How to Avoid Being Burned by the Stock Market

Editor’s note: Murray Dawes is the editor of Alpha Wave Trader, a short-term trading service that trades stocks and indices from the long and short side. He is filling in for Harje while he is away overseas.

I’m guessing if you have chosen to spend your time reading Money Morning rather than playing Fortnite on your phone, you are on the lookout for useful information that will help you build your wealth.

None of us are getting any younger, and as we race towards retirement we often ponder if our nest egg is going to make the distance. Interest rates are at lows not seen in a generation, so a term deposit is hardly worthwhile. Interest is steadily increasing in corporate bonds because the return is solid, but you need to be sure you understand the credit risk involved.

The property market is on the nose and will probably get worse if Labor wins the upcoming election. The eradication of franking credit refunds for retirees who don’t pay tax will also hurt.

So there are not a lot of options left for someone who is eager to build their wealth as they head towards retirement in the next decade or two.

Getting involved in the stock market is appealing because there is the opportunity to get some big returns, but the volatility experienced by stocks is huge. The inexperienced person should either leave it to a professional or start trading with only a small percentage of their wealth.

There are of course people who have plenty of capital and are prepared to allocate a large amount to a trading account. But it is often people who are successful in other industries with plenty of capital who get themselves in the most trouble due to their overconfidence.

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The bigger your ego the bigger your fall

Being a successful doctor, engineer or CEO doesn’t mean you will be a successful trader or investor. The market couldn’t care less how clever you are. It takes no prisoners and as I said yesterday, the bigger your ego the bigger the fall.

The information I want to impart to you over the next few weeks is that there is a process for navigating the incredible volatility experienced when trading the stock market. You may not agree with my process at all and may have your own. If so, great.

But if you have been burnt in the past and are too scared to dip the toe in again…Or if you are too confused by the endless flood of information to make a decision one way or the other, I hope to give you the outlines of an approach that simplifies the mind-bending complexity and helps you to make clear decisions in an environment that is incredibly unstructured.

Fundamental analysis is incredibly important. I am not one of those purists who think that charts are all you need. I spend most of my time doing fundamental analysis because my technical analysis theory and risk management processes are set in stone.

I no longer need to work on my technical approach to the markets. I just need to find solid opportunities that I can apply my technical analysis rules to.

I run scans every week, month and quarter using specified rules.

That usually throws up a bunch of stocks that are potential trades. I then need to do the legwork of understanding everything I can about the business. The ownership, capital structure, balance sheet, debt, competitive landscape, past earnings trajectory and future potential. I call my contacts and track down any existing analysis and get in contact with the company if I think it is necessary.

When you have hundreds of stocks on your watch lists that is a LOT of work.

But at the end of the day, that fundamental analysis work is only part of the story. If you don’t have the technical knowledge to create solid risk/reward opportunities by knowing where you are proven wrong, and where you should be taking your first bit of profit so that you can be free carried on the trade, you will invariably end up getting yourself in trouble. Or at the very least tying your capital up in substandard trades.

By observing price action incredibly closely over many years (with the first five standing in the trading pits at the Sydney Futures Exchange), I have developed a simplified model of price action that reflects what is happening. The map is not the territory. Any model you create will always be a model and not reality.

But if your model reflects universal characteristics of price action and allows you to make informed decisions, it is far superior to relying on gut feel. With clear definitions you can analyse markets across different time scales and make trading rules that are repeatable.

If I ask you what ‘up’ or ‘down’ means in reference to the price of a stock, do you have a clear answer? Or do you think it’s such a simple question that you don’t need to think about it?

I assure you that answering that simple question can take years.

There is a huge amount of scepticism about technical analysis and rightly so when it pertains to most snake oil salesmen who read a $25 book on technical analysis and then consider themselves a professional. As far as I’m concerned, classical technical analysis is bunkum. As soon as someone starts talking about head and shoulders patterns or pennants and flags, I switch off.

But if I am going to discuss the patterns I look for, I need to describe them to you in detail and explain why they occur. We have three weeks to dive down deeply into the theory so any future articles that I write can make sense to you. So let’s get stuck into it.

The widening distribution

Money Morning

Source: Port Phillip Publishing
[Click to open new window]

Yesterday I introduced the widening distribution to you. It is an incredibly fascinating structure when you understand it. I will be giving you different characteristics of these structures as we go along, and you will be able to check everything I say by looking at your own charts on any stock or market you can name.

I am going to finish today’s article by giving you one characteristic of the widening distribution that can be used to enter powerful trades. It will also explain why I said yesterday that the US Dollar Index was a great buy at the end of 2017.

US Dollar Index monthly chart

Money Morning

Source: tradingview.com
[Click to open new window]

Yesterday I showed you the US Dollar Index with the three black dashed lines in the centre showing the point of control, which is the middle of the range and the top and bottom of the range.

Today I am adding in two blue dashed lines that are 61.8% (a Fibonacci level) above and below the initial range. The fascinating thing about widening distributions is that reversals often occur around that level, prior to a move back to the point of control.

Go and look at any stock or index and see if you can find a few of them and I will come back next week and give you more details on how you can use these structures to enter powerful trades.

Regards,

Murray Dawes,
Editor, Alpha Wave Trader

 


Murray Dawes is the Editor of Alpha Wave Trader and contributing Editor at Money Morning. He was one of five, from 5,000 applicants, chosen for a graduate position with the Swiss Banking Corporation — now part of banking giant UBS. The bosses quickly cottoned on to his potential and pushed him up the ranks as a futures broker on the floors of the Sydney Futures Exchange. Murray later broke out on his own, and developed custom trading systems to trade leveraged financial instruments like futures. Due to his success, Murray became the ‘hired gun’ trader for Australia’s rich and famous. Today, Murray runs a trading service through Port Phillip Publishing to help everyday Aussie investors use his advanced trading methods.


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