Learn to Trade the Markets : Part 1 (of 6) Risk Management

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“…AIM stocks can become ‘lobster pots’ – easy to get into but rather harder to get out of, and certainly not at the price a seller might be looking for…”

 

In this first of a series of articles, we look at how you can look to trade the Markets, be it full time, part time or occasionally.

Every one reading  these articles will be at a different level compared to the next man. Fundamentally the rules are the same. Over 80% of retail “punters” lose money. Hopefully, here, we will try and help you be in the 20% that doesn’t.

We will cover different strategies, ideas, entry and exit plans and try and get you to just think a little more before giving your hard earned cash away. There is no right and wrong way to make money in the markets. Find a strategy that works for you.

The markets have been around for centuries, they are not going anywhere so take your time with your research. There is a plethora of information around these days with the advent of social media and the internet, use it. Ensure you have an exit plan. Any fool can buy a share, the trick is selling higher than you bought. We hope you find some benefit in one or some of the articles. We kick off with maybe the most important lesson of them all : Risk Management

“Amateur traders think about how much money they can make. Professional traders think about how much money they can lose”

 

We are only part way through February but 2021 has already produced some of the most vivid illustrations in recent years of the compelling and dangerous business of trading shares.

As TMS discussed in detail last month Bitcoin has resumed its stop-start quest to establish itself as an alternative to gold as a respectable safe haven asset. Despite notable endorsements from Tesla and PayPal, and interest from established British fund manager Ruffer, for most mainstream observers surging interest in cryptocurrencies is a classic bubble that looks rather more like a latter-day recurrence of the 17th century Dutch tulip bulb mania than the early signs of a restructuring of the world’s financial system. What is certain is that many private investors have been caught in the currency’s undertow, jumping on the latest wave just as it comes crashing down.

The reddit/WallStreetBets campaign orchestrated on Reddit by a group of retail investors achieved brief – and spectacular – success in driving up the prices of GameStop, BlackBerry and a cluster of other shares against hedge fund short sellers before tumbling back down to earth. In the space of a few days more than $36bn had been wiped from the valuations of the five targeted companies, with GameStop shares plunging nearly 90pc.

Increasing appetite for risk

 

The current appetite for risk amongst many retail investors is illustrated by a new Goldman Sachs report on the trajectory of the bank’s Non-Profitable Tech Stock Index, which tracks technology sector shares that do not produce profits, a useful benchmark for investor willingness to take a chance. Since mid-March last year the index is up nearly 400pc, trading more than one trillion shares in December alone, easily its busiest month since it launched six years ago.

The efforts of retail investors to influence the path of individual stocks rather than working within the market conditions set by the big funds has electrified the financial world, encouraging excited talk of a new era of shareholder democracy.

There certainly have been individual successes, stories of ordinary investors turning a few thousand dollars or pounds into six or even seven figure sums. But there are perhaps rather more stories of bitter regret, of painstakingly accumulated trading capital squandered, and even life savings, house deposits, and pension pots.

Managing your risk

 

All of which makes the rather dull business of risk management at least as important as it has ever been. Making money through trading shares is not so much about spotting opportunities as minimising losses. Overlooking a good performer is frustrating, but the market continually generates fresh opportunities. Your first duty as a retail investor is to protect the capital that allows you to keep trading and take advantage of at least some of the opportunities that will come your way. Many trades will be losers, but a few big winners will more than compensate for dozens of small losses. 

Edwin LeFevre captured the sentiment well nearly 100 years ago in Reminiscences of a Stock Operator, a fictionalised account of the life of the securities trader Jesse Livermore, observing that ‘[W]hen you know what not to do in order not to lose money, you begin to learn what to do in order to win.’ Investors’ Chronicle writer and trader Michael Taylor recasts the thought nicely: ‘Amateur traders think about how much money they can make. Professional traders think about how much money they can lose.’

AIM’s strengths

 

Risk assessment is particularly important in the highly charged world of AIM trading. As TMS readers well know, with so many growth companies seeking to capitalise on emerging trends the index offers great opportunities for investors prepared to seek out winners.

2020 demonstrated AIM’s strengths, the market performing strongly relative to the FTSE 100 and 250, standing 27pc higher than a year ago. As usual its star stocks were small nimble enterprises that responded quickly to economic conditions, including the biotech group Novacyt (AIM:NCYT), which rose by 1,388pc, and respiratory drugs developer Synairgen (AIM:SYN), up by 1,400pc. Other strong performers included mixer drinks business Fever-Tree, which climbed 75pc, and video games developer Team17 – the programmers behind the lockdown best seller Worms, up by 80pc.

Since it launched in 1995 the market has nurtured big winners like the fashion portals ASOS, now a £4.9bn business, and Boohoo, valued at £4.4bn. An investment in ASOS worth £1,000 when it first listed on AIM 20 years ago would now be valued at more than £160,000, an annualised return of 45pc.

The market’s volatility is a necessary condition for its vitality. In his AIM manifesto The Future is Small Premier Miton small cap manager Gervais Williams argues that exchanges like AIM offer enterprising private investors exposure to vibrant microcaps that cautious institutional investors charged with securing reliable returns tend to overlook. As Williams notes, versatile small caps have the potential to perform strongly through the harshest economic headwinds, driving much of the innovation that propels the wider economy forward.

As well as presenting an ever changing pick of eager startups the AIM market offers investors certain pragmatic benefits. AIM investments are exempt from inheritance tax relief and stamp duty, and since 2013 can be included in stocks and shares ISAs.

The difficulty of spotting winners – and getting out

 

But though opportunities abound sharp eyes are needed to spot them. A frequently cited London Business School study published on AIM’s 20th anniversary in 2015 found that of the nearly 3,000 companies to have listed on AIM some three-quarters have never produced a return for investors. Shareholders lose 95pc or more of their initial investment in a third of AIM companies. And less than 40 companies in the 20 years from 1995 – just 1.4pc of the historic total – have secured multiyear returns in excess of 1,000pc. Before its 2020 rally AIM had seen some lean years, its list of companies falling by half from 1,600 in 2007 to less than 900 12 years later.

The conditions necessary for the market’s successes also contribute to its failures. AIM’s relatively light regulations give fragile enterprises the opportunity to get started, and room to grow. But a good many whose prospects don’t bear close scrutiny slip through the net, some rapidly going down in flames, others burning out agonisingly slowly, surviving well beyond their natural lives on shareholders’ money.

There have long been concerns about the stringency with which AIM stocks are audited, and the ambiguous role of nominated advisers. Notoriously, the watchdogs responsible for overseeing companies are appointed by the companies themselves. Though AIM companies must report regularly on material changes to their circumstances the relative lack of analyst and media scrutiny they receive makes it difficult for private investors to know who or what they can trust. And then there is the issue of liquidity. AIM shares can be tricky to offload: substantial holdings in smaller AIM stocks do not always find ready buyers. To borrow the imagery of one fund manager, AIM stocks can become ‘lobster pots’ – easy to get into but rather harder to get out, and certainly not at the price a seller might be looking for.

Designing your exit

 

So it’s important to plan AIM trades. That means doing sufficient research to understand the rationale for your investment: taking the time to understand what the company does, to assess its prospects for generating cash, to look into its assets, and the scale of any debts. You need to decide how much you are prepared to trade – from perspective of risk management that means the proportion of your portfolio you are prepared to lose if the investment doesn’t work out. And you need an exit strategy, some idea of how much are you prepared to lose before selling a share that isn’t working out, and how much profit you want to make before selling one that is. 

That means thinking in advance about the price at which you will sell. If you don’t enter into a trade with a plan your decisions will be made on the hoof in response to events. You may take profits too soon, or more likely, leave it too long before taking any. Worse, you may stay in losing trade for too long, continually leaking money. With an exit strategy you at least close the trade, successful or otherwise, on your own terms, rather than improvising in the heat of the moment.

Our next article will look at well established guidelines for designing an exit strategy that will help you minimise losses, and take profits before a share begins to lose momentum.

 

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