Tricks of the Trade

Posted By Robert On Thursday, December 12th, 2013 With 0 Comments

Building on the previous section that discussed the tools of the trade, in this section I’ll share with you some tricks of the trade (pun intended) that might help you become a better spread bettor. If the tools of the trade are like the controls of your car, then learning the tricks of the trade may make you a better driver, notwithstanding the fact that you will still be at the mercy of the market’s driving conditions.

Dread the Spread

I’ve been there and I’ve done it. I mean that I have rushed into pressing the “buy” button without noticing that my “investment” will become 40% less valuable as soon as I have committed to it, because I didn’t notice that the bid-ask spread on Allied Irish Banks (for example) was a massive 0.05 – 0.08. In this case, it would mean that the share price must rise by 60% for you even to break even on your purchase.

In general it’s better to trade markets that have narrow spreads so that you’re not at an instant disadvantage, so it’s no wonder that the spread betting companies often boast about their tight spreads. Often those boasts about tight spreads refer to the highly liquid markets that they would like you to be day-trading, such as stock indices, commodities and foreign exchange currency pairs. When it comes to individual equities, the spreads might not be so tight and you’ll need to double-check on a case-by-case basis just before you press the “buy” (or “sell”) button.

In some cases you may be willing to accept a wide spread in exchange for the massive upside potential that you see. Whereas a stock like Tesco may have a bid-ask spread of just 318-319 (less than 1%), you might consider it to be far less likely than Allied Irish Banks to become a “ten-bagger” (a stock whose price rises tenfold). If a stock rises tenfold over the longer position trading timescale then an initial 40% hit on the bid-ask spread may be neither here nor there. But it will matter a great deal (and lead to a not-so-great deal) if you’re planning on closing the trade within a day.

The bottom line: double-check the bid-ask spread before you commit to the trade, but take account of your trading timescale.

Mind the Gap!

It’s no fun to see one of your stock holdings fall in price unexpectedly and far, apparently instantaneously without giving you time to think let alone close your position. If you don’t know what a price gap looks like, it looks something like this:

Aquarius Platinum Chart courtesy of Yahoo! Finance

Price Gapping

Do you see how, overnight, the price dropped from about 73p-per-share to about 65p-per-share without apparently passing through the prices in between? Any non-guaranteed stop order that you had put in place at 71p would likely have been executed at the lower 65p-per-share, losing you six points unexpectedly and leaving you “out of position” (i.e. no longer holding the stock) for any possible rebound.

When these kinds of price gaps occur, even my weapon of choice (the stop order) cannot save you, and it may be detrimental because you may find that you need not have stopped out at all. But don’t count on this, as the price may go even lower!

There is no cast iron solution to the price-gap problem, but there are some things you can try to at least part-mitigate the risk:

  • A guaranteed stop order at the 71p price level would certainly have executed at that price, but due to the necessarily wider stop distance you could only have guaranteed your stop at that level when the price was up at around 78p-per-share. On spread betting platforms like IG you would have needed to guarantee the stop order at the time you opened the original trade, whereas on the Capital Spreads platforms you could have guaranteed your existing stop order at a later time… but obviously not after the price gap had occurred!
  • You might anticipate the gap (or the possibility of one occurring) by not leaving trades open overnight when most price gaps are likely to occur; which is exactly what day traders do.
  • You might temporarily remove or relax your stop order before the markets open if you have read pre-open news that is likely to lead to a temporary adverse price gap. This is one of the very few situations in which it might be advisable to widen a stop order, and it’s risky, but you might have little to lose if you expect the price to “gap through” your stop order anyway. Don’t forget to return your stop order to a more appropriate level as soon as the price has settled down!
  • One of the best protections against price gaps that I have found is diversification. By holding a diverse set of individual equity positions, and by not letting any of those positions grow disproportionately large, you can ensure that no one price gap can ever wipe you out.

We can’t prevent price gaps from occurring, but these stop-gap solutions might help to mitigate their effects.

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