Before we start to trade warrants we need to have a trading plan in writing. The trading plan should contain information on the following five points:
The Entry
The Exit
Stop Losses
Position Sizing
Money Management
It is necessary to have a predetermined plan so we know the risks involved before we enter a trade. Also, once we have a plan we need to follow it.
A lot of people don't have a plan, or if they do have one, they don't follow it because they are afraid of taking a loss. We cannot afford to do this when trading warrants because the down side is a lot bigger than if we were just trading shares. Time is also a factor, we cannot afford to just hold on and hope that the price will rise again, while we are trading equity warrants. Always have a trading plan and always follow it.
Before we start to trade we need to work out our time frame as traders. Are we short-term traders or are we long-term? Time frame also determines the type of warrants that we will trade. Equity warrants need to be traded with a short-term view. Instalment warrants can be traded both short and long-term, although they ideally suit the longer-term trader.
Your time frame also helps to determine what your entry and exit signals will be. A long-term moving average like a 50-day EMA is useless for trading equity warrants. The same as a 4-day EMA is useless for trading with a long-term view.
You could even decide to trade two different time frames. Some positions could be traded with a short-term view, using short-term indicators and the others could be traded with a long-term view, using longer-term indicators.
Once you have determined your trading time frame you need to work out what your entry signals will be. You entry signals should contain a combination of indicators that work well together on the shares that you wish to trade. (Warrants are traded using the price and volume data of their underlying shares).
You should first choose the shares that you wish to trade warrants over. Then back-test all the different indicators on the charts of these shares, using several years of previous data, to find a combination (no more than four) that seem to work well together. Keeping in mind that no indicator is going to be right every time.
You should also not forget chart patterns, trend lines and volume data. Candlestick patterns are also reliable as well.
Remember, never trade on the signal given by one indicator alone. Also, don't fiddle with the standard settings of the indicators too much. The more you change the settings to try and get the indicators to "fit" the previous data, the more unreliable they are likely to become in the future.
Once you have worked out what your entry signals will be you then need to work out your exit signals. Exit signals can be given either by the same indicators that were used to signal the entry or they can be given by different indicators. The reason for this is profit protection. Some indicators work slower or faster than others do. By the time you wait for a slower indicator to give a sell signal you will have given back a fair amount of your profit. By using a quicker indicator to signal when to sell you get to keep more of your profits.
An example of this is some traders use the crossing of two medium-term moving averages (13 - 30-days) to signal a buy. Then they introduce a short-term moving average to signal when to sell. A popular combination of moving averages to use is 4,9 and 18-days. Buy when the 9-day MA crosses above the 18-day MA. Sell when the 4-day MA crosses below the 9-day MA.
Remember to back test to find out which indicators give the most reliable signals on the shares that you want to trade warrants over.
A stop loss is defined as a predetermined price level, that if reached, you will sell your holding of warrants to prevent further capital loss. There are four types of stop losses that should be contained in your trading plan, I have listed them out below.
Initial Stop Loss
Break Even Stop Loss
Time Based Stop Loss
Profit Protecting Stop Loss
Initial Stop Loss
Your initial stop loss determines how much capital (including brokerage) is at risk on the trade. It should be set before you enter the trade. It can either be a set dollar amount or a percentage of total trading capital. Above all, it should be set at a point, that if reached, you know that your initial analysis was wrong.
Setting your initial stop loss at 2% of your total trading capital is the most recommended method. Which is fine if you have $50 000 or more but if you only have $5000, using this method you would only be risking $100.
2% of $50 000 = $1000
2% of $5000 = $100
Taking brokerage out of this, even if we are using an internet broker is about $35, leaving us with $65. Hardly enough to let the position run without getting stopped out of the trade.
More appropriately, we could double this amount to $200 or 4% of our total trading capital which will give our position much more room to move. I will give you an example of how to calculate your initial stop loss below. Imagine that you want to buy 500 NABIMD warrants priced at $4.73. Your total outlay will be:
500 x $4.73 = $2365
Add on total brokerage (buying and selling) which is $35:
$2365 + $35 = $2400
The total cost to you will be $2400. Now let's assume that your total trading capital is $5000 and you decide to risk 4% of it on this trade.
4% of $5000 = $200.
Now subtract this amount from the total cost and divide the answer by the number of warrants that you want to purchase.
Initial Stop Loss = ($2400 - $200) / 500 = $2200 / 500
Initial Stop Loss = $4.40
It is hard when you are starting out and you don't have much capital. Start with your initial stop loss set at 4% of your total trading capital and gradually decrease it as your capital grows.
Break Even Stop Loss
Your break even stop loss is set at the point where you will break even if you sell. If you have been in a trade for a few days that hasn't progressed like you thought it would, you can use your break even stop loss to sell at the point at which you can exit the trade without losing any money.
For example if you buy 500 NABIMD warrants priced at $4.73 your total outlay is:
500 x $4.73 = $2365
Add on total brokerage (buying and selling) which is $35:
$2365 + $35 = $2400
The total cost to you is $2400. To work out your break even stop loss you divide this amount by 500 (the number of warrants that you purchased).
$2400 / 500 = $4.80
Therefore your break even stop loss is set at $4.80.
This is the point at which you can exit the trade and not lose any of your trading capital.
Time Based Stop Loss
You should set a time based stop loss to protect your capital in trades where the price just goes side ways. Imagine that you just entered a trade and you had set a time stop loss of five days. If after five days the trade hasn't progressed and the price has just been moving side ways, you then exit the trade. This means that your initial analysis was wrong and you used your time stop loss to protect your capital.
Profit Protecting Stop Loss
You should set a profit protecting stop loss to protect the profit that you have gained from a trade. A profit protecting stop loss is usually set as a percentage of he profit. You only use them when a trade is in profit by a set amount.
Imagine you entered a trade with a profit protecting stop loss of 20%. Once the trade is showing a profit of 20% you then use your profit protecting stop loss to manage the trade. If the price of the share starts to retrace and 20% of your profit has been lost, you sell, protecting the other 80% of your profit.
Stop losses are an important part of the trading plan. They allow you to protect your capital so that you can keep trading. Always use stop losses and always work them out before you enter a trade!
Position sizing is all about trying to minimise risk. I'm sure that you have all heard the old saying "you should never put all your eggs in the one basket", well the same applies to trading on the stock market. You should never put all your capital into one trade.
There are two main ways to work out your position size. Firstly you can divide your capital up into equal dollar amounts. If you have $5000 you could divide this into two positions of $2500 or three positions of $1650. I wouldn't have any more than three positions with $5000 as brokerage will eat up too much of your profit. If you have $10 000 you could divide this up into four positions of $2500.
The other way is to size your position according to risk. Let's assume that you want to buy NABWAB warrants. Your proposed entry price is $0.335 and your initial stop loss level is $0.265.
Capital = Total Trading Capital ($10 000)
Risk = 4% Risk ($400)
Total Brokerage (Buying & Selling) = $35
Entry = our proposed entry price ($0.335)
Exit = your initial stop loss ($0.265)
Position Size = ((Capital x Risk) - Brokerage) / (Entry - Exit)
Position Size = (($10 000 x 4%) - $35) / ($0.335 - $0.265)
Position Size = (($400) - $35) / $0.07
Position Size = $365 / $0.07
Position Size = 5214.285
Rounded Down = 5000 (warrants) x $0.335
Position Size = $1675
Using this method you should buy no more than 5000 NABWAB warrants (Equity warrants are traded in parcel sizes of 1000.) for a cost of $1675 (plus brokerage).
It's up to you to choose which method you use, although if you have less than $10 000 in total trading capital it is probably better to use the equal dollar amount method. If we did the above calculation using a total trading capital of $5000 it would only let you buy 2000 warrants for a total outlay of $670 (plus brokerage). It would hardly be worth it.
Money Management
Money management is all about managing your profits. What are you going to do with your profit? Are you going to add your profits into your future positions or will you sweep some, or all of it aside into a separate Cash Management Account to cover future expenses and tax etc.
It needs to be worked out and it needs to be included in your trading plan.
There are three additional rules that should be added to your trading plan when you are trading warrants.
RULE 1: NEVER BUY A WARRANT WITH LESS THAN 30 DAYS TILL EXPIRY.
RULE 2: NEVER BUY A WARRANT THAT IS NOT HIGHLY LIQUID
RULE 3: ALWAYS TRY TO BUY A WARRANT THAT IS AT-THE-MONEY OR JUST OUT-OF-THE-MONEY.
Never buy a warrant with less than 30 days till expiry. The risks are just too great!
Never buy a warrant that is not highly liquid. Every Monday in The Australian Financial Review there is a list of all the warrants that are available and their total trading volumes for the previous week. This information is also available from websites like www.parity.com.au.
There are two points to always remember about your trading plan.
ONE: ALWAYS HAVE A TRADING PLAN!
TWO: ALWAYS FOLLOW YOUR TRADING PLAN!
There is certain information and equipment that we need to have, or have access to, to trade warrants effectively.
A computer and an internet connection are the hub of all trading activities. Minimum system requirements are set out below:
Pentium 100 Mhz Processor
64 Mb of RAM
15'' Monitor
56K Modem
Printer
Windows 98
These system requirements are a guide only. It also depends on what type of charting software that you intend to use. I would also recommend that you get some type of back up system so that you can back up your data. I have two hard drives installed in my computer for this purpose. All of my data can be backed up on to the second drive. I have also found that a 17" monitor is excellent for charting. I wouldn't use anything else any more.
There are several different charting programs available in Australia. Some of them are aimed at beginner's while others are aimed at more advanced users. The two most common charting programs used in Australia are Ezy Charts and MetaStock.
Ezy Charts
Ezy Charts is an excellent program for beginners. It comes with about 40 pre-programmed indicators and it is very easy to use. It is priced at about $380 which makes it the cheapest of the two. Ezy Analyser and Ezy Portfolio manager are available as additional modules or all three can usually be purchased as a package for about $650.
MetaStock
MetaStock is a charting program that is aimed more at advanced users. It is an excellent program but beginners would find it hard to use (although there are training courses available). It even has the facilities for you to program your own indicators into it. It is also very good at system testing.
For further information or to download a demonstration version of the above programs visit the following websites:
The other point to remember when choosing software is data supply. The data format required for the two programs above is available from a number of different data suppliers. The data that runs some of the other charting programs is only available from one source.
Data Suppliers supply the end of day data that runs our charting program. Every night we log on to the internet and download the data from our supplier. Data can vary in price a lot between the different suppliers. Some suppliers supply it for nothing and others charge up to $600 per year for it, so it pays to shop around. Another factor that effects the price is the time that the data is ready for downloading. The earlier the data is ready, the more it usually costs.
The following list of data suppliers is not exhaustive:
Online Trading Systems www.ezycast.com.au
Almax Information Systems www.almax.com.au
NetQuote Information Services www.netquote.com.au
Paritech Pty. Ltd www.paritech.com.au
JustData www.justdata.com.au
InvestorWeb www.investorweb.com.au
We need a stockbroker to place our orders in the market for us. These days the online brokers are good enough for us to use. They are also cheaper than the full service brokers.
When you are choosing a broker it pays to shop around. Different brokers offer different services for different prices. Look for a broker that offers real time price quotes and depth of market information. Some brokers also offer dynamic information (dynamic means that the information updates itself, without you having to refresh the screen) but you may have to pay a subscription fee or it might cost you more per trade.
The following websites allow you to compare the differences between various online brokers:
There are a few records that need to be kept when we start to trade. We can split them up into two categories, financial records and personal records.
Financial trading records need to be kept for tax purposes and also to help measure our success as traders.
Personal trading records need to be kept so that we can identify our bad trading habits and mistakes, and hopefully correct and learn from them.
Record keeping is an important part of trading and it can be done either on a computer or by using handwritten records.
We need to keep financial records of our trading activities for tax purposes. These records will also help us to measure our success as traders.
The Trading Ledger
The trading ledger is where all of our financial transactions are recorded. It can either be a portfolio manager program on a computer or a handwritten ledger. I use Ezy Portfolio Manager, which is an additional module for Ezy Charts. I also keep a handwritten ledger because I like things to be written down.
A trading ledger, whether a computer program or handwritten, should contain the following information:
Date: The date of the transaction.
Transaction: The type of transaction (buy / sell).
Warrant Code: The ASX code of the warrant.
Number of Units: The number of units being transacted.
Price: The price per warrant of the transaction.
Brokerage: The cost of brokerage per transaction.
Total Purchases: The total cost of a purchase.
Total Sales: The total amount received from a sale.
Profit: The net profit received from a winning trade.
Loss: The net loss from a losing trade.
Cumulative Profit and Loss: A running total of the "Profit" and 'Loss" columns.
Account Balance: A running total of the "Total Purchases" and "Total Sales" columns.
If you decide to keep a handwritten ledger, you might find it useful to keep running totals of the "Brokerage", "Total Purchases" and "Total Sales" columns. This will save you the hassle of having to add them all up at the end of the financial year. I use an 18-money column book for my handwritten ledger. This gives me plenty of columns for recording everything.
As with all records, the most important thing to remember is to keep them all up to date.
Contract Notes
Every time that you buy or sell warrants your broker will send you a buy or sell contract note. This is your receipt of the transaction. The contract note contains information on the total cost or total amount received from the transaction and the brokerage that you paid.
Always keep your contract notes because they are your proof of the transaction. When a trade has been completed always staple the buy and sell contract notes together before filing them away.
When we are starting out in warrants we need to evaluate our performance every so often, so that we can try and correct any mistakes that we might be making. We use a trading diary to help us do this.
The Trading Diary
The trading diary is a diary of all our trading activities. Every time we enter a trade we should write the following information in our diary:
Warrant Code: The ASX code of the warrant.
Date trade opened: The date that the trade was opened.
Date trade closed: The date that the trade was closed. (To be filled in when the trade has been completed.)
Duration: The duration of the trade in days. (To be filled in when the trade has been completed.)
Purchase price: The price that the warrants were purchased for.
Sell price: The price that the warrants were sold for. (To be filled in when the trade has been completed.)
Number of warrants: The number of warrants that were involved in the trade.
Stop Losses: The prices at which our stop losses are set. (Initial, Break even, Time & Profit protecting.)
Time Frame: Our anticipated time frame for the trade.
Win / Loss: Whether the trade was a win or a loss. (To be filled in when the trade has been completed.)
Win / Loss Ratio: Our total number of winning trades compared to losing trades. ( This is a measure of our performance as a trader.)
Profit / Loss: The amount of profit / loss made from the trade. (To be filled in when the trade has been completed.)
Comments: Any comments that we may have on entry, during or on completion of the trade.
The trading diary is a summary of all of our trading activities. As such it should be reviewed regularly to see if there are any areas of our trading that we can improve upon. As with all records, it should be kept up to date at all times.
Trading Sheet
A trading sheet is used to monitor all of our open trades. Every day we should write down on it the closing price and our stop loss prices for each of our open positions. We should also write down the closing figure for the All Ordinaries, so that we can keep track of what the general market is doing.
Every week I start a new trading sheet and I always carry forward the last values from the old sheet.
I also find it useful to use different colours to differentiate between up days and down days. I write up days in blue, down days in red and I use pencil for days when the price moves sideways.
As I have said before, the most important part of record keeping is to keep it up to date!