ASX Game Round-up

As I'm sure a lot of my readers are aware the ASX virtual trading game as just come to a close. I hope it was both successful and illuminating regarding the strengths and weaknesses of your trading strategy. I would like to post a special congratulations to Becky, the winner of the game increasing her portfolio to $130,000 from $50,000 a 260% increase!

Since reminding my readers about the commencement of the game, I have been asked several times for an update of how my own trading is going. I have held off from announcing my results, knowing that the stockmarket is a volitile beast and could turn against me at anytime.

As the game has now finished I feel as though I should let me readers know my results. However, I would first like to describe the types of trading and investing I was partaking in. I had three ASX accounts and was trading with all of them simultaneously.

The first was a purely technical trend following/ momentum style. The second was purely fundamental, and the third was a mixture of technical indicators and fundamental analysis.

The results are as follows:

Purely Technical: $48,793
Purely Fundamental: $50,622
Mixture: $54,262


Now before you jump to any conclusions, I would just like to say this is not a reflection on the styles of analysis. The type of technical trading I was pursuing was more suited to a longer timeframe and thus only really incurred costs rather than profit (we all make mistakes but with the capital is virtual it doesn't matter much!). The purely fundamental trading was also limited to certain industries as gaining an extensive knowledge across the full 250+ companies would have been impossible. Due to this I missed potential opportunities that could have been very profitable if they had been identified earlier.

Finally, the mixture of technical and fundamental analysis was wildly successful. This account was ranked inside the top 200 for a significant period of the game. The final rank was 288 out of over 17000 participants. It achieved an 8.5% return in only a few months, I think most people would be happy with that kind of return!

The takeaway from this post is that you have to try many different trading styles to find one that works for you. However, I do feel as though I have just been very egotistical and written about my success.

Let me know how you went or if you have any questions as usual email me on  illuminatingfinance@gmail.com

Technical Analysis: Support and Resistance points

Okay, so as I expected since covering the type of analysis I have had an influx of readers who are keen to know more.  I have previously covered the difference between technical and fundamental trading, for those who missed them have a read before you finish reading this post (http://illuminatingfinance.blogspot.com.au/2014/05/fundamental-trading.html and http://illuminatingfinance.blogspot.com.au/2014/05/fundamental-trading.html).

However, as the title of this post indicates I would like to go into slightly more detail on technical analysis. The basis of technical analysis comes from analysis of quantitative data and graphs. Using technical analysis we are able to pick points of support and resistance for price in the future. Support points are prices in the markets where large groups of traders buys will continue to buy the product. Resistance points are prices in the market where a large group of traders will sell the product. This would regularly be due to ideas of under or over pricing, which they intend to exploit. Often due to psychological reasons these tend to move towards round numbers. These points can be found through an examination of graphs, as seen below.

We can learn a lot from analyzing this graph with the benefit of hindsight. An example of a support point (a point that it is unlikely for the price to descend below), can be found on the line A. At the $33 point, the price hit this support point and then went back up 4 times. This could be because some traders believe that at the support point this stock is very cheap and undervalued and thus demand rises. The line B is a good demonstration of a resistance point (a point that the price is unlikely to rise above). The price hit the $35 mark twice before retracing and then breaking through. A breakout is a price rise beyond the resistance or support point. Once this occurs often new support and resistance points are established, often at the point that was broken (ie. Support becoming resistance points or vice versa).

This will just be the one part of many on this very large topic. If you have an idea on what you would like the next post to be on or would just like to contact me please email illuminatingfinance@gmail.com

Review of the Market wizards

I first read this book awhile go and remember the value it had. So this week I have reread it so I can provide a review for you, the readers!

The book Market Wizards by Jack D. Schwager is a Finance classic. Everyone in the trading world seems to have read it. It is the recorded conversations that Schwager had with the most successful traders in the world in the late 1980s. He speaks with 15 traders and one psychologist about their views on trading under several different topics. He talks with most of the traders on their particular method to being successful.

However, the message that came across in the book was there is more then one successful methods to making money. Each person is different and could deal with different amounts of risk and return, and thus required different strategies. This realization allowed me to stop searching for a holy grail strategy but instead work on my own strategy. This book is very well recommended to anyone interested in finance or trading, as it is a very good starting point for further research.

Enjoy reading!

Does it have to be a choice?

Okay since posting over the last two weeks on the main types of analysis (that you can see here: http://illuminatingfinance.blogspot.com.au/2014/05/fundamental-trading.html, and here: http://illuminatingfinance.blogspot.com.au/2014/05/technical-analysis.html), I need to clear up a question I have received a from a few concerned readers.

"I now understand the difference between technical and fundamental analysis, but I'm not sure which one to choose. Could you help?"

Okay let me start by saying, it doesn't have to be a choice. There are a many traders and investors who are extremely successful who use both fundamental and technical analysis. They design their trading system around the complementing elements each type of analysis provides. An example of this could be using technical analysis to indicate possible buy movements and then using fundamental analysis to decide whether to pull the trigger.

Now before the next question is asked, no you don't have to use a combination of both types of analysis. As a trader or investor you have to decide how you want to design your system. You may have more of a focus on one type of analysis, an equal mix, or even completely reliant on style. It is up to you!

Good luck!

Make sure you to let me know if anything I've said has helped you! Just email illuminatingfinance@gmail.com

Technical Analysis

Following from last week's post on Fundamental analysis (that you can see here: http://illuminatingfinance.blogspot.com.au/2014/05/fundamental-trading.html), I thought this week I would explain to the other type of analysis referred to as technical analysis.

Technical analysis uses an examination of historical data to form predictions for future price action. These are most commonly an analysis of price and volume. Traders who utilize technical analysis to make trading decisions often run very systematic trading strategies. This reduces emotional involvement to almost zero, instead using quantitative data to indicate when to enter or exit the market. The graph below shows a trend which a technical trader may have picked up using his system.

Fundamental Anlaysis

This week's post was inspired by another question from an avid reader.

 "What are people referring to when they talk about Fundamental analysis?"

Fundamental analysis uses information available about companies, industries and economies in an attempt to understand and predict price action. The more information a fundamental trader has about the trade the more informed they feel. Thus they seek to fully understand the market in which they are investing before they commit their money. The specific data on the companies can be found in the annual financial reports, which they release to market. For commodities, an examination of more macro factors can give a deeper understanding of the good and where the price may be heading. These factors may include the weather, changes in demand, and even changes in government regulation.

Some examples of types of ratios used in fundamental analysis include; Overall performance, iquidity, profitability,  efficiency and leverage ratios. Some of the most common examples are; PE ratios, dividend yield, ROA, ROE and growth forecasts. The trader would then combine these with current events and his own judgement to come to a decision to proceed with a purchase or exit a position.

ASX Share market game

ASX Share market game

The Australia Stock Exchange (ASX) is having another share market game! It is a virtual trading game based on current real world figures. It is an amazing opportunity to test all of the trading strategies you have been working on without risking any capital. It has just opened for trading and will be running for the next few months!

Game specifics:

·      You begin the game with $50,000 in capital.

·      Each transaction has a $20.00 brokerage fee.

·      You are limited to 20 transactions a day.

Link: http://www.asx.com.au/education/sharemarket-games.html

Good luck trading and remember there is a $3000 prize money if you make the most profit!

Trading Strategy

In this week's post I thought I would introduce the concept of a trading strategy. Everyone who trades, whether it is stocks, commodities or currency, needs a trading strategy. A trading strategy gives you consistency and allows you to solve problems before you are even presented with them. Without a trading strategy you are just stringing together random trades, without purpose or direction. Consistently following your trading strategy should, in the long run, lead to an edge or an advantage that leads to profit. Everyone's trading strategy will be different but anyone trading in any market should know their strategy before making a trade.

The way that you view the market will lead to different ways of trading and thus different strategies. For example, if your plan is to buy low and sell high, you are saying that you can see something in that trade that the market has missed. Possibly some potential good results, or good fundamentals in the company that you believe will eventually raise the price. The other side of this view is that the market has fairly priced the stock or commodity for what it is worth. This leads you to the buy high and sell higher approach, popular with technical traders. Thus you need to think about how you view the market to develop your approach to trading and create a strategy.

However you decide to trade, the most important point is to have a complete trading strategy before you begin to put money into the market.

Payout Policy - Retained earnings

I have not had a specific question on this topic yet, but I think it may make for a series of interesting and informative blog posts. This series should go over the next few posts so that I can explain all of the concepts. Remember to send your questions to illuminatingfinance@gmail.com!

A payout policy is the way a firm chooses between the alternative ways to pay cash out to shareholders. When a firm generates a profit, the managers have a choice with what they would like to do with the excess funds. They have several options and each choice has advantages and disadvantages, which I will try and explain. The diagram shows the options available to a firm once all debts have been serviced.

 

This week we will cover the options when the firm decides to retain the profits. By retaining the excess cash flows (profit), the firm can choose whether to invest them in new projects or increase their cash reserves.

If a firm is presented with a profitable investment opportunity it can choose to reinvest the cash and increase the value of the firm. Many young, rapidly growing firms choose to reinvest all of their cash flows this way. By successfully investing the cash the firm would increase the value of the shares for the shareholders.

Choosing to retain all of the profit to increase cash reserves is not a particularly common choice. Often firms choose to retain a small percentage to 'top up' their cash reserves but distribute the rest. If firms retain cash reserves that are too high there is no benefit to shareholders. Some make the arguement that by having excessive cash reserves it can encourage managers to inefficiently allocate the funds. However, by increasing cash reserves the company can be confident that they will have sufficient funds to invest in a future project. Possibly avoiding the often costly process of raising capital in either equity or debt markets.

What have I been working on?

Recently I have been exploring the more complicated aspects to trend following and a purely systematic approach to trading. I enjoy the idea behind a systematic trend following approach to trading, taking out the emotions and doubt. However, before I would even consider attempting this (or any for that matter) approach, I will submit it to a rigorous back-test to ensure it will actually be profitable in the market. For me, this meant making a relatively complicated excel spreadsheet. 

It is still in the works but I thought I would put a draft version up here to see if anyone had any advice for improvements or to point out any mistakes I have made. Currently the spreadsheet is split up into 4 sheets; an Executive Summary page, an Inputs page, a Raw Data page, Dividends, and Calculations page. At the moment most of the work is going into the calculations page where the real magic happens. So far the spreadsheet will take the inputs put into the inputs page (No. days high/low, initial capital, capital at risk) and calculate when a trend is occurring that you would buy or sell. The spreadsheet will then calculate any profits or losses on each trade and give you an updated capital figure. A summary will be displayed on the Executive Summary page that will have a graph of capital over the length of time specified, amount of profit/loss, and a count of how many buy/sell signals occurred over the period.

However, this excel spreadsheet is still incomplete. I have not yet included the dividends as a type of income to increase the capital on hand (as I use the high and lows of the day in my calculations, I cannot use an adjusted figure.). Also I have not yet managed to effectively pyramid the trades to buy more shares as a trend continues, a fundamental part of trend following. Due to these flaws, the macro I have been developing to take the raw data, run the calculations I want and then display all of this information is currently useless. Once I have ironed out these flaws I will create the macro again, which will hopefully work the way I envision it and save me a lot of time. I just hope my computer can handle it as I have had some issues with excel/my computer crashing due to an overloaded CPU (I guess it isn't that unexpected when you are trying to do ~32 million calculations simultaneously!) 

Let me know what you think! 

Capital Structure

A continuation on the topic of capital structures has been demanded by some readers (remember I exist to serve the readers so email your questions to illuminatingfinance@gmail.com). For first time readers make sure you check out this blog post before continuing with this one - http://illuminatingfinance.blogspot.com.au/2014/03/debt-and-equity-capital.html.

Okay so remember that the proportions of debt and equity a firm has outstanding can be referred to as its capital structure. Today we are going to delve a little deeper in the some of the advantage and disadvantage of different capital choices for firms.

One advantage of using some debt in the capital structure of a firm is that it enables them to leverage the equity for an increased investment. In layman's terms this means that it lets them spend more money than the firm has access. Another advantage of firms using debt is the tax benefit derived from the interest payments. Firms are able to deduct interest expenses from their taxable revenues to create a more favourable tax environment.

However, despite the advantages using too much debt has the potential to put the firm in serious financial distress. If a firm who has used excess debt in their capital financing has difficulty meeting its debt obligation (repayments), they may eventually be forced in bankruptcy. Even if the financial difficulty does not spread to the extent that it forces bankruptcy it can still have negative consequences. These may include: loss of customers, loss of suppliers, cost to employees, and fire sales of assets (selling assets very quickly accepting prices that are well below market value).

So now we know some of the main advantages and disadvantages we reach THE question regarding capital financing and capital structures.

'What is the optimal capital structure?'

Or in other words - 'How much debt is too much?’. This question is very difficult to answer in generic terms as it will vary for each firm. In finance there are ratios and calculations that are used to try and estimate the answer to this question. However, in reality the answer is at the point where the probably and magnitude of the firm incurring financial distress outweighs the advantages of including debt in the capital structure.


I'm sorry to end on that ambiguous answer but the answer will be individual for each company. If you would like to know more about the calculations and ratios make sure you email illuminatingfinance@gmail.com (or if you have any other questions!)

What are derivatives?

We are coming to the end of the most popular questions I have been sent recently. So next week we will be back to regular programming about subjects I think may help you more clearly understand finance. This week’s question is based on a finance term that they did not understand (feel free to ask me questions about even the smallest and simplest concepts as I often find they can open up into very interesting topics to explore. Email me at illuminatingfinance@gmail.com).

“I heard someone say ‘floating security over assets’ and had no idea what they were talking about. Could you please explain what this means?”

So the phrase ‘floating security over assets’ does sound quite intimidating, and if you were on your own I wouldn’t blame you for just saying ‘oh forget it’, and moving on with your life. Luckily you have me! Together this week we will explore what this phrase is actually referring to.

So what the phrase is referring to are derivatives. Derivatives are financial instruments whose values depend on (or derives from) the values of another underlying variable, as if they are 'floating' over the asset. Very often the variables underlying derivatives are the prices of traded assets. A stock option, for example, is a derivative whose value is dependent on the price of a stock. However, derivatives can be dependent on almost any variable from the weather to the quality of harvest of a crop.

In recent years derivatives have become increasingly more important and popular in finance. Futures and options are actively traded on many stock exchanges and many financiers enter into forward contacts, swaps, options, and other numerous other derivatives. Primarily derivatives are used to transfer risk from one entity to another, but realistically they can be used for hedging, speculation, or arbitrage.

As usual this is just scraping the surface when it comes to derivatives. Contact me at illuminatingfinance@gmail.com if you would like me to go into more detail. I am sure I will cover this topic in time as this is a very complex and often misunderstood subject.