Is Trading Bad for Your Wealth?

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On the surface I’m not a passionate man. I am British after all, and that “stiff upper lip” stoicism is inbred and reinforced at an early age. Those that know me, however, will tell you that, given certain subjects, I can become quite agitated; passionate even. Some areas of concern are universal, such as family and friends. Some are a little more esoteric; fine wine, great food, test cricket and Brentford F.C. will all get me talking as much with my hands as with my mouth. There is another thing that gets me all riled up.

Investors are frequently told that anything resembling trading is bad for their wealth. They should “buy and hold” like good little sheep. This may have been true when trading costs were prohibitive and information was at a premium, but in the modern age it is no longer the case.

The cynic in me believes that there are two reasons this is the standard advice. First and foremost, it is easier for the advisor. Trades are placed and then forgotten. There are no orders or levels to watch. Secondly, it lessens the chances of a firm getting in trouble. If your advisor routinely recommends duds, you can’t sue, you can only move, but advisors are told that if a “trade”, rather than an “investment” goes wrong they could be at risk.


I am not advocating that investors jump in and out of the market on a regular basis, nor do I advocate betting your entire nest egg on the next hot biotech sensation. I am not suggesting that individuals should day trade, attempting to compete with high frequency traders. What I do passionately believe is that there are some trading techniques that can be of enormous benefit to individuals.

Foreign exchange traders, for example, will often establish a position contrary to their overall view in order to establish a position later at an advantageous level. Let’s say a cable (GBP/USD) trader is ultimately bullish for Sterling but sees a wave of selling. He or she has three choices, they can pick a level to buy at and wait, hoping to buy there, buy into the selling and hope they hit the bottom, or trade into their desired position. In my experience most would do the latter. They will go with the flow and sell. If the move continues downwards, then, at a predetermined level they will buy twice as much as the original short position. If they sold 5 at 50 they might buy 10 at 30. This gives you a net position long 5 at 10 and enables you to set a stop-loss that minimizes or removes the potential of a real loss.

FX, of course, is fast moving and easy to trade both ways. It may not be practical or possible for many to trade stocks this way. The point, though, is that the much maligned practice of averaging a position is not always bad. If you know you are going to do it, and do it in a controlled manner, it can be helpful.

 

The above chart is for Micron Technology (MU), a semi-conductor manufacturer whose stock is frequently traded in ranges. Following a break out above $7, the stock moved rapidly to test the $8 level, but after three failed attempts to establish itself above $8 has fallen back a little. There are, in my opinion, sound reasons to buy the stock for the medium to long term, but this technical pattern is not encouraging in the short term. To an investor who thinks like a trader, this isn’t a problem. If you have a margin account, then you could try my preferred play here. Short MU at $7.80, with a view to buying twice as much at either around $7.20 (average $6.60/share) should that leg of the trade go in your favor, or at $8.10 (average $8.40/share) should it not. Stop losses just below key levels, say at $6.80 and $7.90 may be a good idea once the final position is established. If you don’t have, and don’t want, a margin account, you can go ahead and buy it now (around $6.80 at time of writing), but only for half of your intended position. The rest can be invested either on a clean break of $8, say at $8.20, giving an average of $8 per share, or on a drop back toward $7, at around $7.20, giving an average of $7.50. The same stop loss levels could be used.

This strategy involves potentially committing what some regard as the ultimate sin, averaging a loser, but in a controlled, deliberate manner. There is, as always, a chance that everything could go wrong and you would show a loss. No trade is foolproof, but with just a little effort you would give yourself a chance of owning the stock below the market. Those who are paid to trade do this kind of thing all day, why shouldn’t you?

Martin Tillier has been dragged, kicking and screaming, into the 21st century and can now be followed on Twitter @MartinTillier.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Forex and Currencies , Stocks

Referenced Stocks: MU

Martin Tillier


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