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Playing The Box - A Practical Bottom Fishing Strategy for Small Investors - March 5th 2003



At various investment conferences where I have spoken during the past ten years, I have been often asked to describe my bottom fishing strategy and how it can be successfully applied by the average investor. There are different variations of the bottom fish strategy. The particular version I use the most is often referred to as “playing the box,” much like a market maker does or a broker with a “market maintenance” account. To further test the strategy, we allocated approximately $4,000 to the bottom fishing of 2 stocks during the summer of 1999. In only two months, the strategy generated approximately $1,500 in profit (after commissions) despite the fact that both of the stocks selected for the strategy actually dropped slightly during the same period. Not a staggering return, but not bad either, especially given the typical sideways movement of the small-cap markets during the summer months. I will discuss stock selection criteria for the strategy later. I am confident that the strategy works if followed with discipline.

 

STEP 1 - Is the strategy appropriate for you?

 

First and foremost, this strategy does not work well for investors looking to invest large sums of money. In fact, you may find it relatively difficult to regularly use more than $15,000 in a bottom fish only portfolio when playing with small-cap stocks. The lack of liquidity and the fact that bottom fish opportunities typically entail small volumes make it difficult to acquire large positions in a given company. As a result, this strategy works best for investors with $5-10K to invest in small-caps and is a great stepping stone to building a larger more diversified portfolio. This strategy requires patience and discipline. You must stick to your objectives and remove emotions from the decision making. A basic knowledge of technical analysis to determine support levels is helpful but not essential. DO NOT worry about commissions. Yes, your broker will want to become your best friend due to your frequent trading, but as long as you are making money too, don't worry about the broker. However, do try to limit your commissions as much as possible by trading on-line through a discount broker. Expect to get partial fills and pay about 20-25% of your profits to your broker as buy/sell commissions. This strategy is particularly effective in making money during market downturns and corrections which tend to be accompanied by significant volatility. Bottom fishing requires an investor to maintain significant cash reserves as you can't predict when you will get an order fill.

 

STEP 2- SELECTING POTENTIAL BOTTOM FISH STOCKS

 

There are a number of criteria to look for in a bottom fish opportunity.

 

1. ****Solid fundamental value to reduce downside risk. Do NOT abandon traditional stock picking criteria. Stocks selected for the strategy should: - be profitable, preferably growing at 20%+ per year - have a solid balance sheet, and ideally a strong cash balance to provide support from downside risk - low p/e multiple - generally, look to buy stocks trading at price to trailing earnings (fully-diluted) of less than 10. The lower, the better. Stocks trading close to, at, or below their book value or liquidation value can be particularly attractive.

 

2. Price Volatility and Technical Support - stocks selected for the strategy should have day-to-day volatility or even intraday volatility of at least 10%. The best candidates have volatility in the range of 20-30% or even higher. Large spreads between the bid price and the ask price or severe weakness in the bids down to a strong long-term support level are ideal candidates. Market depth information is extremely useful in determining this weakness. Liquidity is not a big issue although less liquid stocks that are relatively unknown in the market tend to exhibit the price spreads we need to make this strategy work.

 

STEP 3 - PICKING BUY/SELL POINTS.

 

Let's examine XYZ:TSX (fake company). Print off a chart from your favorite charting service before going further. Please note that this example is used for illustrative purposes only and should NOT be construed as investment advice. Consult your investment advisor or do your own research/analysis prior to making any investment decision.

 

Last summer, XYZ fluctuated on low volume quite consistently (several times) between about $1.20 and $1.60, a spread of as much as 33%. This is the “box.” The strategy is to buy at the low end of the box and sell at the high end, and keep recycling the strategy over and over - therefore, the strategy has been to buy below $1.32 and sell above $1.45, depending on the market depth at the time, ensuring a spread of at least 10%.

 

Market Depth Information for XYZ:TSX (SAMPLE ONLY - not actual) price and #shares

BIDs: 1.00 1,000, 1.20 4,000, 1.23 5,000, 1.26 1,500, 1.35 500

ASK (OFFERs): 1.50 1,000, 1.55 10,000, 1.57 700, 1.60 5,000, 1.74 500

 

QUESTION: Where would I place a buy order based on the current depth?

 

ANSWER: $1.27. An argument could be made for $1.24 (more conservative, but less likely to get a fill). A bid of $1.36 provides for too much downside ($1.36 down to $1.27 on a relatively small market order, and does not provide as much % upside back to the top of the box). A relatively small market order (anything more than 500 shares, would result in at least a partial fill if you bid $1.27. At that point, the Bid / Ask could become $1.26 to $1.50, a 19% spread - perfect for a quick flip.

 

QUESTION: Where would I place a sell order based on this market depth?

 

ANSWER: Either $1.49 or $1.54. It would take significant volume to push the stock above $1.55 due to the 10,000 share sell order at that level. I would position myself in front of this order for sure. I would probably select $1.49 just so I could get out early, making 17.3% before commissions, so I could re-bid at $1.27 again. The faster you turn the stock, the more money you can make, so sometimes that extra couple of pennies isn't worth it. On the other hand, there would be no need to offer the stock at say $1.40 because nobody else is willing to sell that cheap. Just make sure you are next in line or at least not too far behind. $1.54 isn't too bad because there would be only $1,000 shares in front of you.

 

The above market depth suggests support at $1.20 and resistance at $1.55, very close to the established trading pattern (the “box”).

Illustration of trading profits: Buy 1,300 XYZ:TSX at $1.27 = $1,651.00 + commission of $30 = $1,681.00 Sell 1,300 XYZ:TSX at $1.49 = $1,937.00 - commission of $30 = $1,907.00 Profit = $226.00 or 13.7%

 

While this does not sound like a lot of money, if you are working with a $10,000 portfolio, and you do this once every 2 weeks, your portfolio would increase by 64% in a year (excluding compounding). Of course, you probably couldn't do this with the same stock 26 times a year. That's why you need to find a basket of stocks to “play.” Note as well, that because you would essentially spend a significant proportion of your days with cash balances while bidding on opportunities as opposed to being fully-invested, you are often better insulated from a market correction. In fact, this strategy forces you to buy on corrections and sell on market spikes - a strategy that has historically been extremely rewarding (it does require nerves of steel to buy on corrections though - that's where the discipline comes in and your research to ensure solid fundamentals and value to start with).

 

FAQ's

 

QUESTION: Do you restrict your orders - “all or none” or “minimum quantity,” for example?

 

ANSWER: Absolutely not. Partial fills are a part of life using this strategy. Remember, your broker will become a close friend (you will pay him a lot of commissions given the frequency of transactions and the fact that you will get partial fills on orders). Restricting orders will frequently result in missed opportunities due to the order priority rules of the exchanges. In the above example, even if you had 3 partial fills on the buy side and 3 on the sell side (very rare) to accumulate / sell your entire position, you would have still made $106.00 or 6.4%.

 

QUESTION: When should I place my sell order?

 

ANSWER: IMMEDIATELY after you buy the stock.

 

QUESTION: What is your average hold period using this strategy?

 

ANSWER: Average is 3-5 trading days. Can be as little as 1-2 hours or as long as 3 weeks.

 

QUESTION: Do you ever have to adjust your buy/sell prices while your orders are open?

 

ANSWER: YES. It is important to monitor the company for fundamental changes and for changes in the market for its stock. For example, in the above example (XYZ). If you had originally placed a buy order at $1.27 and another order had entered the market to buy 15,000 shares at $1.30 before you received a fill, you would have to consider the option of moving your buy order to $1.31. The most important factor is whether or not you can do so without jeopardizing your minimum 10% spread on the flip. Be wary of increasing your bid too much, there are always other opportunities. If someone had bid only 1,000 shares at $1.30, you may want to leave your order where it is since there is still a reasonable chance that you could get a fill, especially if you are patient. On the other hand, don't miss out fighting for 1 or 2 cents if you can be first in line. Sometimes you will find that a large order previously providing support or resistance will leave the market. In this situation, you can lower your purchase price or raise your sell price for extra profit. Sometimes the company's trading pattern will change (spread narrows) and for a time (sometimes permanently), the strategy will no longer work.

 

QUESTION: How many opportunities should I “play” at once?

 

ANSWER: 2-3 with a $5K portfolio, 3-6 with a $10K portfolio, 5-8 with a $15K portfolio

 

QUESTION: How do I determine how much to buy?

 

ANSWER: This will be dictated by the liquidity and average trading volumes of the stock, as well as your portfolio size/diversification. Rarely would I buy more than $3K worth with a bottom fish portfolio of under $15K. If you have less than $5K, try to play at least 2 or 3 stocks. Never get caught without cash to fill a purchase - this will often require you to sell a good holding too early. Given that many brokerages increase their commission scale on trades above $2K in principal value, I often try to hook bottomfish trades in just under the $2K value mark to minimize commissions while still ensuring a reasonable sized stock position and diversification. Note the XYZ-TSE example above takes this into account on the BUY and SELL side.

 

QUESTION: Do you ever play both sides of the market (Buy and sell) on the same stock at the same time?

 

ANSWER: YES, subject to ensuring that the original purchase will not be too difficult to sell (liquidity) and to the rules of diversification. Frequently, I have the highest bid and lowest offer on the same thinly traded stock.

 

QUESTION: What happens if you remain on the bid for a few weeks and you don't get a fill, or visa versa?

 

ANSWER: Patience is critical. DO NOT move your price up if you are already the highest bidder and visa versa. If you notice you are missing the “box” as it cycles up and down, you may have set your prices inappropriately. It is also possible that the stock is simply too thinly traded to flip consistently. Don't expect to get rich overnight with this strategy. It takes practice and it takes time to monitor your holdings closely, so be willing to put in the time and effort before you begin.

 

SPECIAL CONSIDERATIONS:

 

Tax Consequences - It is possible that Revenue Canada could determine that you are in the “business” of trading stocks for profit due to the high frequency of the trading activity and short hold periods inherent with “playing the box”. In such a situation, you are considered to be earning business income and not capital gains. This is not true in a registered (RRSP) account since all income/principal is taxed the same (when it is removed from the registered plan). You may wish to consult your tax practitioner/accountant prior to engaging in this strategy with unregistered accounts to determine the effects on your tax situation.

 

Grant Robertson, B.B.A.

 

Disclaimer: The author is not a registered investment advisor. Accordingly, this article is presented for educational and information purposes only. Those seeking specific investment advice should consult a registered investment advisor. You are urged to consult your investment advisor before embarking on any new investment strategy as the strategies depicted in this article may not be suitable for all investors.

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