Trader tips in an inflationary environment

There has been a change in the market in recent weeks. People are talking about inflation, and the effects this could have. One thing that I am acutely aware of is that I have only ever traded in a low interest rate environment. Thus, it is difficult for me to imagine that I can put my money in a bank account and not see the value of that capital erode year-on-year.

Anyone who started trading after the financial crisis in 2008 has traded in an environment where stocks have had a huge tailwind. Low interest rates mean cash and debt are not so interesting for capital growth. Property is regarded as a safe investment (at least safer than equities, although this always comes from people who don’t understand how to trade or invest and believe stocks are therefore a gamble and risky) but the yields are not much better than owning a solid dividend stock.

Maybe inflation will go up, and if so, there will be an effect on equities. But there will always be opportunities, and always new and innovative companies to trade and invest in. The market may be have been flat recently and I have seen many strong statements result in a sell off – Sanderson Design (SDG) this Tuesday is a good example, but once this lull finishes, we will see a new market direction. There is a quote by Warren Buffett which I feel is rings true in trading as much as it does for his long-term investment approach: “you don’t need to swing for every pitch”. 

Many traders find themselves jumping into stocks freely, which can be great when the market is rising. However, I find it necessary to keep cutting and moving in order to keep the positions down. For example, I may risk 5-10 per cent of my portfolio on a stock and aim to make 20 percent plus, then shut down the position and move on. Not doing so can see a trading account swell to more than 30 positions, which is too many for me. Furthermore, if the market does turn for the worse, holding lots of small noncore positions means you can end up taking more than a 1R loss on the stock, which means the downside on the trade was greater than you anticipated.

Another benefit of not swinging for every pitch is that you wait for the right pitch to come along. When it does, you’re in a position to swing properly and have the benefit that you are entering the stock where you are wanting to enter rather than making the mistake of chasing. Many people are often annoyed that they miss their entry and decide to chase – but this only means the risk/reward ratio is becoming ever more skewed against you. Wait, don’t chase, and let the trade come to you.

Capital Limited: approaching the entry zone

One stock that I have been waiting for and is now slowly coming into the target entry zone is Capital Limited (CAPD), which is the old Capital Drilling. The company first came onto my immediate radar in December last year, when a transformative contract was announced alongside an equity fundraising to support its execution. The contract was said to deliver incremental revenues of between $235-260m over a four-year period which made it the largest award of new business in the company’s history. The placing proposed to raise up to £22m. I tend to avoid large raises because there is often a lot of churn that comes with these placings.

Chart 1 shows how the stock traded through the worst of coronavirus and demonstrates the problem of holding illiquid stock – especially on leverage. Within less than two months the stock had halved and then doubled again to recover where it previous was. Anyone who suffered a margin call and forced liquidation into that drop will be sorely regretting taking on too much risk as the stock has recovered nicely throughout the rest of 2020.

The issue with SETSqx – the electronic trading service of the stock exchange – is that market makers (and other traders who aggressively sell to cause fear) can mark down the price quickly in order to induce selling. However, do not make the mistake of confusing an actual sell-off with a tree shake. Market makers will typically take a stock down 10 percent or so then run it back up, whereas a selloff keeps falling.

Moving to Chart 2, we can see the big volume spike on the bottom of the chart and that the price trending in a sideways range be churned quickly. The price is now gently trending towards the previous highs which represent all-time highs.

I’ve been waiting for this and think that if the stock can break out then momentum traders will jump on board and start a new trend. The prices of many commodities are rising, which means more projects are economic, meaning more potential business. That does come with the flip side though – that if commodity prices fall then Capital will be vulnerable. There has been a raft of post-year end contracts announced, and big institutional buying.

The chart looks to have consolidated for the last eight months, and this has allowed weak holders and placing flippers to sell their stock to new buyers. I intend to take a breakout trade should the price break through the line and arrow marked in Chart 2.

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