This is a collection of commonly used financial ratios to assess the health of a company, as part of fundamental analysis. They include financial ratios from categories such as: Management Ratios, Profitability, Liquidity, Working Capital, Debt Structure, Debt Protection.
The definition are taken from a financial course in Valuation which I took a few years ago. The definitions may be more Australian focussed but it should be mostly applicable to international companies too.
Please feel free to comment.....
Note that these formula will be used in later articles when I start analysing blue-chips. For technical traders and Gann followers, notice that as of today, the ASX has plunged for the third time, meaning either this is the bottom or there is one more to go. Hence my move to analysing blue-chips since this is the period to buy. I would leave biotechs for a while at least until it is quite certain we have hit the bottom of this cycle.
Tuesday, November 18, 2008
Monday, October 6, 2008
Analysis Update - PGL - Progen
Price($) 0.72
NTA ($) 1.31
P/NTA 0.546
Team 7.5
BurnPeriod 4.89
ProductPipe 2.4
ForeignMarket 1
Cash:Debt Debt Free
Following the abandonment of its most advanced study (Ph III PATHWAY study for liver cancer), this marks the third failure of the compound PI-88 (previous targeted applications were lung and Prostate cancers). Its other series of compounds (eg PG 500) are in pre-clinical stages of development. The company mentions it is focussing on M&A with the remaining funds. The product index has fallen to 2.4 which is below average.
Cash burn is a main indicator for yet to be profitable biotechs. In the case of PGL, its re-capitalisation in the last financial year of over $92m still leave PGL with over $76m this financial year. Simple projection, assuming constant cash burn indicate PGL can last over the next 5 years.
Other financial indicator point to a relatively strong position with no debt.
There are many questions to be asked of this company. The fundamental question is what will PGL do with its stash of cash? How could it have abandoned a late stage product, for which so much cash has been raised? What kind of perseverance can we see from PGL for its remaining early stage products?
Although it is currently trading much lower than its net tangible assets (almost half), investors need to be convinved by management that they can convert the pile of cash into greater return, rather than being consumed with no returns.
NTA ($) 1.31
P/NTA 0.546
Team 7.5
BurnPeriod 4.89
ProductPipe 2.4
ForeignMarket 1
Cash:Debt Debt Free
Following the abandonment of its most advanced study (Ph III PATHWAY study for liver cancer), this marks the third failure of the compound PI-88 (previous targeted applications were lung and Prostate cancers). Its other series of compounds (eg PG 500) are in pre-clinical stages of development. The company mentions it is focussing on M&A with the remaining funds. The product index has fallen to 2.4 which is below average.
Cash burn is a main indicator for yet to be profitable biotechs. In the case of PGL, its re-capitalisation in the last financial year of over $92m still leave PGL with over $76m this financial year. Simple projection, assuming constant cash burn indicate PGL can last over the next 5 years.
Other financial indicator point to a relatively strong position with no debt.
There are many questions to be asked of this company. The fundamental question is what will PGL do with its stash of cash? How could it have abandoned a late stage product, for which so much cash has been raised? What kind of perseverance can we see from PGL for its remaining early stage products?
Although it is currently trading much lower than its net tangible assets (almost half), investors need to be convinved by management that they can convert the pile of cash into greater return, rather than being consumed with no returns.
Thursday, October 2, 2008
Lightning Analysis - AVE - AEVUM Limited
Following huge volatility in the sharemarket over recent weeks, it is now time to look at commercial / industrial stocks, while always keeping an ear open in the biotech space. The reason is not of fear and panic of the market, but simply a recognition that there may be undervalued stocks out there. Note that, Warren Buffet's Berkshire Hathaway just invested US$3bil in GE preferred shares. This follows a US$5bil investment into Goldman Sachs 2 weeks ago.
Hence it is time to go hunting.....
One local aussie stock that look stable due to its nature of business is Aevum Limited (AVE). AVE is in the business of managing retirement villages. One would expect a steady income stream unaffected by the current market turmoil. The rationale is the AVE's clients would have saved up for their retirement and they would tend to belong to the higher than middle income group, thus able to support themselves.
Having selected the industry and company, next step is to dive into the financial statements (see its 2008 Annual Report) ...
The first focus is DEBT. AVE has long term debt of $80m; which appeared to be taken on during 2007-08, having repaid previous debt. This compares to cash of $17.5m, receipts of about $21m and total assets of over $809m. A large portion of assets comprise of investment properties at $790m, and little intangibles. On the surface this appears good, in terms of the relative size of the debt to hard assets, as well as the ability to service its loans.
The next thing to look at is the cash flows. Over the last 2 financial years, AVE has made significant acquisitions - $118m in 2006-07 and $52m in 2007-08. While this is not necessarily bad, there should be caution on companies that tries to grow too fast too quickly, especially in such a bear market, with worldwide recession looming.
Also from the operating cashflow, the net operating cashflow, although positive $20m, is made up of other quantities such as resident loans and bonds. The receipts from residents and subsidies are only $21m compared to payments to suppliers and employees of $31m. These two quantities should be considered the basis of the business and the outflow in this case is more than inflow.
The above discovery leads to a more careful look at the profit statement. Overall, the profit is $28.5m, compared to $22.9m the previous year. Looking at the details again, out of the $60m gross income, only $24.7m is from revenue, the remainder is due to revaluation of property. This compares with an expense of $28.4m. The question is, without going to the actual sites nor knowledge of the real market price, can we believe that the properties can be revalued to an extra $35m? Clearly without the revaluation, there would be a net loss.
The summary is that AVE looks to be a business that would be stable in a frightening bear market. But open closer inspection of the financials of the company, the real amount of money made from the business does not look too promising.
Hence it is time to go hunting.....
One local aussie stock that look stable due to its nature of business is Aevum Limited (AVE). AVE is in the business of managing retirement villages. One would expect a steady income stream unaffected by the current market turmoil. The rationale is the AVE's clients would have saved up for their retirement and they would tend to belong to the higher than middle income group, thus able to support themselves.
Having selected the industry and company, next step is to dive into the financial statements (see its 2008 Annual Report) ...
The first focus is DEBT. AVE has long term debt of $80m; which appeared to be taken on during 2007-08, having repaid previous debt. This compares to cash of $17.5m, receipts of about $21m and total assets of over $809m. A large portion of assets comprise of investment properties at $790m, and little intangibles. On the surface this appears good, in terms of the relative size of the debt to hard assets, as well as the ability to service its loans.
The next thing to look at is the cash flows. Over the last 2 financial years, AVE has made significant acquisitions - $118m in 2006-07 and $52m in 2007-08. While this is not necessarily bad, there should be caution on companies that tries to grow too fast too quickly, especially in such a bear market, with worldwide recession looming.
Also from the operating cashflow, the net operating cashflow, although positive $20m, is made up of other quantities such as resident loans and bonds. The receipts from residents and subsidies are only $21m compared to payments to suppliers and employees of $31m. These two quantities should be considered the basis of the business and the outflow in this case is more than inflow.
The above discovery leads to a more careful look at the profit statement. Overall, the profit is $28.5m, compared to $22.9m the previous year. Looking at the details again, out of the $60m gross income, only $24.7m is from revenue, the remainder is due to revaluation of property. This compares with an expense of $28.4m. The question is, without going to the actual sites nor knowledge of the real market price, can we believe that the properties can be revalued to an extra $35m? Clearly without the revaluation, there would be a net loss.
The summary is that AVE looks to be a business that would be stable in a frightening bear market. But open closer inspection of the financials of the company, the real amount of money made from the business does not look too promising.
Thursday, August 28, 2008
News - Alerts and Biotechs writeup
Two quick items on this post:
1. Get emails sent to you when your company made any announcements. You can do this by signing up to www.newsalerts.com.au .
2. An article by "The Australian" entitled "Drug trials revive interest in biotechnology sector" introduces a few local biotechs.
The article is found mirrored here:
Tim Boreham | August 20, 2008
THE biotechnology sector is showing tepid signs of life, having outperformed the overall market in recent months. Of course that isn't saying too much and the trends are patchy, but at least the sector doesn't rival the Gaza Strip as a no-go zone any more.
Such is the improving sentiment that a few of the minnows are muttering about a capital raising. For instance, vaccine champion Avantogen (ASX code: ACU) might have a chequered history, but this hasn't stopped new management from doing the broker rounds ahead of an equity raising of up to $8 million.
If anything, the established players have been doing it toughest. Biota, for instance, abandoned its monstrous damages action against Glaxo, while CSL's share price took a hit after US partner Merck revealed disappointing sales of its Gardasil cervical cancer vaccine.
Elsewhere, some interesting clinical trial results have maintained patchy interest in the sector.
There's always a sane reason not to get too carried away by early-stage results from thinly capitalised companies, but there's a few to which warm-hearted Criterion will extend the benefit of the doubt. Take Living Cell Technologies (LCT), the Kiwi outfit working on a diabetes cure based on the pancreatic islets of specially bred pigs.
In July, Living Cell reported the first five diabetes sufferers implanted with the said porcine cells showed no adverse side-effects but also displayed better than expected benefits.
The Moscow-based trial saw a reduction of daily insulin requirements of 23 per cent to as much as 100 per cent, while four out of five maintained "good control" of blood sugar levels. Living Cell has a $10 million and (probably) the capacity to raise equity, so it's at least one to watch.
Then there's our skin disorder friend Clinuvel (CUV), which gained US fast-track approval for one of its key compounds.
Clinuvel announced the US regulator, FDA, had granted "orphan drug" status to afamelotide (formerly CUV1647), aimed to treat a rare sun allergy called EPP.
Clinuvel's next step -- and there's always a next step -- is to apply to undergo a commercial trial in the US. Still, it's backed by $25 million and has a legitimate seat in the "most likely" camp.
Investors in regenerative medicine pioneer Mesoblast (MSB) are having a blast after nine patients had their broken legs healed with the use of their own stem cells. The ground-breaking trial took place at Royal Melbourne Hospital, with Mesoblast holding the right to commercialise the know-how. It's all very promising, but any revenues of course are years away.
On a more downbeat note, cancer drug Progen (PGI) has benched its experimental liver cancer drug PI-88 after years of attempts to develop the drug. It's a major disappointment in that Progen has raised almost $100 million over 18 months, with nothing to show but $77 million of change.
On a more modest scale, Biosignal (BOS) is headed for a spell in the naughty corner after disappointing your columnist about thrice too often.
The bacterial slime buster is working on an extract from seaweed that prevents the bugs from multiplying on surfaces by impeding their ability to communicate.
The trouble is, the company lacks focus in terms of developing end-uses for the extract, with a number of collaborations -- including one with Californian New Age squillionaire Paul Hawkens -- falling through.
Recommendation-wise, it's hard to be too proscriptive across what's a highly eclectic sector. As a general rule, your columnist leans to cashed-up advanced-stage prospects.
Candidates include Clinuvel, Avexa (targeting HIV), Chemgenex (leukemia), Neuren (neuroscience), Novogen (cancer) and Pharmaxis (bronchiectasis and cystic fibrosis)
According to Biotech Daily analyst Marc Sinatra, Chemgenex's drug "looks the most likely to generate big returns for investors".
He adds that any could surprise. "One thing for sure is that at today's prices all of them look like good value," he says.
The Australian accepts no responsibility for stock recommendations. Readers should contact a licensed financial adviser.
1. Get emails sent to you when your company made any announcements. You can do this by signing up to www.newsalerts.com.au .
2. An article by "The Australian" entitled "Drug trials revive interest in biotechnology sector" introduces a few local biotechs.
The article is found mirrored here:
Tim Boreham | August 20, 2008
THE biotechnology sector is showing tepid signs of life, having outperformed the overall market in recent months. Of course that isn't saying too much and the trends are patchy, but at least the sector doesn't rival the Gaza Strip as a no-go zone any more.
Such is the improving sentiment that a few of the minnows are muttering about a capital raising. For instance, vaccine champion Avantogen (ASX code: ACU) might have a chequered history, but this hasn't stopped new management from doing the broker rounds ahead of an equity raising of up to $8 million.
If anything, the established players have been doing it toughest. Biota, for instance, abandoned its monstrous damages action against Glaxo, while CSL's share price took a hit after US partner Merck revealed disappointing sales of its Gardasil cervical cancer vaccine.
Elsewhere, some interesting clinical trial results have maintained patchy interest in the sector.
There's always a sane reason not to get too carried away by early-stage results from thinly capitalised companies, but there's a few to which warm-hearted Criterion will extend the benefit of the doubt. Take Living Cell Technologies (LCT), the Kiwi outfit working on a diabetes cure based on the pancreatic islets of specially bred pigs.
In July, Living Cell reported the first five diabetes sufferers implanted with the said porcine cells showed no adverse side-effects but also displayed better than expected benefits.
The Moscow-based trial saw a reduction of daily insulin requirements of 23 per cent to as much as 100 per cent, while four out of five maintained "good control" of blood sugar levels. Living Cell has a $10 million and (probably) the capacity to raise equity, so it's at least one to watch.
Then there's our skin disorder friend Clinuvel (CUV), which gained US fast-track approval for one of its key compounds.
Clinuvel announced the US regulator, FDA, had granted "orphan drug" status to afamelotide (formerly CUV1647), aimed to treat a rare sun allergy called EPP.
Clinuvel's next step -- and there's always a next step -- is to apply to undergo a commercial trial in the US. Still, it's backed by $25 million and has a legitimate seat in the "most likely" camp.
Investors in regenerative medicine pioneer Mesoblast (MSB) are having a blast after nine patients had their broken legs healed with the use of their own stem cells. The ground-breaking trial took place at Royal Melbourne Hospital, with Mesoblast holding the right to commercialise the know-how. It's all very promising, but any revenues of course are years away.
On a more downbeat note, cancer drug Progen (PGI) has benched its experimental liver cancer drug PI-88 after years of attempts to develop the drug. It's a major disappointment in that Progen has raised almost $100 million over 18 months, with nothing to show but $77 million of change.
On a more modest scale, Biosignal (BOS) is headed for a spell in the naughty corner after disappointing your columnist about thrice too often.
The bacterial slime buster is working on an extract from seaweed that prevents the bugs from multiplying on surfaces by impeding their ability to communicate.
The trouble is, the company lacks focus in terms of developing end-uses for the extract, with a number of collaborations -- including one with Californian New Age squillionaire Paul Hawkens -- falling through.
Recommendation-wise, it's hard to be too proscriptive across what's a highly eclectic sector. As a general rule, your columnist leans to cashed-up advanced-stage prospects.
Candidates include Clinuvel, Avexa (targeting HIV), Chemgenex (leukemia), Neuren (neuroscience), Novogen (cancer) and Pharmaxis (bronchiectasis and cystic fibrosis)
According to Biotech Daily analyst Marc Sinatra, Chemgenex's drug "looks the most likely to generate big returns for investors".
He adds that any could surprise. "One thing for sure is that at today's prices all of them look like good value," he says.
The Australian accepts no responsibility for stock recommendations. Readers should contact a licensed financial adviser.
Wednesday, July 23, 2008
Company Brief - PGL - Progen
PGL suspends its phase III trial for PI-88 today and the share price dropped more than $0.62 to close at $0.58, more than 50% drop. For a biotech to fail a trial at such late stage, it will no doubt bring on these dramatic fall in its share price.
I hinted at the more than likely possibility of failure of this drug back in my Feb 26 blog this year.
http://ozstock.blogspot.com/2008/02/analysis-pgl-progen-pharmaceuticals.html
In my analysis of PGL on 26 Feb, various of the indicators (financial, product pipeline, management) suggest that PGL is a very attractive stock trading at $1.62. However, it turned out to be a classic example of the case where even if every indicator is good, success is not guaranteed. I did point out caution on PGL and the likelihood that PI-88 may not succeed, even though it reached Ph III. It was after careful examination (beyond all the optimistic jargon) of the history of its product, in particular PI-88, it was found that the same compound had failed in previous applications. This was what raised my doubts on PI-88.
In conclusion, it pays to read between all the glossy annual report and get a real feeling of how the products are actually performing. I may do an update analysis later when the aftermath of this latest news has been properly digested.
I hinted at the more than likely possibility of failure of this drug back in my Feb 26 blog this year.
http://ozstock.blogspot.com/2008/02/analysis-pgl-progen-pharmaceuticals.html
In my analysis of PGL on 26 Feb, various of the indicators (financial, product pipeline, management) suggest that PGL is a very attractive stock trading at $1.62. However, it turned out to be a classic example of the case where even if every indicator is good, success is not guaranteed. I did point out caution on PGL and the likelihood that PI-88 may not succeed, even though it reached Ph III. It was after careful examination (beyond all the optimistic jargon) of the history of its product, in particular PI-88, it was found that the same compound had failed in previous applications. This was what raised my doubts on PI-88.
In conclusion, it pays to read between all the glossy annual report and get a real feeling of how the products are actually performing. I may do an update analysis later when the aftermath of this latest news has been properly digested.
Saturday, July 12, 2008
The 9 Golden Rules according to Lincoln
This list is a set of 9 so called rules to decide if a company is worth investing in.
Rule 1. Financial Health
Lincoln suggest to invest in companies with Financial Health ratings of Strong or Satisfactory. Unfortunately, this rating is only available from the Lincoln Stock Doctor. However, we can do our own assessment in determining financial health. Some of the indicators that may be helpful are: debt levels eg. debt to equity < 1, current ratio > 1.5 (for retail companies), ability to service loans -> Interest cover (receipts to interest payments) > 3, cashflow history, and so on.
Rule 2. Management Assessment
Lincoln measures management using ROA and ROE, thought I don't believe this is a good measure. For biotech companies for example, ozstock uses the qualifications of its management team and directors. Back to Lincoln; they suggest ROA > 8% and improving is good. In addition EPS > 8% for last 18 months is good. For bank and insurance companies, Lincoln suggests ROE > 14% and improving, as well as EPS growth of > 12% (>8% over past 18 months)
Rule 3. Share Price Value
Lincoln suggests a PE ratio less than industry average may be underpriced and so a buying opportunity. When the PE is greater than industry average, they suggest using PE/EPS growth ratio where PEG < 1 is good.
Rule 4. Liquidity Volume
Liquidity level is to ensure that you can sell your stock when you need to. Lincoln suggest the average daily volume traded should be 5 times of your exposure level.
Rule 5. Share Price Trend / Sentiment
Buy when the trend is positive. Never buy when a stock price is "screaming down hill".
Rule 6. Market Capitalisation / Size
Large companies, ie those with large market capitalisation, are seen to be less volatile and have greater liquidity, i.e. higher traded volume. Lincoln considers stocks only if they have market capitalisation > $100m
Rule 7. Company Activities
Have a basic understanding of the company's activities, potential opportunities and threats that can affect future earnings of the company or industry.
Rule 8. News and Announcements
Lincoln suggest to look for positive announcements as this generally improve share price of company. Ozstock believes that the market tend to overreact quickly with good news and may overprice a stock. On the other hand, in the current bear market, it looked like even genuine good news may still result in share price dive - be careful in bear market. Lincoln also suggest that investors beware of negative news or announcements. Again, ozstock has found that once negative news hits the press, the shares would have dived already.
Rule 9. Follow all the above rules
Apply the above rules in a consistent manner.
Rule 1. Financial Health
Lincoln suggest to invest in companies with Financial Health ratings of Strong or Satisfactory. Unfortunately, this rating is only available from the Lincoln Stock Doctor. However, we can do our own assessment in determining financial health. Some of the indicators that may be helpful are: debt levels eg. debt to equity < 1, current ratio > 1.5 (for retail companies), ability to service loans -> Interest cover (receipts to interest payments) > 3, cashflow history, and so on.
Rule 2. Management Assessment
Lincoln measures management using ROA and ROE, thought I don't believe this is a good measure. For biotech companies for example, ozstock uses the qualifications of its management team and directors. Back to Lincoln; they suggest ROA > 8% and improving is good. In addition EPS > 8% for last 18 months is good. For bank and insurance companies, Lincoln suggests ROE > 14% and improving, as well as EPS growth of > 12% (>8% over past 18 months)
Rule 3. Share Price Value
Lincoln suggests a PE ratio less than industry average may be underpriced and so a buying opportunity. When the PE is greater than industry average, they suggest using PE/EPS growth ratio where PEG < 1 is good.
Rule 4. Liquidity Volume
Liquidity level is to ensure that you can sell your stock when you need to. Lincoln suggest the average daily volume traded should be 5 times of your exposure level.
Rule 5. Share Price Trend / Sentiment
Buy when the trend is positive. Never buy when a stock price is "screaming down hill".
Rule 6. Market Capitalisation / Size
Large companies, ie those with large market capitalisation, are seen to be less volatile and have greater liquidity, i.e. higher traded volume. Lincoln considers stocks only if they have market capitalisation > $100m
Rule 7. Company Activities
Have a basic understanding of the company's activities, potential opportunities and threats that can affect future earnings of the company or industry.
Rule 8. News and Announcements
Lincoln suggest to look for positive announcements as this generally improve share price of company. Ozstock believes that the market tend to overreact quickly with good news and may overprice a stock. On the other hand, in the current bear market, it looked like even genuine good news may still result in share price dive - be careful in bear market. Lincoln also suggest that investors beware of negative news or announcements. Again, ozstock has found that once negative news hits the press, the shares would have dived already.
Rule 9. Follow all the above rules
Apply the above rules in a consistent manner.
Ten simple rules to avoid large trading losses (with CDFs)
This article is published by CommSec and is intended for CFDs. However the techniques seem to be quite useful for other derivatives and even trading stocks directly.
"Avoiding the commitment to failure
In theory, when a trader experiences a decline in the value of an investment the desire should be to exit the position. But often the opposite occurs. A behavioural concept known as ‘escalating commitment to a chosen course of action’ can be the downfall of a trader, especially when using a leveraged product such as contracts for difference.
Forced compliance studies induced individuals to perform unpleasant or dissatisfying acts in the 2003 text The Social Psychology of Organizational Behaviour, edited by Leigh Thompson. Because the individual could not undo the consequences of the act, it was found that the individual biased his attitude towards
the experimental task so as to reduce any negative outcomes resulting from the behaviour. By justifying prior behaviour the decision maker increased his commitment in the face of negative consequences and the higher level of commitment in turn led to further negative consequences.
Probably the most famous example of escalating commitment to a chosen course of action was the Vietnam War. In a 1965 memo from former Under Secretary of State George Ball to US President Lyndon Johnson, Ball wrote “Once we suffer large casualties we will have started a well-nigh irreversible process.
Our involvement will be so great that we cannot - without national humiliation – stop short of achieving our complete objectives.”
In the trading world, once a trade turns bad a trader can rationalise his bad decision and increase his commitment by either staying in the position as losses grow or by adding to the position in what is commonly known (with long positions) as averaging down.
When a losing trade is not exited quickly, because of the leverage factor, losses can mount exponentially. Nick Leeson’s futures trading in Singapore in the 1990s was an example of an escalating commitment to a chosen course of action in a leveraged product. But small private traders managing less spectacular
amounts of capital should also be aware of the phenomenon because it is not uncommon for small traders to end their trading career with a single catastrophic trading loss.
Some simple rules can help you to avoid the big loss and stay disciplined:
1. Trading is a 50-50 prospect. A trader can win less than 50% of the time and still be profitable. Success or failure is not due to the amount of winners you pick but rather the dollar return on winning trades versus losing trades. In other words, be consistent with your risk amount and stop losses and aim to make your wining trades larger than your average losing trade.
2. Markets don’t behave rationally therefore sticking to a losing trade can never be rationalised. Prepare mentally and financially for both scenarios before you enter the trade - winning and losing - by placing stop loss orders and identifying possible price points where the trend may become exhausted.
3. A study of multiple choice examination habits has shown that going back and changing answers increases the chance of being wrong. Never move a stop loss level once it is set, unless it is in the direction of the trend you are trading.
4. Moving a stop loss order with the trend will help you maximise profits because you are changing your exit level in accordance with the market direction. Some experts advocate never exiting a trade unless it’s on a stop loss order – any other approach is effectively picking a top (or bottom).
5. Always aim to place a break-even stop-loss order after your initial stop loss order. A break-even stop is a free ride. No one ever went broke from not taking losses.
6. Choosing not to trade can be more difficult than taking a trade. When there are no good trading opportunities it’s best to sit on the sidelines.
7. In a bull market your goal is to make money from the upside and in a bear market your goal is to make money from the downside. In other words, it’s smarter to look for short trades in a bear market.
8. The middle of the trend is the “meat in the sandwich”; the beginning and the end of a move are inconsequential. If you want to be profitable only trade the middle of the trend.
9. The bull market for stocks has created a bullish bias. Therefore stocks that are breaking down can do so more quickly than rising stocks as the majority of traders exit long positions. Be prepared to act quickly in a falling market.
10. Information such as technical indicators and economic news can be used to justify a losing position. Price is the ultimate arbiter of value. Follow the price. "
As with all other articles on this blog, this article is not considered financial advise, but merely for thought and discussion.
"Avoiding the commitment to failure
In theory, when a trader experiences a decline in the value of an investment the desire should be to exit the position. But often the opposite occurs. A behavioural concept known as ‘escalating commitment to a chosen course of action’ can be the downfall of a trader, especially when using a leveraged product such as contracts for difference.
Forced compliance studies induced individuals to perform unpleasant or dissatisfying acts in the 2003 text The Social Psychology of Organizational Behaviour, edited by Leigh Thompson. Because the individual could not undo the consequences of the act, it was found that the individual biased his attitude towards
the experimental task so as to reduce any negative outcomes resulting from the behaviour. By justifying prior behaviour the decision maker increased his commitment in the face of negative consequences and the higher level of commitment in turn led to further negative consequences.
Probably the most famous example of escalating commitment to a chosen course of action was the Vietnam War. In a 1965 memo from former Under Secretary of State George Ball to US President Lyndon Johnson, Ball wrote “Once we suffer large casualties we will have started a well-nigh irreversible process.
Our involvement will be so great that we cannot - without national humiliation – stop short of achieving our complete objectives.”
In the trading world, once a trade turns bad a trader can rationalise his bad decision and increase his commitment by either staying in the position as losses grow or by adding to the position in what is commonly known (with long positions) as averaging down.
When a losing trade is not exited quickly, because of the leverage factor, losses can mount exponentially. Nick Leeson’s futures trading in Singapore in the 1990s was an example of an escalating commitment to a chosen course of action in a leveraged product. But small private traders managing less spectacular
amounts of capital should also be aware of the phenomenon because it is not uncommon for small traders to end their trading career with a single catastrophic trading loss.
Some simple rules can help you to avoid the big loss and stay disciplined:
1. Trading is a 50-50 prospect. A trader can win less than 50% of the time and still be profitable. Success or failure is not due to the amount of winners you pick but rather the dollar return on winning trades versus losing trades. In other words, be consistent with your risk amount and stop losses and aim to make your wining trades larger than your average losing trade.
2. Markets don’t behave rationally therefore sticking to a losing trade can never be rationalised. Prepare mentally and financially for both scenarios before you enter the trade - winning and losing - by placing stop loss orders and identifying possible price points where the trend may become exhausted.
3. A study of multiple choice examination habits has shown that going back and changing answers increases the chance of being wrong. Never move a stop loss level once it is set, unless it is in the direction of the trend you are trading.
4. Moving a stop loss order with the trend will help you maximise profits because you are changing your exit level in accordance with the market direction. Some experts advocate never exiting a trade unless it’s on a stop loss order – any other approach is effectively picking a top (or bottom).
5. Always aim to place a break-even stop-loss order after your initial stop loss order. A break-even stop is a free ride. No one ever went broke from not taking losses.
6. Choosing not to trade can be more difficult than taking a trade. When there are no good trading opportunities it’s best to sit on the sidelines.
7. In a bull market your goal is to make money from the upside and in a bear market your goal is to make money from the downside. In other words, it’s smarter to look for short trades in a bear market.
8. The middle of the trend is the “meat in the sandwich”; the beginning and the end of a move are inconsequential. If you want to be profitable only trade the middle of the trend.
9. The bull market for stocks has created a bullish bias. Therefore stocks that are breaking down can do so more quickly than rising stocks as the majority of traders exit long positions. Be prepared to act quickly in a falling market.
10. Information such as technical indicators and economic news can be used to justify a losing position. Price is the ultimate arbiter of value. Follow the price. "
As with all other articles on this blog, this article is not considered financial advise, but merely for thought and discussion.
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