Trading Lesson of the Week

• October 27, 2024
• SOUN | BOH

In This Week’s Issue:

• Market Outlook – Weak Canadian Dollar, Weak US Bond Market
• This Week’s Market Minutes video – Is the Stock Market Predicting a Trump Win?
• Trader Training – Does Your Trade Promise Bang for Your Buck?
• Strategy – Stockscores Simple Weekly

Market Outlook – The Bulls are in Control

The major market indexes are all in upward trends, showing that the buyers are in control. This has been the case for some time but we are now starting to see the strength spread to a broader range of stocks. After a slow summer, the more speculative stocks that day and swing traders like to play are showing more life. Short-term trading has been improving over the past two weeks.

To get a true broadening of the Bull market will be easier if we see interest rates come down. The US Treasury Bond market has fallen significantly over the past month, taking interest rates in the bond market higher. The bond market is predicting fewer interest rate drops by the US Fed in response to what seems to be a strong US economy.

The Canadian economy seems to be lagging the US, causing the Canadian Central Bank to drop rates. The difference in rates between the US and Canada is causing the Canadian Dollar to weaken against the US.

These weak markets are at areas of support where they should bounce back from weakness. Bounce back does not mean they will reverse, wait for a break up from a rising bottom before getting optimistic on the bond or Canadian dollar markets.

This Week’s Market Minutes Video – How I Picked a 3000%+ Gainer This Week

As the US Presidential Election approaches, what is the stock market saying about who will win? This week, I show how DJT has reacted to the Presidential race and what it is saying about who will win the election. Then, my analysis of the overall markets and the trade of week.

https://youtu.be/nBcYh7jL4eg

Commentary – Does Your Trade Promise Bang for Your Buck?

A Stockscores user asked me a question that I think many people have, "If you have more trade opportunities than capital, how do you pick which trades to take?"

The short and simple answer is to take the trades that give you the most bang for your buck. Let me explain.

We size our trade positions based on the risk of the trade. The risk of the trade is the difference between the entry price and the stop loss price. Divide the risk in to your risk tolerance amount and you have the number of shares you can buy.

Consider two trade possibilities, each with strong charts that show the same potential for price appreciation. The first has an entry price of $5 with support, and therefore our stop loss point, at $4.50. That means there is $0.50 of downside, or the potential for a 10% drawdown.

The second trade has an entry price of $20 with a $19 support price and stop loss point. On this trade, if wrong, we stand to lose $1 per share or 5% drawdown, since $1/$20 is 5%.

If we are willing to risk $500 on each trade, we will buy 1000 shares of the $5 stock for a total cost of $5,000 and 500 shares of the $20 stock for a total cost of $10,000. Each trade has the same amount of risk but the second trade requires more capital because the stock is less volatile. That also means the expectation for percentage gain on the second position is also less. The price volatility on the entry signal is a good predictor of what price volatility will be in the trend.

Clearly, the first trade gives more bang for the buck. We can use less capital for the same profit potential. We may believe both trades have the potential to make $1000 but the first trade will do it with half as much money invested. For a trader with limited capital, the first trade is the one to take.

Generally, lower priced stocks will be more volatile on a percentage basis, making them a source of greater percentage gain potential. You can place less capital in to a low priced stock to get the same dollar upside as a higher priced stock trade.

I did a quick survey of this week's best gainers to confirm this fact. I ranked the 2000 most actively traded stocks in the US last week by percentage gain and focused on the top 20 gainers. Of the top 20, 17 were under $10. The other 3 were under $20.

The lesson here is to focus on lower priced stocks if you have less capital to trade with. Many will argue that these lower priced stocks are riskier and maybe dangerous for a risk averse trader. They are actually not riskier, they are more volatile. That means you have to take a smaller position size in them so that the risk of the trade does not exceed your risk tolerance.

By adjusting position size based on the difference between the entry price and stop loss price, you can make every stock trade have the same amount of risk. If the stock is volatile buy less. If your amount of capital is insufficient for all the trades you find, focus on the lower priced stocks.

There is one caveat to this style of risk management. Lower priced stocks tend to have an added element of risk because they have a greater potential for price gaps. Lower priced stocks tend to have less established or diversified businesses which means a problem with one of their businesses can have a major impact on share price. It is much easier for a small Biotech stock to gap down 30% on bad news than it is for Pfizer to. That means the low priced stocks you trade could blow through your stop loss point if bad news brings a big price gap.

That makes it important to not put all of your capital in to just a few low priced stocks. If you are going to focus on relatively cheap stocks then you must own a number of them so that a larger than expected loss on one of them does not bring your portfolio performance down significantly.

If you have less capital to trade with than what you would like, focus on the lower priced stocks. You can adjust your Stockscores Market Scans to include a price filter for stocks under $10 or even lower if you like. Just remember to size your positions based on the volatility of the stock, the difference between the entry price and support on the chart, where you will put your loss limit. By doing that, you can match the risk of the trade to your risk tolerance and use less capital to gather the same dollar profit potential.