Monday, February 4, 2013

CACH: Small stocks bring big problems to traders

Caché Inc. (CACH) broke above its 20-day price channel on Friday and continued up that day through the 55-day channel.

There was no obvious news about Caché to explain the stock's 24% rise.

CACH was the best prospect left standing from my analysis of 4,343 stocks and exchange-traded funds tracked by the stock-rating company Zacks. And it removed itself from consideration in the first half hour of trading today by dropping below the breakout level, $2.79, creating a non-confirmation.

So this will not be a trading day for me. But even so, CACH is a good starting point to talk about position sizing, and why low share-price less-liquid stocks can create problems for traders.

CACH bubbled to the top like this: After excluding stocks near or just past an earnings announcement, I was left with a handful of fairly low volume issues. Low volume means low liquidity means no options or at best a poor selection with low open interest, and sometimes wider bid/ask spreads.

The price peaked on Friday at $2.97 before dropping back.

Position sizing is the practice of figuring out how much money to commit to each trade. Some people set a simple dollar figure. I prefer to base my dollar figure on my total trading funds, and then to adjust it for the volatility of the stock.

I begin by defining a unit -- the base size of the opening position in a trade. Under my rules, the unit is 1% of my trading funds. 

There's a lot going on in that short statement. "Base" means before I've adjusted for volatility. I specify that the unit is the size of the opening position in a trade because as a trend continues, I will add to it, each time committing an adjusted unit.

My limit for any one position, after adding to it, is four units.

I use the average true range, or ATR, to make the adjustment. The ATR measures the average daily movement, from the day's low to high or, if the prior day's close was outside the day's range, from that close to the day's low or high, depending upon whether the close is above or below the range.

The calculation is completed by averaging the ATR over a number of days. I average over 20 days, to match the 20-day price channel that I use in my analysis.

The Wikipedia article gives the formula.

This method isn't original to me, by the way. It was a mainstay of the original Turtle Trading method. This Investopedia article gives a rundown of the method, and this pdf file explains the Turtle Trading rules in detail.

To adjust for volatility, I divide the unit by the average true range. If the ATR is 1, then the unit and the adjusted unit will be identical. If the ATR is greater than 1, the adjusted unit will be smaller than the unadjusted, and if less than 1, the adjusted unit will be larger.

Low share prices produce small ATRs, because it doesn't take much of a price change to produce a significant percentage change.

CACH today has an ATR of 0.186 (18.6 cents), or 6.3% of the breakout point. That's fairly volatile, considering that the S&P 500 exchange-funded fund SPY has an ATR of 1.0076, amounting to 0.7% of the price.

So, let's assume a unit of $500, which would imply trading funds of $50,000. It's a fairly good sum, but not out of reach of many private traders. (That's not my unit size, by the way. I'm keeping that private.)

If I were buying SPY, then my adjusted unit would be barely changed from the base: Only $496.23.

CACH, however, is a different story.

If I divide the $500 base by the CACH average true range, 0.186, it gives me an adjusted unit size of $2,688.

The low price of CACH produces an unintended consequence: The more volatile stock has a far larger base. 

Generally, that's not a problem. A $80 stock is only four times the price of a $20 stock. But CACH is only 1/7th of the $20 stock and about 1/30th of the $80 stock. That bigger difference matters.

My present tactic has been to not adjust for low-priced stocks and just to buy a round lot, 100 shares, which adds slightly to the liquidity, and to count it by however many unadjusted units that comes out to.

There must be a better way, but I haven't worked it out yet.

The second problem is that a large unit for a low priced low volume stock means that I'm buying a lot of shares, possibly with insufficient liquidity to support it.

For example, a $500 unadjusted unit would mean the purchase of 179 shares of stock, probably rounded up to 200 shares for two round lots. 

The average volume of CACH is 39,684 shares a day. So that amounts to buying half a percentage of total volume. That's the equivalent of buying more than 61,000 shares of SPY.

Adjusting the unit according to the Turtle Trading rules implies the purchase of 900 shares of CACH, equivalent to 2-1/4% of the average daily volume. I can buy up to four units under my rules, so I could end up trading 9% of average volume.

It will be difficult to get good fills on CACH, or any other small stock, when placing orders of that magnitude.

Even worse, if the trade goes sour, it might be impossible to sell my shares at any reasonable price. I'd be stuck, like the last person standing in a game of musical chairs.

My purpose in this posting has been to point out problems, not to propose solutions. The analytical engine I built in software enables me to consider many more stocks than I could before. I gives me the power to reach beyond the mega- and large-cap stocks into the less liquid issue.

The problems I've discussed here call into question whether it's wise to use the power to expand my trading universe. I'll be looking at the issues over the next weeks and months, and will share my conclusion in this venue.

Please feel free to offer your thoughts on the subject  by posting a comment.


My trading rules can be read here.  A discussion of recent modifications to my trading methods, which haven't yet been incorporated in the original write-up, can be found here.

And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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