Why momentum is now part of my journey - Part 3 (Final)

In this third and final instalment into the brief exploration into my momentum journey. I will discuss the ideas of money management and how I use the insights in Stockopedia to keep me disciplined.

If you wish to read part 1 again where I discussed why I have incorporated momentum as part of my overall strategy please click here.

If you wish to re-read part 2 where I discuss how I apply technical analysis and what indicators I use please click here

Money Management

When I first heard this concept I thought it had something to do with portfolio construction and weightings. But in fact in the world of technical analysis the concept of Money Management incorporates a number of elements including position sizing, risk allocation and ultimately when to sell.

Any mug can pick stocks. That's why tip sheets are prolific and opinions as common as noses - everyone has got one. But the reality is that it's only the disciplined few that can actually manage money, and it's often where most investors fail.

Hence why, in my opinion, Money Management is crucial and an important concept to grasp before embarking on a momentum or technical analysis strategy.

Author note: It's why I love Stockopedia so much. Because it delivers quantitative insights without bias, making it so much easier to develop a strategy that is both manageable and replicable.

At its core I believe Money Management gives us the ability to continue to invest regardless of losing trades or a series of losing trades. What we want to avoid at all cost is a terminal loss of capital which removes us from the game altogether.

Markets get nasty, I know. I have lived it a few times now and I can definitely vouch for the idea that they are not fun. Especially now that my life circumstances had changed (refer to Episode 1 of my momentum journey to learn more)

I want to have an idea of what the maximum damage will be in a big correction. I want to ensure that any loss is only a small part of my capital, meaning that it would require an almost impossible amount of losing trades to deplete my capital to a point where I can’t continue anymore.

As I have mentioned before, markets go up and they go down. However over the long term they go up more than down. Therefore I need to ensure I always have enough capital to live to fight another day and benefit from any positive swing in sentiment.

The topic of Money Management is wide and varied, and I would encourage you to read up more on the topic via the plethora of resources available on the internet. However I am going to limit my discussion to two key aspects:

1. How to apply stop losses to manage downside risk
2. How many stock to hold and position sizing

Apply Stop losses to manage downside risk

The vast majority of investors and traders focus the bulk of their time on the buy side of a stock. Mistakenly thinking that all their work is front ended, and surely nothing can go wrong… right?

No matter how you like to invest, you acknowledge that things don’t always go to plan. Even if they do, there will be times to exit a stock. And here was something I learnt from very early on.

I should know when I will exit a stock BEFORE I buy it.

When investing Fundamentally, if a stock develops traits that are opposite to the reason why I bought it, then I sell. Eg if I bought a stock because it was cheap and growing. But now it is expensive and growth is slowing, then I exit.

With technical analysis it is the same concept, if I bought a stock because it was going up, and now it’s not anymore, then I get out.

As with all things, prices can be a little more nuanced than my simple explanation above. That is why I actually have a three-step stop loss strategy that I implement to help manage downside risk. My approach has been adapted from the teachings of Nick Radge, founder of www.thechartist.com.au.

Basically I have three stages of stop loss that progressively get implemented the higher a price rises (assuming it does at all). I have named them:

1. Parachute Stop
2. Close Call Stop
3. Controlled Stop

1.Parachute Stop. This is the initial stop I place when I first buy a stock. I call it a parachute stop because it's used in an emergency before the price crashes, I push the eject button and launch my parachute.

You know this scenario. You buy a stock and it goes down straight away. This is normal behaviour that can often happen (some may feel like it happens all the time), but then again you have to allow a little leash to let your stock find itself price wise.

But not too much lead, after all there is no point having a leash if it is long enough to still let the dog bite Mr Smith’s ankle. So I implement a “Parachute Stop” to protect my capital from a stock price that has immediately gone the wrong way and could end up getting much worse.

Where do I set my parachute level?

It could be a fixed percentage or you can use a technical indicator or structural support to set the level. How do I implement a parachute stop loss?

I don’t risk more than 1% of my portfolio value on an initial position which means:

• If I have a hypothetical portfolio of $100,000
• Then I am willing to sacrifice $1,000 on a trade
• So if I buy 20 stocks with $5,000 in each then my parachute stop will be anywhere between 10% ($500) to 20% ($1000)
• I write down the exact stop price I choose and execute that with discipline

There are a few things to unpack in this example here.

• First I am willing to sacrifice $1,000 for potential unlimited gains.

• If I lose $1000 every initial trade I buy, then I would need to trade 100 times and lose each time to eradicate my capital. (Assuming the portfolio value stays at $100,000)

• If the portfolio falls to $90,000, then so too does the amount I am willing to risk to $900 (1% of the portfolio)

Whether I choose 0.5% or 1% depends on the market at the time. This is why I like to understand whether the market is bearish or bullish before looking at stocks, it’s so I can set my initial stop loss level. If I am very aggressive (markets are going up) the stop loss level will be set closer to 1%.

If I am very cautious on the market, or I am entering a stock that doesn’t have a perfect set-up, I will set my level at 0.5%

Writing down my stop loss is a very important step. Knowing when I will get out, before I even get in, provides great comfort when the fear of, “Am I buying at the right time” sets in. It's never the wrong time to get in if you know when to get out. Which is why the parachute stop is so important.

For example… I entered ASX:WHC at close to $4 after the price had already risen 300% and was at multi-year highs. I was comfortable entering a position because I had a parachute stop loss set to indicate when the trade had gone wrong. Today (20/12) nine months later the price is ~$10.30 and my stop loss has risen to a higher level (more on that in a moment).

The other thing you will notice as I explain the other two stops is that the most thinking goes into setting a parachute stop, indicating that I enter the trade with a 'prepare to fail' mentality, which makes sure I protect my downside. The opposite of course is to be overly optimistic which most of us naturally are, but can be problematic when a trade goes against us.

2. Close Call stop What if you get on a winner? ie You select a stock based on the indicators all looking favourable, and it goes up! Congratulations! However, after a few days of boasting, you notice the price starts to retrace and all of a sudden your early gains are starting to erode and you are on the cusp of going into the red.

This is when a close call stop is required. It is a price close to your purchase price that is designed to protect your capital, if the initial move up proves to be a fake move and runs out of puff.

This is a two step process:

1. Find a percentage above the buy price as a top level
2. Set a percentage below the highest close since you bought. I like to implement these rules:
   1. A greater percentage than your cap
   2. Not lower than your initial parachute stop. If it is then your parachute stop loss remains in play

I have currently settled on an 8%/10% rule. Though I will continue to explore other combinations.

8%/10% means that if the price rises up to 8% , my close call stop is 10% below that new mark.

• For example: Say I buy a stock at $1.00.
• It subsequently goes up $0.06 (or 6%) = $1.06
• My close call stop becomes 10% below $1.06 (~$0.95)
• If it goes up another cent to $1.07
• My close call stop becomes 10% below $1.07 (~$0.96)

If this price rise runs out of puff and pulls back to the stop loss I am out. If it however goes above 8% ($1.085 or higher) then we move to the third and final stop loss criteria.

3. Controlled stop is once the price has crossed the threshold of breakeven, I look for points of support as the next stop loss level. I instigate many of the techniques discussed in my week 2 article where I:

1. Don’t worry unless the price is below the ATR
2. If the price closes below the ATR look for a level of support. That becomes the new stop loss level

So looking at ASX:WHC Whitehaven Coal, it well and truly stayed above my parachute stop loss level. It broke though quite easily my 8% threshold so it no longer requires a close call stop.

Now I have a controlled stop in place which is set. As the price is above the ATR I don’t worry, however say the price falls below that my stop will be set at $7.96 as that is a support level that has been tested twice.

WHC Chart 3 months

How many stock to hold and position sizing

So how much should you buy of any stock? $2,000, $10,000 or $100,000. Obviously everyone's circumstances are different so talking in dollar amounts is not particularly useful.

Rather we should look at percentages of the portfolio and the idea of risking a small percentage of your total capital per trade is the cornerstone of the concept around Money Management.

As retail investors, you should be ideally focused on an equal weighting for your exposures. Fund Managers will utilise what is called a “benchmark aware” strategy that weights holdings in stocks relative to their impact on the index. This is not practical for retail investors, and often results in under performance anyway!

The other thing that can complicate the issue is that stocks are fluid. They don’t stay the same. While you might start with a portfolio that has 20 stocks and are equally weighted at 5%. The next day this changes. So do you rebalance the portfolio once one stock gets to 5.2%?

Of course not.

Rather it is better to work within target ranges. The good news is the stop loss strategy described above covers the downside risk. But as a general rule I try to keep my exposures as even as I can so that one stock doesn’t have too big an influence on the overall portfolio.

For example, if I have 10 stocks. One holding accounts for 50% of the portfolio and the others account for the remainder. Then even if each of the 9 stocks rises 5%, I would have a bad day if my single 50% holding falls 10%

Rather what I do within a tech analysis strategy is this:

• I aim to take a minimum position that is at least 3% of the portfolio (2% if I am cautious on the broader market) So for example with a $1 million portfolio, I take a position size of between $20K - $30K)
• If the holding over time becomes 10% of the portfolio (remember, we stay in the stock for as long as it is going up and meets our rules) then sell back down to 5%
• Keep repeating this process until the stock meets your exit criteria.
• All stocks that make up between 2% - 10% of the portfolio AND still meet your technical rules - no action is required.

This disciplined form of profit taking is a good way to ensure you never let the portfolio get out of whack, and that you manage your downside risk which becomes more elevated as the portfolio and share price grows.

But don’t mistake the 10% rebalance rule as a target. If the chart says to get out - then get out. Don’t wait hoping you will achieve 10%. After all, it's better getting out with 7% than 5%

Using a technical analysis strategy, there may be on very rare occasions, examples where a stock takes up less than 1% of the portfolio. I say “very rare” because this would imply that if the stock hasn’t triggered an exit signal on the chart, and all your other stocks have risen by over 100% collectively. If this occurs, and the chart still looks OK, you may want to top up. But as I said, this is very rare, and the more likely scenario is that you missed an exit signal.

Topping Up / Averaging down - the great divide

One of the biggest issues that divides fundamental and technical analysts is the issue of topping up into a stock that is falling.

A fundamental analyst will tell you that when a stock has fallen, and if it is still a good business, investors should top up and take advantage of a cheaper price. This concept however horrifies a technical analyst who sees a falling price as a sell signal… not a buy signal. It highlights one of the key reasons why investors should never change strategy mid-stream eg buying on the technicals but holding because of the fundamentals (or hope) and vice versa.

Investors who use technicals to enter a stock do not and should not average down. How can you buy into a stock where all the indicators are pointing the wrong way?

This is the same for the concept of averaging into a stock i.e. spacing out your buying over a number of weeks/months. A technical analyst is unable to do this because in a week’s time the price might be flagging a downtrend, so how can a technical strategy buy into that? It can’t.

Author note: I have found “averaging in” and “topping up” strategies very effective when I am investing using the fundamentals, so I am not dismissing the strategy at all. All I am saying is that if you are employing a technical strategy, or the one I have described, then you can’t "average in” or “top up” because it is counter intuitive.

How many stocks should an investor hold?

Say you have a $100,000 portfolio, you can allocate that across 20 stocks and have $5,000 in each name. Or you can choose $10,000 in each and decide to hold 10 stocks. Either way your parachute stop loss and capital you risk is calculated the same way as discussed above. Just note that more of your portfolio value is eroded with a pullback in a stock that you have a heavier weighting in.

So what is the ideal number, how many stocks should you hold?

There is a belief that after an investor gets above 15-20 stocks, the diversification benefit starts to diminish. The cost and effort of managing extra stocks erodes any potential capital gain benefit of having more stocks. The spread of 20+ stocks gives you a diversification benefit ensuring not too much of your capital is at risk on any single trade (refer above)

A quick comment for those of you who perhaps think a portfolio of around 100+ stocks is the way to go.

It’s not!

The time and effort required to manage a portfolio of that number is extensive and very difficult.

Also trading is a double edged sword. Just like you increase your chance of finding a winner by holding more stocks, you also increase your chances of holding a loser.

But with Stockopedia by your side, coupled with a more simple process for entering and exiting a stock, you can hold more as I do. My current amount is over 40, however these are a combination of stocks selected for technical and fundamental reasons, and I have defined strategies for each. Author note: I have turned my passion into my career so I really like looking at stocks and can manage a larger number. I acknowledge that not everyone is wired like me (thank heavens for their sake.)

Just remember though, if you start to dread the investing process and occasionally let things slip, there is a high probability that whatever strategy you are employing is too difficult to implement consistently, which will ultimately result in failure (sorry). 

The reality is a simpler approach may cap your potential returns somewhat, but if you can apply it with discipline, you will likely achieve better results than trying to apply a strategy you have no hope of implementing consistently.

Over the many years of educating investors, I have come to acknowledge that very rarely is it the specific strategy that is employed that results in under performance. Rather it is the failure to adhere to the strategy with discipline that results in long term underperformance.

Ultimately the investment strategy you employ should work around your lifestyle, not the other way around. So be sure to apply the strategy that you can commit to. Just as I do with Stockopedia.

Using Stockopedia

So we have come to the final part of my momentum journey. How do I use Stockopedia in my strategy?

Author Note: This section is going to be relatively brief, which highlights the power of a tool which completes 95% of my investing work in less than 10 seconds.

When it comes to investing in stocks we are spoilt for choice. There are 2000 stocks on the ASX each has a wonderful backstory which sounds incredibly convincing. They all have the potential to go up in price, and vice versa.

Therefore, one of our biggest issues is limiting our universe to a manageable list of stocks. We cannot have our eyes spinning and be in all stocks that go up the most. At the end of the day, 20 stocks going up 5% yields the same result as one stock going up 5%. There is an old Chinese proverb that I feel is very relevant here:

If you chase one rabbit, you catch one rabbit. If you chase two, you catch none.

So, what we need is a curated selection of stocks to choose from and monitor them on a regular ongoing basis, ready to identify entry signals and act on exit signals.

And this is where Stockopedia becomes invaluable. To reduce the list of potential investing candidates to a more manageable number is incredibly valuable to me. It completes a process that would literally take weeks to conduct and does it in 10 seconds. Not only does it reduce my universe, but it puts forward a selection of stocks that as a collective have the properties of stocks that outperform, helping put the odds further in my favour. 

What value could I possibly put on that?

With Stockopedia's screening tool and factor models I can have stocks to consider served to me on a platter.

I run this scan:

• QM Rank > 80
• Market cap greater than A$500m

Two simple rules do all the work for me. Immediately the list of stocks drops to 199 (113 if I lift the QM score to greater than 90).

I then do two things with the list.

• I view the selection as charts
• Then I change the time frame to six months

OK... that was quick. Let me fill in some of the blanks.

What is the QM score?

The QM score is a combination of the Quality and Momentum rank. You can read more about it here. If you want to learn more about how StockRanks work in general then please click here

So why this combination? Why consider Quality?

I feel the combination is a good mix of what I am trying to achieve.

I am trained and had previously invested with a heavy bias toward quality metrics. Financial Health, strong cash flow generation, margin analysis, rising profitability.... these were all cornerstone concepts of what made the investing process I built become the number #1 managed fund in the country a number of times.

So quite simply it was an easy decision to stay with Quality as it had treated me so well in the past.

Why Momentum?

This is a good question, particularly as I have just spent the last 10,000+ words over three published articles explaining how I am using charts to time an entry or exit.

It comes down to how the Momentum rank is calculated. As I mention at the beginning of each Momentum Monday newsletter, Stockopedia's Momentum indicator is more than simple price moves. To learn more about it click here

I rely on the Momentum Rank to do two things for me.

• First is that it shows me companies where the Momentum of earnings factors is improving. Things such as forecasts, upgrades and earnings surprises are captured here.

• Finally it covers longer term price moves and 52 week high proximity which are things I don't have to worry about charting and analysing because Stockopedia does it for me automatically.

In summary, I combine the two factors of Quality and Momentum to conduct a primary screen of stocks to then apply my charts on top of that. Without Stockopedia I couldn't invest the way I do.

Once I have my list, I then open the chart view and scroll through the graph on a 6 month basis and look for stocks that are above their 50 day MA and appear to have a reasonable set up.

The final step is to drill into the charts of the ones that look promising and just ignore the rest.

Author note: I also select stocks where I do not use Momentum in any form to manage them. They are selected through a more detailed and rigorous fundamental research process that is beyond the scope of this topic.

This process I have just described is obviously when I look for new inclusions into the portfolio. This is because once I own a stock, I am monitoring it daily against the metrics specified above and in previous articles.

Conclusion

And that brings us to the end of the explanation of why Momentum is now part of my journey.

I sincerely hope you enjoyed the candid nature of the discussion. Should you have any questions please feel free to ask them below. (We are all friends, so don't be shy. )

At the end of the day, we are all on this learning journey together and I look forward to sharing more as I define my own path over the coming years.

You can learn about this journey staying up to date with our Momentum Monday Newsletter where I will document my journey in further detail.

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Important Information: Stockopedia Ltd ABN 39 757 874 670 UK business registration number 0637267 (“Stockopedia”) is an Authorised Representative of Daylight Financial Group Pty Ltd ABN 77 633 984 773 (“DFGPL”) which is the holder of an Australian Financial Services Licence (AFS Licence No. 521404).

Information in this commentary is current as at date prepared unless otherwise stated. However, please bear in mind that investments can go up or down in value, and that past performance is not a reliable indicator of future performance. For more Important Information please refer to the Disclaimer section of this website.

This communication may contain general financial product advice. It has been prepared without taking into account your personal circumstances, and you should therefore consider its appropriateness in light of your objectives, financial circumstances and needs before acting on it.

If our advice relates to the acquisition or possible acquisition of a particular financial product, you should obtain a copy of and consider the Product Disclosure Statement (PDS) before making any decision.

The author holds interests in the following stocks mentioned in this article: WHC. This position can and will change at any time without notice.