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Risk Management: A Successful Trading Ingredient
In the Spotlight | 03 September 2014
By: Shane Goh
Articles (99) Profile

Daryl Guppy is a technical analyst and trader who is featured frequently on CNBC Asia. In an exclusive interview with Shares Investment, we seek to understand the market structure across various asset classes and trading strategies retail players can employ in the market.

Shares Investment: Presently, both the Dow Jones Industrial Average and S&P 500 indices are flirting around their record highs.

This is a far cry from the depths experienced in 2009 following the credit crisis. Are there any differences in the market structure before and after the crisis?

Daryl Guppy: Since 2008, there have been changes in the market structure. During the crisis, many people lost money and exited the markets.

While some have returned, many have chosen to enter the markets via exchange traded funds (ETF) instead of individual stocks to diversify their risks.

This has contributed to the growth of ETFs and high frequency trading (HFT). In the New York Stock Exchange, ETFs account for about 45 percent of the market’s trading volume while HFT is responsible for about half.

This resulted in a shift of liquidity away from the lower- and middle-end into the upper-end of the market. Unfortunately, the concentration of liquidity at the upper-end of the market means that there are limited opportunities for meaningful profits.

This also means that the trading techniques that used to be appropriate for the lower- and middle-end of the market, are not as successful as they were before.

The key purpose of a secondary market is price discovery. However, HFT and ETF distort that purpose due to the nature of their businesses.

When an ETF receives a sell order, it offloads a proportion of all the stocks in its portfolio in order to maintain the ratio, regardless of the underlying performance of an individual stock.

This means that an individual stock may be sold down, if it’s part of an ETF, even though its underlying trend is strong.

The rise of ETFs has compromised the link between price discovery and valuation while volatility has been amplified as trend changes tend to take place very rapidly now, compared to six years ago.

SI: How about other asset classes like foreign exchange (FX) and commodities?

D: While the FX markets provide liquidity unavailable elsewhere, it poses a different set of challenges. In the FX market, about half the participants do not wish to be there.

For example, if you go to a bank to exchange Singapore dollar for US dollar, they have to serve you irrespective of the house view on the currency pair.

However, if they think that the US dollar will appreciate against the Singapore dollar, they will enter the FX market to convert it back into US dollar.

Psychologically, price behaviour in the equity markets reflects genuine buyers and sellers as everyone is there voluntarily, while the FX market is filled with unwilling participants.

As such, the same pattern seen in both the FX and equity markets may hold different meanings.

Although commodity markets are similar to the equity markets in terms of intention – both wish to be there – the former is driven by a host of fundamental reasons to a larger extent than the other markets, particularly if you look at the soft commodities.

Personally, I steer clear of soft commodities as seasonal and weather events, which are out of human control, have profound impact on their prices.

While hard commodities like gold and silver are exposed to external factors as well, they are not impacted quite the same way as the soft.

SI: Given the changes in the market structures seen, what can a retail player do?

D: Retail traders have to move towards platforms that offer better price discovery potentials, such as derivatives and FX.

If one chooses to remain in the equity markets, using CFDs and warrants instead of the underlying stock, could help mitigate risk that arises from time in the market.

SI: What are some chart patterns you employ in your analysis and trading?

D: In the broader market, head and shoulders and rounding top patterns are useful in identifying an end of a trend.

On a shorter time frame, parabolic, triangle and flag patterns as well as simple trend, support and resistance lines are incorporated into my analysis.

SI: Moving forward, what are your predictions for the major equity indices?

D: I think the bull run experienced in the Dow and S&P would continue and buying on dips is favoured. However, I will pay attention to the formation of any end of trend patterns.

Presently, both indices are in trading bands. For the Dow, price action is clustered around 17,000 to 18,000 without any massive upside targets. For the S&P, the immediate resistance level is 2,150 with a support found at 2,000. The next support is seen at 1,850.

In China, the Shanghai Stock Exchange Composite Index is developing a major fan pattern. The last time we saw such a development was in 2005/06, prior to the run up from 2006 to 2008.

The fan pattern suggests that a genuine trend change is taking place and likely to be a sustainable uptrend.

Currently, the Shanghai index has a resistance at 2,260. We expect the market to come back potentially to as low as 2,160, before establishing a more stable long-term uptrend.

On local shores, the Straits Times Index is struggling to stay above 3,300. A potential upside target is 3,450, which was the peak made in May 2013, while the potential downside is 3,250.

SI: What is a key factor of success for any trader or investor?

D: Investors spend a lot of time worrying about the entry. Traders worry about the exit. You will have your fair share of winners and losers in the technical or fundamental realm.

The key denominator in successful people in the market is a disciplined approach to risk management. This means setting and abiding by appropriate stop losses while allowing the winners to run with a trailing stop.

Personally, I have a maximum stop loss of 2 percent of total trading capital in each trade, regardless of the size of the individual trade.

Although one may find a high probability trading system, we should not be discouraged during clusters of losses, as the system is based on long-term results.

It simply means that you may have to make some adjustments to suit the current market conditions.

Any fool with money can buy, it takes intelligence to sell.

Daryl is accredited with the development of the Guppy Multiple Moving Average and has his own trading system – ANTSSYS. The trading software is available on Oanda and MetaTrader 4.
Currently pursuing his Chartered Financial Analyst qualification, Shane provides coverage on the property, consumer and environmental sectors at Shares Investment.

Please click here for more information about this author.

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