Traders need to adapt. Those who don’t are weeded out of existence. Nobody remembers the pit traders who failed to adapt to electronic markets. Nobody remembers the die-hard shorts that did their dough in the euphoria of 2021. And nobody will remember the trader who doesn’t adapt from the markets of excess in the years prior to 2023.
It’s true that traders need a disciplined system that they stick to and do not jump to something new the moment something isn’t working. But great traders realise when there has been a fundamental shift in the market and when their strategy is no longer the most effective way to trade. For example, shorting overvalued stocks was a great strategy in 2022, but valuations have shrunk to levels and discounts that haven’t been seen for years.
Market dynamics change. Volatility changes. Traders need to adapt their strategies to navigate these volatile periods, adjusting their risk management approaches and trading techniques accordingly.
Technological advancements also play a role. Like the pit traders I mentioned earlier, high-frequency trading and algorithmic trading are established in the fray. But like anything, these can be gamed. Once you understand how an algorithm works on the book, you know what it’s going to do and how you can create a workaround.
And it’s not only markets that change. Investor behaviour changes too. The Covid crash saw a lot of young investors pile into the market oblivious to risks. And so prices rallied way beyond logical values and the ‘diamond hands’ mantra was thrown around – the idea that you needed hands of diamonds to hold and not sell. This, of course, was incredibly foolish and many people eventually found out that they were the bagholders. But for a time the market was awash with incredible tales of bravery, bravado and foolishness. When you’re shorting a stock where the main holders are playing a different game, then the thesis for your short can be thrown out of the window.
For example, Tesla (US:TSLA) has a history of burning shorters. This is because many who bought the stock were not buying it on valuation. They were buying it to be part of the club. They’d fully bought into the idea financially and emotionally; the sort who would proselytise friends whenever they could about the virtues of Tesla and the electric revolution. Selling the stock would have therefore been an attack on their self-identity, and so no matter how low the price went those people were never going to sell.
Understanding the market you’re trading in is a huge part of being a trader. Back during Covid when everyone was cooped up with nothing to do (and furlough money was being printed) people inevitably turned to home furnishings, online gambling and the stock market. This distorted the market and stocks that had never been profitable in the years leading up to the pandemic were suddenly being bid up to monstrous highs.
My case in point here is AO World (AO.). This stock did the Grand Old Duke of York, going all the way up and all the way down again. Chart 1 shows the rapid advance of the stock from 40p to 440p and the fall back down to 40p. Those who thought the business had suddenly changed for the better were mistaken, as the fortunes of the stock rose and fell on distorted market conditions (or back to reality in the slump some would say).
AO has since refinanced and the business is performing ahead of expectations. But with a market cap of roughly £400mn and the business expected to report adjusted earnings before interest, tax, depreciation and amortisation (Ebitda) of between £37.5mn and £45mn, my feeling is that there is better upside elsewhere.
Looking in the same sector, Marks Electrical (MRK) is a minnow compared with the whale that is AO World, but is growing quickly and looking to start eating more of AO World’s lunch. It had a revenue growth rate of 21.5 per cent with revenues at £97.8mn, up from £80.5mn – small compared with AO World’s expected £1.13bn, yet Marks Electrical is expecting to exceed adjusted Ebitda of £7.5mn. Clearly, the margins are far higher than AO World’s and this means the business doesn’t need to grow revenues as much to get the same cash profits.
With a market cap of £93.4mn, one could suggest much of this success is currently priced in. And I wouldn’t argue with them. However, continued improvements in gross margin and revenue expansion could see the share price move further north. I think it’s worth keeping an eye on.
We can see the stock more than halved from its IPO and since then the trend appears to have reversed. This could be a base to trade from as the stock has been trading in a range of 20p range from 80p to 100p since the start of the year.
If you wanted a wide stop, you could place this below the stop loss liquidity of the range, however this would need a smaller position size to factor in the widened stop loss. Ideally, it would be good if the stock gently trended upwards toward the breakout zone and stopped before breaking out. We want volatility expansion after the breakout and not before it. Any quick moves before the breakout could mean selling pressure as fast moves create fast profits. Marks Electrical is worth a place on the watchlist and the results will be out on 14 June 2023.
