, according to most of the long-term players in the market, is that 90 per cent of would-be traders are washed out of the stock market within two years.

Should you choose to follow the stock-market road, be prepared for what will most likely be the hardest and most demanding journey you have undertaken in your life. The market is a dynamic, ever-evolving beast that is only ever mastered by a select few. (By masters, I refer to traders who consistently take more income from the market than they require to live the lifestyle they desire. It is questionable whether any trader really ‘masters’ the market in the true sense of the word.) Others, while not necessarily being masters of the market, will become very proficient in trading and make a more than comfortable living from their activities. From here we quickly wind up back with the 90 per cent group previously mentioned. This group continually receives financial injuries caused by the market beast, responsible for their slow, fatal and agonising demise. The market will show no mercy: it has no conscience or compassion, no heart, and no respect for anybody choosing to be associated with it. It cannot be controlled or tempered by our actions. It has no comprehension of friendship. Dreams of wealth and abundance are shattered, and you will blame everything and everyone but yourself. The dream has become a nightmare — and to think you personally wrote, produced and bankrolled the entire epic yourself, and then, just to add insult to injury, you also played the leading role! Not exactly what you planned. This is the 90 per cent.

Even if you are part of the surviving, and perhaps thriving, 10 per cent, you can expect to make every mistake in the book, and you will even have the dubious honour of inventing some astounding new errors. I can guarantee you that you will lose money on trades regardless of your ability, experience or time in the market. Only you can determine how much is lost, as there is no-one to pull you from the sinking ship. From a trading perspective, it’s human nature to pull the bung on a sinking ship rather than to bail it out. It’s sad but true that we help sink ourselves.

You will experience every conceivable emotion during your market activities. Life can be a rollercoaster ride if you do not learn to control and manage your emotions. The first component in trading the market is the physical act of trading, but there is also the emotional side of the equation. This component of trading has no relevance For beginners, because at this point people still consider themselves to be smarter than most, their egos are intact, and overconfidence reinforces their opinion that they are 10 feet tall, bullet-proof and totally indestructible. After several near-death experiences with the stock market road-train they discover that the market will not show them the same respect as their partner, no matter how much they stamp their feet and protest. This element now takes on new meaning in their overall strategy. Those who soldier on stubbornly, ignoring the obvious, go broke, simple as that!

Get rich quick?

If you are looking for quick wealth, then the stock market is not for you. Generally speaking, the stock market does not bring instant fame either, except for major wipe-outs such as Nick Leeson and Barings Bank. If you are seeking a quick way to wealth and its trappings, your resident lotto agent should be able to relieve you of your hard-earned money; alternatively, cruise down and rob your local credit union. While neither is recommended (and one is highly illegal), these approaches should cover such an investment strategy. I would imagine the odds of long-term success using either method would be similarly dismal.

The bad news is, there is no ‘Holy Grail’ to making squillions from the market — sorry to burst the bubble this early in the book — only hard work. Even if you are armed with discipline and diligence, coupled with a sound practical working knowledge of the stock market and your own trading methodology, there is still no guarantee of the wealth you may crave. If you feel you need some form of guarantee, I suggest you buy a toaster. Like it or not, this is the reality!

If you do not like what you have just read, then all I can suggest is that you do not waste your time reading further. I cannot offer you any magical approach to the stock market — anyone who claims they can should be treated with the greatest of scepticism — any more than I can change your personality. You should always remember that the world’s great traders are just that because they are true masters of their own unique approach and they have an intimate understanding of the market. They did not achieve this status because of some magical formula or the latest ‘V8 fuel-injected quad-cam’ software package being bandied about in a stock magazine promising to return 20 per cent per month for five minutes a day of your time — yeah, whatever!

To those of you who choose not to proceed further, I admire your honesty and congratulate you on being truthful to yourself. Such a decision is not a sign of failure, nor does it carry any element of shame. I wish you all the best in your life’s pursuits and apologise for not being able to help you in your quest for wealth. I hope you find your money tree in whatever form it may take — after all, people are still winning the lotto. The true failure lies with those people who know, deep down, that this is not for them but for whatever reason continue, against their better judgement. These people are almost guaranteed to fail.

For those who have chosen to continue, now comes the good news. I will endeavour to show you how to get started in the business of share trading. In the first part of the book I will address some basic techniques and principles that will assist you in your decision making. I can offer no guarantees of success, as ultimately only you can determine this. As much as you might like me to make all the calls for you, this is not possible. These are simple, straightforward techniques that, when applied correctly, can allow you to achieve success and survive long enough for you to stand on your own. The techniques I use today have changed little over time — they are just finetuned for today’s increasingly volatile conditions.

I cannot stress enough the enormity of the task you are undertaking. I want you to be under no illusions about the effort it takes to succeed and the successes, failures and frustrations you will encounter along the way. This is not an easy road to travel, and it contains many potholes and washouts. However, if you keep your head out of the clouds and your feet on the ground, then you too may become one of the few who conquer the market beast.

My apologies to those of you who feel I may have overemphasised the potential downside of trading. This chapter may have been a little long-winded! However, some people have large egos and a total inability to comprehend their insignificance in the overall scheme of things when it comes to activities such as trading. Even now I’ll bet there are some of you saying, ‘Ah, what a lot of rot, this is going to be easy as pie’. If this applies to you, ask yourself, ‘Why do women, in general, make good traders?’ I’ll include the answer later in the book.

Whatever you may decide at the end of this book, I wish you the best of luck. But now, let the journey begin.

Chapter 2: Basic nuts and bolts

It is widely accepted that there are two main approaches to stock market analysis: fundamental and technical. As I am a technical analyst, my approach may seem to show bias towards this technique. This is not intended, as both forms of analysis have valid applications within the marketplace. I will briefly explain each approach, as well as the increasingly popular ‘combination’ analysis.

Fundamental analysis

Fundamental analysis is the study of company reports and financial statements to ascertain the theoretical value of any given company. The fundamental analyst will examine price–earnings (PE) ratios, dividend yield, net tangible assets (NTA), earnings per share (EPS), debt-to-equity ratios and so on. Add to this, supply contracts, takeover bids, mergers and major plant and equipment upgrades and you can start to see why the fundamentals of a company are seen as essential by many. I say ‘theoretical value’ because the fundamental value is seldom reflected in the actual stock price traded. It is irrelevant if the fundamental (theoretical) value is $3.00 per share if the stock is trading at $1.50 in a down-trend.

A simplistic example for those of you having trouble separating theoretical and actual values may be useful. If you were able to purchase 100 per cent of the aforementioned company’s stock, would you pay $1.50 or $3.00? You would pay only $1.50 per share, because this is the price at which you are able to obtain the shares through the exchange. The market value of the company is its trading price on any particular day. It is this discrepancy between the two that helps stimulate price movement in the stock market.

If fundamental value was also market value, then price movements could occur only when company activities and reports were released publicly, with share prices adjusted accordingly. The fundamental approach allows analysts to compare the current stock price with the theoretical value per share and determine whether a company is undervalued, priced according to its true value or overvalued.

Fundamental analysis is the primary driving force behind the price movements of our major blue-chip companies. Large financial and institutional investors primarily use fundamental analysis for company selection. Technical analysis is also used by some institutions as a secondary source of decision making and market timing. Many technical analysts scoff at the fundamental approach. Do not dismiss it lightly — to do so is potentially to court disaster. Remember, this is the primary technique used by the big players; it is the big players creating price movements by chasing the perceived fundamental value of a particular company. The downside to fundamental analysis is that just because a stock is very sound fundamentally, this does not imply the price trend will be positive. Many sound companies on the exchange are out of favour with the market at any one point in time. Fundamental analysis does not have the ability to indicate changing sentiment relating to the stock in question. Funds invested in these stocks may sit idle for extended periods, with little or no appreciation in value and only the occasional dividend cheque arriving to soothe the boredom of inactivity. In conclusion, fundamental analysis is great for finding quality undervalued stocks; however, the technique does not highlight when the big players are accumulating or there is increasing market interest.

Technical analysis

The technical analyst examines actual price history to gain an insight into the most probable future price direction. Some analysts believe history repeats itself, so they use this approach to locate high probability recurrences. The technical analyst evaluates a stock’s potential by examining the relationships between internal and external strength, momentum, trend, volatility, support and resistance, cycles and volume. Many fundamental experts laugh at the technical approach, comparing it to reading tea-leaves. Such comments highlight ignorance rather than knowledge of technical analysis. As a technical analyst, all I am endeavouring to do is catch a change in price direction. The institutional investors — predominantly fundamentalists — drive price action; all I am doing is attempting to identify change in price. By studying price and volume I can identify areas of increased market interest, accumulation and distribution.

There is nothing mystical about using a technical approach to capture the actions of the institutional professionals. Their annoyance is most likely based on the fact that technical analysts can achieve similar results to the fundamentalists without having spent half their lives at university, or requiring a team of researchers and hugely expensive software programs with a value that could rival the debt of a third-world country. I personally believe this has far more to do with their attitude towards the technical approach and their lack of understanding of its practical application, rather than that the method itself is ‘pie in the sky’.

While technical analysts can ride the wave of institutional research, the drawback to this approach is that they are often not aware of a stock’s fair value and the reasoning behind the current price action and, therefore, they are unable to calculate expected upside price movement when it happens. They rely solely on being able to correctly analyse the sell-off of stock by the professionals using the technical approach. While technical analysts might be going for a ride at the institutional fundamentalists’ expense, they have no idea how long or how short the journey will be and, if the bus stops, whether everyone is getting off or it is only a temporary pause while more climb on board. The price technical analysts pay for a free ride is that they do it blindfolded. In conclusion, a technical approach makes for a great timing tool, but it’s incapable of identifying stocks with strong financials.

Combination analysis (top-down or bottom-up)

This approach involves incorporating both fundamental and technical analysis either by screening the fundamentals first and then applying technical analysis (top-down) or by applying technical analysis first and then screening the remaining candidates’ fundamentals (bottom-up). In theory, traders using combination analysis have the best of both worlds. They can locate companies that are undervalued and monitor them for signs of positive price change. As price action commences they are able to allocate funds to the purchase of these stocks without cash sitting idle for extended periods of time. Combination traders know the probable journey of the professionals. Their blindfold has been removed, but for this they must pay a price. That is, traders are generally not accountants, so they must pay for this information. This may be in the form of a full-service broker, information from an independent analysis company specialising in fundamental reports, or information from data suppliers that include fundamental statistics as a part of their service. Alternatively, you may source the required information from the Financial Review or similar publications. In any case, without doubt, the combination approach is becoming increasingly popular.

Conclusion

Both distinct forms of analysis are perfectly legitimate when used as they are intended. Each has strengths and weaknesses. You can make substantial returns using either technique, and don’t let the old brigade tell you otherwise. There are wealthy traders on both sides of the fence who exclusively use one method only. Should you encounter people dismissing either form of analysis, then excuse their ignorance. There’s a fair chance they do not actively manage their own funds or participate in the stock market. They will most likely consider themselves market players, but 10 minutes into the conversation you will more than likely find out he or she has a superannuation fund and has gained this wealth of knowledge from the weekly column in the local paper. The problem with the stock market is that most people read the occasional article and then become instant experts. Ask them to explain sub-indices and their relationship to market sectors. If they cannot answer such a basic question, ignore these people — their attitudes and opinions are of no use. Old-style fundamentalists have a line they just love to quote to the technically inclined — ‘Show me a wealthy chartist’. Where would you like me to start? The exploits of Larry Williams, Dan Zanger, John Bollinger and Nicholas Darvas, to name just a few, have all been well documented. The list of wealthy technical analysts is too long to include here.

Something to think about

Some brokerage houses still had ‘buy’ recommendations on Pan Pharmaceuticals, Pasminco, HIH Insurance and One.Tel just prior to administrators being appointed. Thus, even the professionals, basing decisions on the fundamentals, get it seriously wrong on occasion. The fundamental approach will not receive coverage throughout this book, nor will I give my personal opinion on fundamentals as I do not want to offend. ‘Are fundamentals essential for analysis?’ you may now be asking yourself. The answer is no.

I know that I have now been labelled a lunatic by the accounting element of the trading community, but think about it for a minute. The reliability of some accounting reports made available can be questioned. The collapse of Enron is a classic example. If you believe the media reports, then it would appear that the accounting procedures surrounding Enron were considered suspect. With fundamental analysis you are relying on the honesty of the company’s major players and the auditors responsible for checking the company’s health.

For some reason it appears that it is the solid companies that end up victim to poor management and auditing practices. HIH Insurance and One.Tel had well-established down-trends in place when evaluated from a technical perspective. Novice technical analysts, equipped with only the most basic of skills, would have been able to avoid these two stocks using the technical approach, while traders using the fundamental approach would have purchased stock at what they considered to be bargain basement prices. The problem was that prices stayed in the basement and, when the final nail was driven into the coffin with the suspension of trading, it became impossible to close out the position and cut losses. For fundamentalists the loss now reads 100 per cent on their trading spreadsheet.

• The BeST approach to stock selection and analysis •

I personally use a technical approach for stock selection and analysis, as I believe the fundamentals have already been factored into current price action by the professionals. Using either fundamentals or technicals for initial selection is perfectly acceptable; however, I prefer to apply technical analysis for specific entry and exit strategies. If you still feel that the fundamental approach has merit and is more applicable to your individual preferences and personality, then this is fine. Do not burn the book just yet. I will explain how you can incorporate the fundamental element into your trading technique in chapter 4.

Chapter 3: How to get started

Before starting out on your investing or trading career, I suggest you tear up that resignation you’ve just printed, and read chapter 1 on the reality of trading again — you did read it, didn’t you? Hold on to that day job just a little longer.

Firstly, you need to find yourself a broker, open a trading account, fill out numerous official-looking documents and make several decisions on the direction you are going to take before you put your hard-earned cash on the line. Remember, the stock market does not give refunds, nor does it have free trial periods. The first choice to make is the type of broker best suited to you. Ideally, you would get this choice somewhere near right the first time.

Full-service brokers

A full-service broker is exactly that. Such brokerage firms will usually give ‘buy’, ‘hold’ or ‘lighten’ — they never seem to say ‘sell’ — recommenda­tions on stocks. Fundamental reports, company updates, in-depth research, advisory services and numerous other services are generally available upon request, usually without additional cost. Goldman Sachs JB Were is an example of a full-service brokerage.

What are the advantages?

Some of the advantages of using a full-service broker include the following:

• You will receive advice on all markets — local and international — along with company reports on most major players listed on the exchange.

• It only takes a phone call to place orders, and you can discuss your stock selection, seeking guidance and a second opinion as required.

• Most major brokerage firms have order placement facilities on their website. However, be warned that some full-service brokers still charge the premium rate for online orders.

What are the disadvantages?

Some of the disadvantages of using a full-service broker include the following:

• This is the most expensive way to place market orders, and they normally charge at a premium brokerage rate. Some brokers still charge 2.5