This article explores trading strategies for use by longer-term value-oriented investors. This article does not address day trading or momentum type trading strategies.
Trading issues faced by long-term investors include:
- minimum size of trades to efficiently spread out trading costs
- impact of buy/sell or bid/ask spreads
- use of market orders versus limit orders
- use of stop loss orders
- using share price volatility to advantage
- taking profits
- income tax considerations
Trading strategies involve choices and risks which may or may not pay-off. Trading strategies in several common situations are discussed below.
Minimum size of trades:
Trading charges for self-directed accounts at the major Canadian bank-owned brokerages are in the area of $30 per trade for up to 1000 shares. I consider $3000 to be the normal minimum size for an efficient trade. On a $3000 round-trip trade, (bought and then sold) about 2% is lost to trading fees. I consider this to be high. Even if you buy and hold, 1% is immediately lost to the trading fee. For stocks priced above $3.00, I would prefer to trade a minimum 1000 shares in order to spread out the trading charge as efficiently as possible. However, for most of us that would be unrealistic.
On more predictable dividend-paying stocks, you are more likely to be hoping for a 15% return in a year as opposed to a 100% gain. In these cases the trading cost is important because a 2% round-trip trading charge can eat up a large portion of your expected gain.
For highly volatile stocks, the trading charge may be the least of your worries. In this case you may be hoping for a 200% gain but also risking a 100% loss. In this case even a 5% round-trip trading charge may not be your biggest concern. In this case the minimum trade size is more likely to be set by the maximum amount that you are willing to risk, although you would not want to go so low as to incur a ridiculous percentage round-trip trading charge.
On “penny” shares (below $2.00), the bank-owned brokerages are charging about 1.5% of the trade value, with a $30.00 minimum. In this case as long as your trade is above about $2000 (i.e. $30/0.015) then you are paying 1.5% each way or 3% for a round-trip trade. Therefore, we should try to use $2000 as the minimum trade size, with about $1000 as a lower limit.
Investors should be aware of the trading charges of their particular broker and set minimum trade sizes accordingly.
Impact of Bid/Ask Spreads:
While broker trading commissions are a concern, they are at least highly visible. Buy/Sell spreads in contrast are rather nefarious in that they are a hidden cost of trading. For more detail see our article on understanding Bid/Ask spreads.
The difference between the bid price and the ask price is the bid/ask spread and should generally be considered to be an added cost of a round-trip trade. Sometimes this cost can be avoided when you are in a position to be patient, but the risk then is that the market will move against you while you are waiting for a favorable price.
Market Orders Versus Limit Orders:
A market order means that you will buy immediately at the best available asking price or sell immediately at the best available bid price. A limit orders means you will buy at or below your limit (bid) price or sell at or above your limit (ask) price.
A market order should generally be used when you are very motivated buy or sell and the stock is very liquid (high volumes traded and small bid/ask spread) and you entering the trade during the trading day. Since you are very motivated to buy or sell it is probably not worth the risk to try and enter a limit price to try to get a better price because the market could move against you and you could fail to make a trade that you were very motivated to make.
Limit orders should always be used for stocks with very high bid/ask spreads. Even if you are happy to take the current bid or current ask, it would not be safe to enter a market order on an illiquid stock since that bid or ask might suddenly change by a material amount just as you attempt to trade.
Limit orders should also generally be used when you are more ambivalent about making the trade. For example you think that XYZ is a probably a reasonable buy at $28 but you are a bit uncertain. In this case you might want to place a limit buy order at say $27. In this case you can take advantage of normal volatility and can often buy at the more attractive price by being patient. Sometimes though the price will rise away from you and you will miss an opportunity.
Orders placed when the market is closed are a special situation. When the market is closed, a situation often arises where there a a number of bid prices that are above the lowest ask price. This can’t happen when the markets are open, abecause the trades would have executed. When the market opens the orders where the bids and offers have “overlapped” will set the opening price. The stock market will determine a fair price at which all the overlapped orders will trade and this becomes the opening price. For example assume the closing price on a stock was $100, and assume that by the time the market is set to open there is an order to sell 1000 at $98 and another order to sell 1000 at $96, and assume there is an order to buy 2000 at $99. In this case while the market was closed these orders became overlapped. The average sell price is $97 and the buy price is $99. In this case, a fair opening price for these trades is $98. Traders may wish to avoid placing market orders when the market is closed because based on over-night news the opening price can be unpredictable. In this case it is logical to enter a Limit price. In this example if you suddenly became motivated to sell you could enter a limit sell at say $95, but you will receive the opening price if it is higher than your limit sell price.
Use of Stop Loss Orders
A Stop Loss order becomes an order to sell at the market as soon as any trade occurs at the specified Stop Loss price, which is set below the current market. If the market id declining sharply, the Stop Loss order could be filled at a price below the Stop Loss amount.
Long-term value-oriented investors do not tend to make heavy use of stop loss orders. The reason is that these investors tend to invest based on the underlying value of the company. For these investors a price decline may signal a buying opportunity rather than a time to sell. However, there may still be merit for using stop-loss orders in some cases.
The stop-loss order should be set lower than the stock would be expected to move on normal trading volatility. On a $22 stock you don’t want to be sold out at $20 on normal volatility only to se the stock bounce back to $22. However, perhaps a price of $18 is outside the normal range and might be more indicative of bad news that is more permanent.
Stop Loss orders could be used to protect against a large decline when news comes out, such as a disappointing earnings release. Stop Loss orders are much more applicable to very liquid stocks. On thinly traded stocks a stop loss order could see you filled well below the Stop Loss amount.
Stop Loss order are more applicable to riskier stocks where you are not as sure about the underlying value. If you are very sure that the stock is already under-valued, then you would not want to be sold out on a Stop Loss.
Using Share Price Volatility to Advantage
Thinly traded shares often exhibit huge volatility. For example, for shares trading around 20 cents, you may see occasional trades at 30 cents or more and at 10 cents or less and then see the price return to 20 cents.
When holding shares like this it may be advantageous to place a sell order at 50 to 100% above the current price. That way, if a some shares go out at a high rice spike, you can take advantage of it. The danger is that if there was good reason for the price increase, like a take-over offer or major good news, then you might have sold at too low a price. But as long as your sell price was well above the current market this strategy may often be advantageous.
Taking Profits
I believe that it usually makes sense to take some profits when gains reach 30% to 100% in a short period of time. Generally in these cases the share price has moved faster than the earnings and the stock is at least less of a bargain. A strategy of selling half the position by the time the gain has reached 100% in a short period of time, is probably sensible. However, if the company fundamentals and earnings are growing as fast as the stock price then it may not make sense to sell.
Income Tax Considerations
Investors in taxable accounts should be much more hesitant to take profits. In this case it may be better to risk a price decline than to accept the certain loss associated with paying income taxes. However, if the shares are clearly over-valued then it probably makes sense to take the profit and run.
END
November 1, 2003
Shawn Allen, CFA, CMA, MBA, P.Eng.
InvestorsFriend Inc.