Why are they cheap?
Traders often buy options that have nominal time to expiry, which means that their bought asset is depreciating like a time bomb. Most options expire worthless and are only ever traded once. People don’t like to be “wrong”. They would rather sweep their bad trade under the carpet, along with any remaining value that they could claim by closing out their position, than confess that the trade didn’t work. There is no room for this type of ego in trading.
Often, naive traders underestimate the strength of a move required to affect the price of the option. These unfortunate souls believe that, even though BHP may have increased by only 10 cents in a month, it could potentially jump $10 within three days (when their option expires). Magically, BHP should recognise the brilliance of the trader with the deal in play and co-operate!
The concept of delta and gamma becomes extremely important in this situation – but, rather than learn what these terms mean and how to use them, overly optimistic traders would rather just place their orders and take their chances.
Delta measures the sensitivity of an option price to changes in the share price. Gamma measures the curvature of delta, so it can act as a precursor indicator when to exit a position. For advanced option plays, these two “greeks” or “option sensitivities” can greatly assist your chances of extracting a substantial profit.
When you next see that amazing bargain option at two cents, ask yourself why it is that price. Maybe there is a reason that you haven’t explored. Perhaps you are about to buy an option that is actually worth that small amount, not an option that has been mistakenly under-priced by market dynamics.

Brokers
Brokers receiving commission based on the number of contracts you buy – rather than your overall exposure – may urge you to buy cheap options with a short time before expiry because they make more money. This way, they convert your trading capital to brokerage with lightning precision. Don’t rely on your broker to guide you in this arena. Stand on your own two feet and take responsibility for your future by educating yourself about options, and identifying trades with a higher probability of success.
There is much less risk on the part of the broker when dealing in bought positions in comparison to written positions. Written positions contain contingent liability. This requires careful monitoring by both the client and the broker to eventuate in a profitable trade.
Alternatively, your trading account can be loaded up with bought positions without the need for close monitoring. With bought options, the worst thing that can happen is that you will lose everything you placed into the trade -you can’t lose your house. This is much simpler for brokers to monitor, and has the side benefit of their not ending up behind bars for inaccurate suggestions that led to their client’s financial collapse.
Buying at or in the money options with two to four months to expiry will often seem like a more expensive trade, but it is much more likely to eventuate in a profitable trade.

Written positions
When I first started writing naked options on NAB, I reached a startling conclusion. I was presented with two choices. I could choose to write five close-to-the-money option contracts, where I would seemingly take on more risk as the share price could easily break through my strike price, or I could write 28 option contracts that were miles out of the money, yet receive the same amount of money overall. For a brief moment, I thought I was completely brilliant!
Can you see the problem with writing more contracts but receiving the same amount of money in total? If you can’t see the problem with this, stop writing options immediately! I have one word that you must learn about before you progress: EXPOSURE.
By writing many more cheap option contracts, it seems as if your trade has a higher probability of success. However, what happens if a huge announcement is made, or if the share price goes ballistic? Your exposure is completely blown out of the water! Rather than being liable for 5000 NAB, I would have become responsible for 28,000 NAB if the trade had backfired. Yikes!
When we begin our trading career, we are strong, brave and bulletproof. The market had better not cross us. Unfortunately, the trading world doesn’t work this way, and often the market will provide a proverbial kick to our soft underbelly to ensure that we don’t repeat our past errors of being too cocky.

Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of four best-selling books – The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. Register on her website to receive a free trading plan template and a 5-part e-course to get you trading like a machine.

In search of the Holy Grail

Expectations are a powerful thing and unfortunately, many trading related articles paint the illusion of the fast road to riches and incredible wealth by following a simple red line crossing above the green line. Often the expectation is set in place that the system you are about to purchase, the Expert Advisor (EA) you are about to download or the trading educator providing their ‘life’s work’ is going to be the Holy Grail, finally providing you with enough profits to say goodbye to the daily 9-to-5 grind. In reality, there is no Holy Grail when it comes to trading systems, but instead, successful trading is a combination of consistently identifying sensible risk reward opportunities with persistence and discipline.

What is the risk reward ratio?

In its most basic form, the risk reward ratio is exactly what it says on the box. It is the amount of potential reward, relative to the risk you take on. In the table below I’ve listed the various trading instruments with hypothetical stop loss and profit taking levels and the risk reward levels that these generate. By way of example, you can see the risk reward ratio is a function of the size of the stop versus the size of the potential reward.

Risk reward levels can be applied to all time frames across any asset class and can even be used for other investments as well – such as managed funds, property or business – but today we’ll be focused on applying this to our trading.

How do you calculate the risk reward for potential trades?

Calculating your risk reward is relatively simple and is often done using technical levels on your chart, such as support/resistance levels, Fibonacci, Average True Range (ATR), Ichi Moku and price projection based on chart patterns. While not exact, they do provide a method to determine the potential risk reward on your upcoming trading opportunities, allowing you to focus on those with the highest potential.

Three ways to take advantage of the risk reward ratio in your trading.

1. Only trade opportunities that meet your risk reward levels and are within your tolerance for risk

Ultimately you need to understand that you control when you pull the trigger to execute a trade, which means you are responsible for each trade you take. For the savvy trader, this is good news. You have the flexibility to take trades that meet your criteria and more importantly, reject those that aren’t up to scratch. Set a benchmark for trades you will accept, such as only trading those opportunities with a 1:2 or 1:3 risk reward ratio.

2. Remove the emotion from your trading

No trader enjoys being wrong, but since most trading systems are wrong 40-60% of all trades, some traders cannot help but get caught emotionally and let this deter them from taking the next trade. It is not uncommon for traders to be immobilised by the fear of loss and just the thought of executing the next trade is enough to induce a cold sweat, and in some extreme cases, being physically ill. By focusing on the risk reward of the trade and understanding the numbers of your trading system (percentage win and average size of wins compared to losses), traders are able to confidently take the next trade, knowing full well that the outcome is unknown but they have put the odds of a successful trade in their favour. This factor alone is one of the most powerful ways to gain control of your trading edge in the markets and will allow you to fully exploit the advantages you have built into your trading system.

3. Scale up once you have built the confidence in your trading system

You’ve now identified the risk reward of every trading opportunity and only take those that meet your strict criteria. You’ve also removed yourself emotionally from the thought of being right or wrong on the next trade. You’ve also managed to discipline yourself over the past six months with these principles and you’ve built up your confidence enough to scale up your capital base to the next level from your current base. Congratulations. This is the path of a mature, successful and constantly improving trader.

By applying the concept of risk reward when identifying your next possible trades, you have, over time, put the odds of success in your favour and are now able to allocate a sensible amount of risk to your trades, but at a higher level than before.  For example, when testing over the first six months, you allocated say $200 risk to every trade (1% of $20,000 capital base), just to test the validity of your system and to build confidence in your trading system. Now you have $50,000 in capital to allocate, of which you will still allocate 1% risk – but now it will be $500 per trade and your profitable trades will potentially be a multiple of your higher capital base.

Imagine doing this over a two-year period, building confidence in your system(s) every six months and upon evaluation, considering whether you can scale up to the next level, always staying within a dollar risk amount that allows you to sleep comfortably at night. What level of trader would you be two years from now or perhaps five years from now?

Hopefully those are motivating thoughts and inspire you to utilise the power of risk reward ratios in your trading and more than surpass your trading goals and financial objectives well into your future.

Ashley Jessen is the author of CFDs Made Simple and Director of Communications at Invast Financial Services, one of the largest global markets brokerage firms offering Forex, CFDs, Direct Equities and their proprietary ST24 platform.

So a double top makes an M formation, while a double bottom makes a W formation. These patterns often recur because, when a price hits resistance or support, traders will begin to close their existing trades and this will cause the price direction to reverse.
The most successful double top or bottom trades occur when the pattern is confirmed using Fibonacci retracement levels. This means the retracement should be at least 38.3% of the prior move.
If we look at the price of gold from the beginning of July to late August 2011, we can see what might be the start of a double top pattern. The price of gold reached a high of USD 1,912.45 an ounce on August 22, and fell back to the 38.2% level on August 24. On August 25 the price continued to fall, almost hitting USD 1,700 an ounce.

Confirmation

Many traders would open a long position now, anticipating the double top with limit orders around the previous high. However, this can often lead to unnecessary losses. In the gold example, if a trader had opened a position at the 38.2% retracement, near USD 1,747 an ounce, his stop probably would have been triggered before the price started to climb again.
The signal to look for is a red candle forming at the resistance levels. In the gold price, this happened on September 6, when gold hit USD 1,920.

Entering the trade

Rather than automatically selling on the next candle, a safer strategy is placing an order somewhere in the middle of the previous day’s range. That way, if the price continues to rise you won’t be caught out. And if it falls, you still have a strong entry price.
In this case, because the next candle was so much lower than the previous one, you could have ordered your trade to open at USD 1,900 and placed a stop at the resistance level of USD 1,920.

Exiting the trade

Two simple ways to exit this trade are either having a profit target, where you would automatically exit the trade when the gold price hit a certain level, such as USD 1,700 (securing you USD 200 in profit), or using a trailing stop (depending on the options offered by your trading provider).
A trailing stop is a stop that will follow a price as it moves in your favour. So, if you had set your trailing stop at USD 20, it would follow the gold price down, always remaining USD 20 behind the most favourable price, closing your trade once the price travels back up through your stop.
The price of gold hit a new low of USD 1,532.70 on September 26, which would have brought your trailing stop down to USD 1,552.70. Later that day, when the price of gold started to rise, you trade would have been closed automatically at USD 1,552.70, securing you USD 347.30 an ounce in profit (excluding any charges such as the dealing spread, commissions, interest and other fees).

Conclusion

The fact that double tops and bottoms are such common patterns means that there is a strong awareness of them among traders, and this results in these patterns being strengthened as traders buy and sell to conform to existing support and resistance. Combining double tops and bottoms with Fibonacci retracement levels, along with waiting for confirmation, increases the potential of this strategy’s success.

This article was written by Jacqueline Pretty at IG Markets.

The dividend low down
There are a few basics that traders need to remember at dividend time.
A company will usually announce its actual dividend amount at the time it reports profits. At this time, the company will also announce the “ex-dividend date” along with the record date and the payment date.
For traders looking to participate in some dividend stripping, the most important date is the ex-dividend date. The ex-dividend date is the date on which you must be holding the stock in order to be entitled to the dividend.
The record date is the date on which the company tallies up who is due for dividend, while the payment date is the date on which the cheques are sent out (or, in the electronic age, the money is credited to your account).
Some companies announce profits and then announce an ex-dividend date in as little as three days time after the announcement. However, other companies will declare ex-dividend dates up to two months in advance.
In short, if the trader buys the share on or after the ex-div date, they are not entitled to the dividend payment.
For those in low tax environments, such as super funds and retirees, the company’s franking credits are also attractive, as no tax or very little tax is payable on franked dividend income, depending upon the individual’s marginal tax rate.
This makes dividends one of the best sources of income and is even more attractive for self managed super funds as even if they don’t pay tax, they are still entitled to a franking rebate.

How to do it
The share is bought before ex-dividend (ex-div) date, thereby collecting the dividend and associated franking credits, then selling the share after ex-div date with the aim of collecting a capital gain.
But for traders that are looking to take advantage of the franking credits, you will have to hold the stock for 45 days in order to be entitled to benefits.
Franking credits are essentially the tax that a company has already paid on its earnings. Because the company has already paid some tax, you don’t need to, and therefore you receive credit for the tax already paid.
The 45-day rule only applied to traders that earn more than $5000 worth of imputation credits. If you are not likely to receive more than $5000 worth of imputation credits, you can buy the stock the day before the ex-dividend date and sell it the next day if you like.

Free lunch? No
Dividends aren’t exactly free money: nothing is that easy. There are a number of pitfalls for careless traders.
In particular, be careful of stocks paying large, one-off dividends. This is because a lot of traders will tend to buy the stock for the dividend and sell it the next day. To best execute the strategy, look to strip companies that pay large regular dividends, such as the banks or Telstra.
Also, don’t leave it too late. Do your homework so you know when companies are likely to pay dividends. Most companies pay dividends at roughly the same time each year.
Most traders say that ideally the stock needs to be bought before the sudden price rise prior to going ex-div. In fact, earlier the better, really.
This is because many stocks actually rise strongly just before the dividend goes “ex”. For example, Commonwealth Bank gained 10% in the 10 trading days before its last ex-dividend date back in February.
In theory, after its ex-dividend day, the stock should fall by the amount of the dividend payment.
To get back to fair value, the stock can actually fall further than the dividend, resulting in a capital loss. And there’s the brokerage further adding to the loss.
A big move lower after a dividend is generally more the case with shares in downtrends rather than uptrends, so think about applying some technical analysis to the dividend stripping scheme.
So, it takes some fancy footwork and strong knowledge of the market to buy a stock, grab its dividend and franking credit and move on to the next one.
Of course, this strategy becomes more dangerous in more volatile or bearish market; especially a market such as the current one where the increasing levels of selling pressure means literally anything could happen.

Recent market action means that you might need to be more cautious with this strategy over this dividend season.

According to the ATO website, the key hurdles to be met include:
1. the nature of the activities, particularly whether they have the purpose of profit making
2. the repetition, volume and regularity of the activities, and the similarity to other businesses in your industry
3. the keeping of books of accounts and records of trading stock, business premises, licences or qualifications, a registered business name and an Australian business number
4. the volume of the operations, and
5. the amount of capital employed.

What does this all mean? Basically, to be classified as a trader, the perfect trader would need to have a home office set up, with computer and internet, and a decent sized trading account (although that’s not crucial).
In some example rulings, the ATO suggests that a trader carrying out just 60 transactions in a year could qualify as a trader. And that’s not trades, that is, open and closed positions, that’s just opening or closing a trade.
To anyone who has traded for any length of time, 60 transactions would be seen as hardly any trades at all. Some traders do that in a day!
The other factor that the tax office looks for is repetition. So, if you are trading around the same amount, risking about the same and looking to make broadly the same amount, that will help you achieve trader status.
You are also able to meet the repetition hurdle by having an in-depth trading plan. According the ATO, a trading plan should include some or all of the following criteria, such as an analysis of each potential investment, an analysis of the markets and market sectors you trade, an understanding how profit will be made and a clear basis for making you trading decisions.
How are they treated?
The most important factor is, of course, capital gains tax. Your classification by the ATO will affect the way you are treated for capital gains purposes.
For investors, any losses incurred from trading, including shares, options, CFDS and forex, will be treated as a capital gains loss for tax purposes.
In this case, you can offset these losses against any capital gains you make in this year, or in previous or future years.
For those classified as traders, however, they must claim any wins as assessable income and can only claim losses against other income.
With share CFDs, however, note that there are no franking credits and the 50% discount for holding an asset for longer than 12 months does not apply. And that goes for whether you are an investor or trader.

What do you want to be?
So, the important question is whether it is better to be an investor or a trader. As always, it depends on your personal circumstances.
For example, a share trader will not qualify for the 50% capital gains tax discount, explained below. For share investors, capital losses can only be used only to reduce capital gains, whereas revenue losses by share traders can be applied against any income or gain.
For example, a trader can offset any costs such as education, books and magazines, as they incur. So each year a trader can get a deduction for costs that have incurred.
On the other hand, an investor can also claim these types of costs, but only once they have realised a capital gain, and in those cases the costs are used to offset the capital gains.
Finally, it wouldn’t be an article about tax and trading without this little disclaimer: always check with your accountant for a comprehensive understanding of your own personal circumstances.

The long and the short

According to the Australian Taxation Office website, while the tax office considers each case on its individual features, it helps outline the difference in broad terms.

A share trader is a person who carries out business activities for the purpose of earning income from buying and selling shares.

This person’s position may be briefly summarised as:

• receipts from the sale of shares constitute income
• purchased shares would be regarded as trading stock
• the nature, regularity, volume and repetition of the share activity are consistent with those of a share trading business
• costs incurred in buying or selling shares are an allowable deduction in the year in which they are incurred, and
• dividends and other similar receipts are included in assessable income.

A share holder is a person who holds shares for the purpose of earning income from dividends and similar receipts.

This person’s position may be briefly summarised as:

• the cost of purchase of shares is not an allowable deduction, but is a capital cost
• receipts from the sale of shares are not assessable income – however, any net profit is subject to capital gains tax
• a net loss from the sale of shares may not be offset against income from other sources, but may be carried forward to offset against future capital gains made from the sale of shares
• costs incurred in buying or selling shares are not an allowable deduction in the year in which they are incurred, but are taken into account in determining the amount of any capital gain
• dividends and other similar receipts are included in assessable income, and
• costs (such as interest on borrowed money) incurred in earning dividend income are an allowable deduction at the time they are incurred.

Source: ATO website

The Institutions
Institutions issue buy or sell orders for a variety of reasons. It may arise from a strategic shift in weighting from one sector to another, increasing or decreasing exposure to the market generically, the impacts of currency shifts or oil and commodity prices on a company.
Large overseas funds move into and out of countries and in fact regions based on sophisticated computer analytics or chase currencies that react in certain ways. For example, they might be tracking the Australian dollar (AUD) to commodities prices and then invest in the underlying stocks with the required exposure. What is important to note is that these buy and sell decisions are often not connected with decisions made by the average retail trader or investor.
So these institutions, having decided a particular stock is no longer relevant to their current strategy will communicate that to ASX participants (stockbrokers) by dealers within these fund management organisations.

Inside the Stockbroking Organisation
Stockbrokers receive brokerage commissions only on what has been transacted, so of course it is in their own best interests to buy or sell an order in full. However clients will often set out parameters within which the order must be executed and they also have to do that within a market that may be reacting to external variables and influences.
Fund managers will judge the performance of a stockbroker against several criteria, including comparing the average market traded price against the Value Weighted Average Price (VWAP) of the share for that day.
When buying shares, an entry price lower than the average VWAP is desirable, and for selling, the stockbroker will be seeking a higher than average price. Scoring a better average traded price than the VWAP is a cause for celebrations and high fives all around. Conversely poor performance compared to the VWAP will go against the stockbroker’s rating, which could affect their ability to gain future business. So a large trade cannot just be lodged into the market to be sold as one bundle but must be managed.
It is important to note the brokers themselves are not trading on a prediction that a share price will go up or down, but market to market within a client’s instructions. The stockbroker has to break up their order into strategic parcels and monitor the market in order to achieve the highest (or lowest) average price possible.
So what does this mean, practically speaking?

The Trade
The largest component parcel will be traded in the first ninety minutes of trade, and you can often see where the big money is going to push the market and the trading range for the day.
When you look at intraday volume and the price range you will see the interaction of volume buyers and sellers transacting.
Occasionally something will occur during the day to cause a sentiment shift, such as a news story or company announcement, and it is important to review what the volume traders are doing. Are they sidelined pending instructions? The tell tale sign here will be volumes tapering off until research analysts determine likely repercussions.
The traditional stockbroking lunchtime is from 12.30-2pm and over lunchtime, volumes will tend to dry up but the thinking stockbroker might leave some orders in the system to snag a good fill and instruct the Designated Trading Representative (DTR) at the firm to monitor activities.
“Call me if it breaks $43.60 – you know where I’ll be!”
Generally they would be aiming for 65 – 70% of the order to be transacted by 2pm, leaving the balance to try and finesse a great trade in the remaining two hours of trade. Drip feeding the market through the afternoon should avoid a last minute panic. Irrespective they would probably keep some firepower up their sleeve for the last few minutes of trade. Just in case.
Then you panic because the market is not going the right way for you, so you quit the balance hitting the market with the remaining stock. After all you do want the brokerage – right?
You see a higher volume of shares enter the market right before close as brokers try to fill the final parts of their orders, finalise their commissions and make their clients happy. Not an easy combination.
So with this scenario in mind, take a moment to look at an intraday chart on your trading software and magnify the time period so you are looking at just one or two days and overlay these thoughts onto the price interaction and volume your are viewing. You might now be seeing behind the chart for the first time.

High Probability versus High Profit
In order for a 1:1 risk reward ratio to work, you would need to have a high probability trading strategy that is successful at least 65 to 70% of the time. This is not impossible especially if you are an ultra short term trader that is only looking to make a small amount of pips. However, in order for it to be net positive, more than half of your trades would need to be winners. For example, if you plan to risk 20 pips on every currency trade, with a return of only 20 pips, 50% of your trades would need to hit their profit targets in order for you to breakeven. Sixty percent of the trades would need to hit their profit targets for you to make 40 pips. If 70% of the trades were winners, then you would be up 80 pips on every 10 trades.
Here is an example of a high probability trading strategy that is loosely based off of the ‘Momentum Strategy’ in the second edition of my new book Day Trading the Currency Market. In this strategy, we are simply looking for the price to break the 20 Simple Moving Average on a closing basis and for the MACD to confirm the direction of the trade within the past five bars (the strategy uses five minute charts).
More specifically if the currency pair closes above the moving average and MACD has crossed from negative to positive within the last five bars, then we go long the currency pair. If price closes below the moving average and MACD has crossed from positive to negative within the last five bars, then we short the currency pair. Thirty pips are risked on each trade for a return of 30 pips.
As you can see in the following example of the GBP/USD four out of the five trades were profitable for a net return of 90 pips and an accuracy rate of 80%.

List of Trades

Trade #1 – LONG GBP/USD Entry at 1.4914, take profit at 1.4944 +30 pips
Trade #2 – SHORT GBP/USD Entry at 1.4925, take profit at 1.4895 +30 pips
Trade #3 – LONG GBP/USD Entry at 1.4930, take profit at 1.4960 +30 pips
Trade #4 – SHORT GBP/USD Entry at 1.4915, take profit at 1.4885 +30 pips
Trade #5 – LONG GBP/USD Entry at 1.4905, stopped at 1.4975 -30 pips

With a high-profit trading strategy however, the success rate can be far lower as long as the risk reward ratio is high. If you had a trading strategy that risked 50 pips for a return of 150 pips on every currency trade, you would only need to be successful 30% of the time to be net positive. In other words, if seven out of 10 trades were losers and three were winners, the net return would still be 100 pips.
A moving average crossover strategy is typically a high profit but low probability trading strategy. The following chart is an example of a strategy that is based upon a 10 and 20-simple moving average (SMA) crossover. In this strategy, we go long the currency pair when the 10-hour SMA crosses above the 20-hour SMA. The trade remains open until the currency pair breaks the 20-SMA. For a short trade, the guidelines are reversed. The currency pair is sold when the 10-hour SMA crosses below the 20-hour SMA; the exit rule remains the same. As you can see in the following example in the AUD/USD four out of the five trades were unprofitable for an accuracy rate of only 20%, but the net return was still 25 pips.

List of Trades

Trade #1 – SHORT AUD/USD Entry at 0.6465, exit at 0.6485 -20 pips
Trade #2 – LONG AUD/USD Entry at 0.6530, exit at 0.6470 -60 pips
Trade #3 – SHORT AUD/USD Entry at 0.6470, exit at 0.6495 -25 pips
Trade #4 – LONG AUD/USD Entry at 0.6520, exit at 0.6470 -50 pips
Trade #5 – SHORT AUD/USD Entry at 0.6380, exit at 0.6200 +180 pips

The difference between a high probability and a high profit trading strategy is that one focuses on small consistent wins while the other swings for the fences. Both can yield positive results in their own right, but swinging for the fences is the most common way to trade and may also be the reason why many novice traders have a tough time staying alive in the currency market. With a high profit trade which is characteristic of picking tops and bottoms, one may need to be able to survive a lot of misses before the big winner is hit. Unsurprisingly, high probability trading is usually synonymous with shorter trade trading while high profit trading usually applies to longer term trades.
Of course everyone hopes to find a trading strategy that is both high probability and high profit but doing so may be as difficult as finding the Holy Grail.

Two Lot Method

One way to increase the probability of winning trades is to follow the two lot method that I use in my forex signal service, BKTraderFX. In 2008, 80 out of the 103 trades were winners, for an accuracy rate of approximately 78%. With each trade, there is always a short target and a long target which means that I trade in multiples of two. The first target is usually easily achievable while the long target is two to three times risk. I always trail the stop as the trade progresses to lock in profits along the way because my trading motto is to never let a winner turn into a loser. The trades are always based on a combination of fundamental and technical analysis.

By trading more than two lots, you expose yourself to double the risk because if your stop is 50 pips away from your entry for example and you are stopped out on two lots, the real loss is 100 pips. This is why it is absolutely necessary to make sure that you are confident in your high probability trading strategy. If you are relatively certain that you can make 10 pips a day for example, then stick with that target and just adjust your trading size.

Two Different Traders, One Result
The type of trading strategy that you have is just as important as trade management. In the currency market, technical analysis is probably, hands down, the most popular way to analyse currencies. Both new and seasoned traders will spend the majority of their time looking at chart patterns, drawing Fibonacci levels, counting Elliott Waves or creating their own combination of indicators with the ultimate goal of developing a trading strategy that gives the perfect entry signal. Based upon my experience however the exit is just as important as the entry. A few years ago, I remember talking to Rob Booker, a fellow currency trader about the importance of entries and exits and he said to me that asking him this question is like asking a pilot what is more important – the take-off or the landing? I am sure that almost anyone who has been on a plane will agree that BOTH are important. This is why every single one of my trading strategies uses the two lot method.
While working at JPMorgan Chase, I once traded alongside two extremely talented FX traders. They went long and short the EUR/USD at the same time and interestingly enough both ended up making money. The trader who went long Euros traded off five minute charts and held his position for no more than 20 minutes while the trader who went short Euros traded off one hour charts and held his position for four hours. The reason why both traders were able to make money even though they had conflicting positions is because of trade management. I strongly believe that the management of the trade is critical to successful trading regardless of whether you practise high probability or high profit trading. How many times have you kicked yourself wishing that you had locked in profits or moved your stop?
As in cooking there is always more than one recipe for trading success and if you are frustrated with trying to adhere to a 2:1 risk reward ratio, high probability trading may be right for you.

Big or small?
There are a number of reasons why smaller investors might try to focus on the smaller end of the market. The major reason is because there are fewer large-scale institutional investors involved in this side of the market, there are more opportunities.
The reason large institutional investors stay away from this part of the market is because it becomes very difficult to buy and sell large amounts of stock. This means that these stocks are less liquid than larger stocks – and liquidity is all-important for institutional investors. If a large investors want to get out quickly, they are unlikely to do so without causing prices to move markedly. This results in these investors facing adverse price movement almost every time they enter or exit a stock.
While smaller investors face the same problem at time to time, it is by no means on the same scale. For larger investors, these smaller stocks are just not an option. With less influence from the larger investors, prices can often take longer to reflect news or changes in expectations. By the same token, smaller stocks are also more volatile – and this volatility can offer opportunity.

Which ones should you go for?
There’s a happy medium when it comes to stock size. Like Goldilocks’ porridge, the stock needs to be ‘just right’. While there are several definitions for what make a smaller company, at the least we can discount all the stocks in the top 100. The S&P/ASX Small Ordinaries Index, and many institutional fund managers, will classify ‘small companies’ as those companies included in the S&P/ASX 300 excluding stops that make up the S&P/ASX 100.
This equates to about 200 stocks, but in reality there are hundreds more, even excluding the microcaps and very speculative end of the market. As a rule of thumb, companies with a market capitalisation of between $50 million and $250 million probably qualify as “small cap” companies.

Corner the research market
The larger companies, especially the top 100 stocks, are all covered to the nth degree by the big broking houses. This result in a broadly consistent market view about the larger stocks. However, smaller stocks see much less research conducted on these companies.
This means there is a valuation gap at times between the company’s value and its share price. This can be exploited by savvy traders that do either their fundamental or technical homework. The slow realisation of investment communities as smaller stocks come on to their radar can also be beneficial. As more broker research is performed it brings more traders into stocks and this is another reason to try to get in early.

Trading the small caps
From a technical perspective, trading smaller stocks has both advantages and disadvantages. With fewer eyes on these stocks, trends can take longer to develop and give traders better opportunities to identify and establish trades. On the other hand, because of the lower liquidity, it can mean that larger players can affect the prices and throw you false signals. Longer term, trend-following indicators are best for traders looking to gain exposure to the smaller end of the market. These types of indicators include moving averages or the Parabolic Stop-and-Reverse system.

How to (and how not to!)
When trading smaller stocks, you are likely to have a longer expected holding period than you might when trading the top 20 stocks. With larger companies, traders are usually looking to take large leveraged positions and benefit from quick gains. But with smaller companies’ greater volatility, you might be looking to take fewer leveraged positions with wider stops.
The trader looking to gain the most benefit from smaller caps is therefore keen to stay in the trade for as long as possible. Therefore, using slower-moving averages, such as 50-day or 100-day moving averages, to determine trends and identify levels for stop losses can help you stay in a trade longer and reap the rewards of a multi-month move.
For technical traders, an easy initial screen of the market can be done by just looking at those stocks outside the top 100 that are making 52-week highs. Beware of stocks that are too small and don’t have enough volume for you to find it relatively easy to get in and out of stocks. Some experienced traders suggest traders avoid stocks that lots size of less than 20 to 50 times the size of your position. Additionally, many say to avoid stocks that don’t trade at least 1% of their overall issued shares each day. Other say to avoid stocks that trade under 50 cents or even $1 are better left to the more speculative punters.

Keep an eye out
Don’t forget the two best- performing stocks of the last decade – iron ore miner Fortescue Metals (FMG) and uranium producer Paladin (PDN) – were both minnows back in the early 2000s.