How to use Smartstock --- Strategies

Strategies

This is where we will discuss various advanced techniques for using Smartstock in combination with a rational investing plan. The flexibility of the system appears to be so great that there are an infinite number of ways to implement the technique in real life and we want to explore some of the options here.
As our users know, the combination of variable settings in the system can produce widely differing results. Our focus here will be to introduce many of the techniques and ideas that may not be completely obvious. We will cover topics relating to the software's features as well as strategies for managing stocks in the system. This is an ongoing learning experience for all of us.
The links below point to various topics relating to techniques and strategies for maximizing results with the software. Please feel free to share your ideas and experiences with us so that we can add information to help other user's benefit from your knowledge.

Setting up Smartstock with existing stocks
Setting Minimum Trade Amounts
Adjusting the Buy and Sell Resistances
Determining Cash Reserve

Setting up existing holdings in Smartstock

Smartstock can manage existing stock holdings or be used to start fresh with a new stock. The advantage of initiating a new stock holding in the software is that the total risk capital is determined at the outset and then divided between cash and equity. Setting up an existing stock is a bit trickier since the price may have moved substantially from the original purchase.
By far, the most important thing when entering an existing holding in Smartstock is to take the total cost of an individual holding (including commissions) and divide by the number of shares you hold. This average cost per share will be your initial stock value. Plug it into the system along with the number of shares you currently hold and you're ready to go. Smartstock will use this average cost as the basis for subsequent trade advice. Sometimes, when a new holding is entered this way, the system will call for an immediate trade at today's price. This is a signal that the price has deviated substantially from your average cost, and executing it is probably a good idea. You can over-write this trade by raising the Minimum Market Order value if you choose.

The formulas and calculations are dependent on the initial values set up in the program as the initial price, initial number of shares, and beginning cash reserve. The user must not enter a series of trades in the program that occurred in the past. New holdings must be started with the average price of the total holding. The reason is that Smartstock is programmed to buy lower and sell higher than the previous trade. If trades are entered in the program that are contrary to the embedded logic, it will throw the numbers off and not generate the proper targets. When you set up a stock you have been holding, there will only be one initial transaction. That will the starting point for subsequent management.

Setting the Minimum Trade values for Smartstock

A very important aspect of Smartstock investing is setting the minimum trade amounts for executions. These minimums can be set in Rupees, shares, or both. In the software, the minimums are also split between buy and sell. The concept of the "Minimum Market Order" is very simple - no trade signal will be issued unless it will occur at a value higher than the minimum specified by the user. A good rule of thumb is that you would never want to trade less than 5% of your portfolio value. This helps to keep the cost of commissions as low as possible and prevents trading too frequently. Smartstock will use whichever minimum is set higher in the system, shares or Rupees, as the absolute floor, below which no trades are signaled.

A powerful way to take advantage of the "Minimum Market Order", is to specify a minimum number of shares to trade. This can really turbo charge the results, however extreme caution should be used when specifying a minimum in shares. If you start with 300 shares of stock, it probably would be unreasonable to set a minimum of 100 shares. It would take quite an exceptional percentage move in the stock to signal a trade that would be equal to 1/3 of your stock value. Using a minimum market order in Rupees is the best way to get a feel for the range of your market order. With today's low trading commissions, it it fairly reasonable to use Rs.500 as the minimum in Rupees, though this will equate to a commission of 2 1/2% of the trade. In larger portfolios, a Rs.1000 minimum may be preferable to really make the cost of commissions inconsequential.

A powerful way to utilize the flexibility of the Minimum Trade settings is to adjust them in accordance with the action of a particular stock at the time. Say that a stock is having a strong run-up that seems to be gaining momentum due to a good earnings report or some bullish news. If you had your software set to trade a minimum of 50 shares and it was already signaling a sell order, you could choose to increase the minimum to 100 shares. this would hold off selling until the price is substantially higher. Another interesting way to use these settings is to split the minimums between buy and sell. If you had a stock that always seemed to be rising, you could set the minimum sell at 100 shares, allowing increased participation, but set the minimum buy at 50 shares so that you would be buying on any meaningful pullback. The Minimum Market Order settings are a very integral component of Smartstock, and the best way to evaluate the consequences of them is to do some testing with a stock you are familiar with. Varying the settings and observing the results will help you to better understand how the minimums affect the trading of the system.

Setting the Buy and Sell Resistances for Smartstock

The Buy and Sell resistance settings in the software will affect the amount of price change required to signal a trade in the holding. The default resistance settings are 10% for both the buy and sell. this seems to be a good general setting for most equities, though tweaking the resistances for the "personality" of an individual stock can yield superior results. the resistance settings can be altered at any time, and the system will use the new values in the subsequent management of the holding.

The Buy and Sell Resistances are one of the best way for the user to adjust the system to trade at levels that make sense at the time. If a stock is exceptionally strong and has a lot of momentum, the sell resistance can be raised to postpone and slow down the rate of selling. The higher the sell resistance, the more the stock will have to rise to signal a sell.

A good technique for capitalizing on a stock that does not fluctuate substantially enough to signal trades frequently is to se the Buy and Sell resistances to 0%. This will accelerate buying and selling so that only a minimal change in price is needed to signal a trade. This technique should be used only after close examination of the results since it can result in the draining of cash reserves rather quickly on price drops, and sell shares too rapidly on run-ups.

The resistance settings are best used to regulate the system to signal trades at levels that the user is comfortable with. If you have a Rs.20 stock in a good uptrend with lots of momentum, and a 10% sell resistance will have you selling at Rs.25, raising the sell resistance to 20% may be a good way to hold off selling until the price reaches Rs.30. Please beware that altering the resistance settings could cause you to miss an opportunity to trade if the stock does not reach the expanded price, and an opportunity can be missed. Please experiment with the resistance settings before changing them from the default of 10% so you know beforehand what the effect will be.

Determining cash reserves

O.K., we've heard it a million times. 50% beginning cash reserve is too conservative for starting a Smartstock holding in your favorite stock. Let's explore the actual numbers and see just how the beginning cash reserve affects the long-term performance of Smartstock. First a thought to ponder, if you think that there is any chance in the world of a Bear Market over the next few years, you should definitely start with no less cash reserve than 1/2 the initial portfolio value.

You see, actual Bear Markets have never been experienced by most investors. If a real one comes along, average stock prices could plunge 50-70%. This would be consistent with history, and the scariest thing is that the majority of stocks will get crushed, even today's leaders.

As a Smartstock user, you already know that the system will be buying on the way down, lowering the average cost per share at every incremental price level. We must make sure that in the event of a Bear Market, we are positioned to have enough cash to really capitalize in the long-run.

An example
Since Smartstock is based on percentages, let's create an example to illustrate what could happen in a Bear Market with a stock that loses 70% of it's value.
To begin, we'll use an example where a Smartstock holding is created with Rs.10,000. We buy 500 shares of stock at Rs.10 and put the other Rs.5,000 into our cash reserve. The stock begins it's 70% plunge from 10 to 3, Rs.1 at a time: At Rs. 9 a share, no trade is
signaled. At Rs.8, (20% dip) we get our first buy using 12% of the initial cash reserve (Rs.600) to buy more shares.
When the price reaches Rs.7, (30% dip) we use another 17% of the initial cash reserve (Rs.873) to buy more shares.

Now at Rs.6, (40% dip) we consume 22% more of the initial cash reserve (Rs.1119). It's interesting to note that at this point, the buy and hold investor is down a full 40% while the Smartstock investor shows only a 23% loss on the portfolio. Also, notice that the Smartstock investor has lowered his cost to Rs.8.57 a share, while still maintaining a 69% to 31% stock to cash ratio. The most interesting thing is that the Smartstock investor is only down Rs.275 more than the lump-sum investor who put all his cash in at 10. We're at a 40% price drop here!
Let's see what happens when the stock has plummeted a full 50% to Rs.5. Surprise, we're buying again! this time (gulping), we purchase Rs.1422 more or 28% of the cash we had allocated at the start. This leaves us with Rs.987 left in cash. Just about 20% of the initial cash. It's interesting that on default settings, Smartstock will invest 80% of the cash reserve when the stock gets cut in half. Seems like a reasonable proposal.

Now here is the really crazy part. When the stock gets to Rs.5, Smartstock will signal another buy right away if the price of Rs.5 is entered again!. Smartstock asks you to buy another Rs.569 worth of stock. This seems to make no sense. If you got a signal to buy Rs.1422 at 5 the first time, why would it want you to buy another Rs.569 if the price hasn't changed?
First of all, this is the part of the software that is saying "prices are very low, and if they continue to be this low, additional shares should be accumulated". Also, if we skip entering the Rs.5 the second time and go right to Rs.4, Smartstock does not have the available cash to execute that trade. We are exactly Rs.870 shy in our cash reserve to make the buy. We could of course choose to add the additional Rs.870 to the reserve, which would give us a buy of Rs.1856 at Rs.4.

This is also where the "time" vs. Price factor comes into play. Seasoned investors know that there are 2 ways to manage the system. Price or Time. The Price method dictates that the trade will be executed at the first possible signal, and the price at which the next buy and sell are should be set as "Good till Cancelled" limit orders with their broker.

The Time method is more "by the book" and can result in considerably differing results using the Price method. Say you only updated your software on Friday morning. Perhaps you missed the initial drop from 10 to 8, and instead plugged in Rs.7 for your first subsequent price. The result would be to buy in with 23% of the initial cash right off the bat rather than the 12% had we executed when the price was Rs.8. Interesting.
Let's get back to our Bear Market scenario. So the price has dropped from Rs.10 to Rs.5, and we are making our second buy at Rs.5. At this point, Smartstock will not make any more buys as he price drops to Rs.3 unless more cash is added. Notice however that Smartstock still keeps Rs.1288 in cash. I guess you could choose to put that in as well at some point becoming fully invested in the "debacle".
So here we are. Our stock price has dropped from Rs.10 to the bottom at Rs.3. Wait a minute, we still have 26% of our original cash in reserve! We have Rs.1285 out of the Rs.5000 beginning cash. Not bad really. Perhaps we should go ahead and kick it in at Rs.3? Perhaps we should use it for a vacation instead!

OK, now let's see exactly where we stand and how we compare to the lump-sum investor who took the same Rs.10,000 we used to start our Smartstock holding. First, the lump-sum investor has 1,000 shares with an average cost of Rs.10. It's a long way back if he didn't dump the stock right away. He has lost 70% of his original investment.

The Smartstock investor has 1284 shares at an average cost of Rs.7.46, and is down only 53% on a stock that dropped 70%. Definitely not something we want, however this is meant to be an eye-opener for anyone using the system. Remember, this is all predicated on using a fully funded cash reserve of 50% of the portfolio value to start.

Now, we can see that our break-even level is Rs.7.46 a share or 25% below the cost of the lump-sum investor. Just for fun, let's say that the stock had a miraculous jump back to Rs.10 right away with no selling on the way up. If you enter a price of Rs.10, Smartstock sells 427 shares, creating a profit of 30% on the portfolio!. The lump-sum investor is now only even and probably has an ulcer! This sell at Rs.10 by the Smartstock investor converts Rs.5,555 back to cash, more than we started with.

Back to our original example. The stock has bottomed at Rs.3 and is on the way back to Rs.10. (3-4-5-6-7-8-9-10). We will spare the details of the selling on the way up and look at the final results. Once the price has reached the original buy price of Rs.10, Smartstock shows a 23% return with Rs.5185 converted back to cash. Remember, the lump-sum investor is just now even.

Our current cost is Rs.6.93 a share and we own 820 shares. We have more cash than we started with and we have 64% more shares. Not bad if you have nerves of steel, and a stock that has staying power.

This example can be applied to any stock, which is why you should think long and hard before deciding to start with less than 50% in cash. A Rs.42 stock would only have to go to Rs.12.60 to have a 70% decline. We see things like this happen all the time in today's market. Imagine what a real Bear Market would do the average stock.

To summarize, even though the chance of your stocks plunging 70% seems near impossible, it is prudent to observe what the results would be. If nothing else, it demonstrates the rate at which our cash reserve will be consumed, so we can plan our initial parameters. It's very plausible that in a Bear Market, the likes of which have not been seen in over a decade, Blue-Chip stocks could drop 70%, and the Smartstock investor would be in much better condition to weather the storm and come out on top once the cycle turns for the better.

Don't let "irrational exuberance" keep you from fully funding your cash reserve from the beginning. Some day, you may need it. Just breathe deep and say "Thank goodness I didn't jump in head-first without first testing the waters".
Good Luck and may you never have to commit your entire reserve!