( ETF ) Creation and Redemption Process

ETFs have a unique so-called creation / redemption mechanism which allows professional market participants to exchange baskets of shares with the same composition at any time for ETFs (and vice versa) with the fund. This ability to continually create or redeem shares helps keep an ETF’s market price in line with its underlying net asset value. A key feature that distinguishes ETFs is that the shares are created by ‘authorised participants’ or creation/redemption brokers in block-size ‘creation units’. The creator deposits into the applicable fund a portfolio of stocks closely approximating the holdings of the index in exchange for an institutional block of ETF shares (usually 50,000). Similarly, they can only be redeemed in redemption units, mainly ‘in-kind’ for a portfolio of stocks held by the fund. The redemption and creation processes are very similar. However, a key benefit is that the in-kind distribution of securities does not create a tax-event, which could occur if the fund sold securities and delivered cash. This is a special advantage of an index-linked ETF versus an open-ended indexed mutual fund, which would have to sell securities to meet cash redemptions.
The issuers and primary traders of index funds operate following the creation – redemption model. In order to track the underlying index, the Designated Sponsors set up a basket of stocks with a composition that mirrors the fund portfolio 1:1. They receive unit shares from the issuers, to the value of the basket, which can subsequently be sold on the market (creation of fund shares). They can also redeem unit shares in the fund, receiving stocks from the issuer in exchange (redemption).

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ETFs – A Leading Financial Innovation

In a relatively short period of time, the market for Exchange Traded Funds (ETFs) has become popular, especially in Europe, and has established itself firmly in the minds of investors. ETFs have been growing faster in Europe than in the US. This is attributed to the fact that many European managers were already familiar with the concept of ETFs before they were made available in Europe. ETFs are now widely used investment vehicles and considered to be an integral component of the overall asset allocation. ETFs might well be considered the leading financial innovation of the past decade.
During the last few years, ETFs have clearly conquered Europe. At the end of October 2004, there were 326 ETFs with assets of US$ 260 billion, managed by 38 managers and listed on 29 exchanges around the world. Year to date, the overall assets under management of ETFs increased by 5% – the US increased by 4.6%, Europe by 15.7%, while Japan declined by 3.9%. During 2004, 45 new ETFs were launched, a further 66 are planned and six ETFs were delisted. The average daily trading volume in US dollars has increased 50.6% to US$ 13.4 billion. This represents a dramatic increase from 1993, when there were just three ETFs with US$ 811 million in assets. January 29, 2003 marked the 10th anniversary of the first ETF listing in the US.1
The attraction of an ETF is that it provides access to a whole index, market or predefined portfolio strategy, but is much less complicated. An ETF behaves like an ordinary share that can be traded on a daily basis, but its underlying assets are an entire index or portfolio, thereby providing diversification.
Their investment objective is to replicate the price and yield performance of an independently published index. This explains why they are often described as index shares. ETFs allow investors to gain broad exposure to specific segments of equity and fixed income markets with relative ease, on a real-time basis, and at a lower cost than many other forms of investing. Essentially, ETFs opened a new, broad range of investment opportunities in large-cap, mid-cap, smallcap, value, growth, domestic, international, country and regional equity indices as well as in corporate and government fixed income indices. Additionally, a trend towards setting up sector ETFs could eventually include style-based offerings and actively managed funds.
Key benefits of return enhancement and the ability to offset custodial and administrative fees help funds squeeze a few extra basis points out of their performance. This can be anywhere between five and thirty basis points on a portfolio, and can often mean the difference between first and second quartile performance.

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introducing ETF ( exchange trade fund )

ETFs are known by a variety of sometimes quirky names — Spiders, Diamonds, OPALs, WEBS (now iShares), Qubes, VIPERs, HOLDRs and streetTracks are just a few. ETFs are a simple, low cost and flexible way to access the potential rewards of market segments. In essence, it brings important advantage in combining index diversification with the flexibility of trading shares. The market growth continued rapidly despite the disappointing investment climate between 2000 and 2003. Therefore ETFs are regarded as the hottest investment product of the new century.
Performance and fees have been the rationale behind index investing for years. In accordance to many investigations only a few actively managed portfolios outperform the broad market over the long run. That’s enough to make investors think twice about paying high fees or pricey sales loads for a fund manager’s supposed expertise. Like conventional index investments, ETFs allow investors to be as active or passive as they wish. Entire portfolios can be built using plain-vanilla
index ETFs that offer broad exposure to stocks and bonds. Further, investors might instead choose to cobble together portfolios based on a dozen or more sector ETFs. Unlike traditional index funds, ETFs can be bought and sold throughout the trading day at intraday prices, rather than based on a fund’s net asset value at a given day and time. ETFs are an evolutionary advance, bringing institutional-quality products to all investors.
In recent years, these unique features and benefits have helped exchange traded funds explode in popularity and emerge as one of the most flexible, multi-purpose investment vehicles available. Ever since the American Stock Exchange pioneered the concept of a tradable basket of stocks with the creation of the Standard & Poor’s Depositary Receipt (SPDR) in 1993, exchange traded funds have evolved into an entirely new investment category. Today, the number of ETFs listed and traded in the US has grown to more than 150 and continues to grow — not only in the number of products and their variety — but also in terms of assets and market value. Currently, there are about 30 ETF managers in more than 25 countries with listings on almost 30 exchanges.
The U.S. Securities and Exchange Commission defines ETFs as “a type of investment company, whose investment objective is to achieve the same return as a particular market index”. An ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index. For example, one type of ETF, known as Spiders or SPDRs, invests in all of the stocks contained in the S&P 500 Composite Stock Price Index.
Typically ETFs are issued for institutions in large blocks, known as “Creation Units”. Payments do not use cash but baskets of securities that generally mirror the ETF portfolio. Creation Units are often split up and sold to individual investors, who are willing to buy shares on a secondary market.
Further it is possible to redeem a Creation Unit back to the ETF by giving investors the securities that comprise the portfolio instead of cash.

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What Creates Trends?

• Government policy. When economic policy is to target a growth rate of 3 percent, then the Federal Reserve (the Fed) raises and lowers interest rates to accomplish this. Lowering rates encourages business activity. Raising rates controls inflation by dampening activity.
• International trade. When the United States imports goods, it pays for it in dollars. That is the same as selling the dollar. It weakens the currency. A country that increases its exports strengthens its currency.
• Expectations. If investors think that stock prices will rise, they buy, causing prices to rise. Consumer confidence is a good measure of how the public feels about buying.
  
• Supply and demand. A shortage, or anticipated shortage, of any product will cause its price to rise. Too much of a product results in declining prices. These trends develop as news makes the public aware of the situation.

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IF YOU CAN’T HELP LOOKING AT THE CHART PATTERNS THEN YOU’RE GOING TO BE A GOOD TECHNICAL TRADER

It’s fun to look at chart patterns and trends and imagine what trades you could have made. In technical trading we’re going to learn rules about price patterns and apply them in the same way to all of the stock and futures markets. Before you move on to the next lesson and see these rules, think about what you already know about price patterns.

Can You Apply the Same Buy-Sell Principles to All Stocks?

• Can you write down the rules you’ve used to buy and sell a stock, any
  stock? Can you write down the rules for when you would have exited the
  long positions in the previous stock charts? If so, you’re a systematic
  trader.
• When you look at a chart, do you see it in terms of continuous price moves?
  Do you look at the highs and lows of price swings? Do you draw conclusions,
  make up rules, and imagine that you can capture large profits?

Looking at a historic chart is frustrating and deceiving. It makes you think that you could have profited from the price moves. It’s much harder when you can’t see the future. However, high-tech display equipment lets you see the past price movement of any stock. It has brought many new traders to the table who think they can profit from future price moves because they can see the past.

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The VIX Index Timing Model

Volatility represents one of the key elements in the pricing of stock index options. Implied volatility represents the options market's consensus opinion of future annualized change in an underlying vehicle. The VIX index, tracked by the CBOE, measures the implied volatility of a series of "at the money" OEX index options. Typically the VIX will range between 10% and 20%. The higher the VIX index, the more expensive option prices are due to volatility.
In developing your OEX trading strategies, you should take into account the level of implied volatility as measured by the VIX. Ideally, you should be selling options when implied volatility is high and about to fall. By the same token, you should attempt to buy options when implied volatility is low and about to rise.
The VIX model that I am about to share with you is designed to give you a small advantage in figuring out the direction of implied volatility. The model has excelled at catching 2-3 point moves in the VIX on the long and the short side. In fact, the model has had a perfect track record using only very simple rules.
The VIX model that I am about to share with you is designed to give you a small advantage in figuring out the direction of implied volatility. The model has excelled at catching 2-3 point moves in the VIX on the long and the short side. In fact, the model has had a perfect track record using only very simple rules.on the trades. Therefore, rather than trade the VIX, you should incorporate the VIX model into your option strategies as noted.

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TYPES OF VOLATILITY RE-EXAMINED

In order to stack the odds in your favor when developing options strategies, it is important to clearly distinguish between two types of volatility:
implied and historical. Implied volatility (IV) as we have already noted, is the measure of volatility that is embedded in an option’s price. In addition, each options contract will have a unique level of implied volatility that can be computed using an option pricing model. All else being equal, the greater an underlying asset’s volatility, the higher the level of IV. That is, an underlying asset that exhibits a great deal of volatility will command a higher option premium than an underlying asset with low volatility.
To understand why a volatile stock will command a higher option premium, consider buying a call option on XYZ with a strike price of 50 and expiration in January (the XYZ January 50 call) during the month of December. If the stock has been trading between $40 and $45 for the past six weeks, the odds of the option rising above $50 by January are relatively slim. As a result, the XYZ January 50 call option will not carry much value. But say the stock has been trading between $40 and $80 during the past six weeks and sometimes jumps $15 in a single day. In that case, XYZ has exhibited relatively high volatility, and therefore the stock has a better chance of rising above $50 by January. A call option, which gives the buyer the right to purchase the stock at $50 a share, will have better odds of being in-the-money and as a result will command a higher price if the stock has been exhibiting higher levels of volatility.
Options traders understand that stocks with higher volatility have a greater chance of being in-the-money at expiration than low-volatility stocks. Consequently, all else being equal, a stock with higher volatility will have more expensive option premiums than a low-volatility stock. Mathematically, the difference in premiums between the two stocks owes to a difference in implied volatility—which is computed using an option pricing model like the one developed by Fischer Black and Myron Scholes, the Black-Scholes model. Furthermore, IV is generally discussed as a percentage. For example, the IV of the XYZ January 50 call is 25 percent. Implied volatility of 20 percent or less is considered low. Extremely volatile stocks can have IV in the triple digits.
Sometimes traders and analysts attempt to gauge whether the implied volatility of an options contract is appropriate. For example, if the IV is too high given the underlying asset’s future volatility, the options may be overpriced and worth selling. On the other hand, if IV is too low given the outlook for the underlying asset, the option premiums may be too low, or cheap, and worth buying. One way to determine whether implied volatility is high or low at any given point in time is to compare it to its past levels. For example, if the options of an underlying asset have IV in the 20 to 25 percent range during the past six months and then suddenly spike up to 50
percent, the option premiums have become expensive.
Statistical volatility (SV) can also offer a barometer to determine whether an options contract is cheap (IV too low) or expensive (IV too high). Since SV is computed as the annualized standard deviation of past prices over a period of time (10, 30, 90 days), it is considered a measure of historical volatility because it looks at past prices. If you don’t like math, statistical volatility on stocks and indexes can be found on various web sites like the Optionetics.com Platinum site. SV is a tool for reviewing the past volatility of a stock or index. Like implied volatility, it is discussed in terms of percentages. Comparing the SV to IV can offer indications regarding the appropriateness of the current option premiums. If the implied volatility is significantly higher than the statistical volatility, chances are the options are expensive. That is, the option premiums are pricing in the expectations of much higher volatility going forward when compared to the underlying asset’s actual volatility in the past. When implied volatility is low relative to statistical volatility, the options might be cheap. That is, relative to the asset’s historical volatility, the IV and option premiums are high. Savvy traders attempt to take advantage of large differences between historical and implied volatility. In later chapters, we will review some strategies that show how.

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Options-Trading Discipline

Proper money management and patience in options trading are the cornerstones to success. The key to this winning combination is discipline. Now, discipline is not something that we apply only during the hours of trading, opening it up like bottled water at the opening bell and storing it away at the closing. Discipline is a way of life, a method of thinking. It is, most of all, an approach. If you have a consistent and methodical system, discipline leads to profits in trading. On the one hand, it means taking a quick, predefined loss because it is often better to exit a losing position rather than letting the losses pile up. On the other hand, discipline is holding your options position if you are winning, and not adjusting an options position when it is working in your favor.
It also entails doing a significant amount of preparatory work before market hours. This includes getting ready and situated before initiating a trade so that, in a focused state, you can monitor market events as they unfold.
Discipline can sometimes have a negative sound, but the way to freedom and prosperity is an organized, focused, and responsive process of trading. With that, and an arsenal of low-risk/high-profit options strategies, profits can indeed flow profusely. The consistent disciplined application of these strategies is essential to our success as professional traders. Plan your trade and trade your plan.
Finally, as option traders, in order to improve in the discipline arena we must identify and either change or rid ourselves of anything in our mental environment that doesn’t contribute to the strictest execution of our well-planned trading approach. We have to stay focused on what we need to learn and do the work that is necessary. Your belief in what is possible will continue to evolve as a function of your propensity to adapt.

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Options-Trading Discipline

Proper money management and patience in options trading are the cornerstones to success. The key to this winning combination is discipline. Now, discipline is not something that we apply only during the hours of trading, opening it up like bottled water at the opening bell and storing it away at the closing. Discipline is a way of life, a method of thinking. It is, most of all, an approach. If you have a consistent and methodical system, discipline leads to profits in trading. On the one hand, it means taking a quick, predefined loss because it is often better to exit a losing position rather than letting the losses pile up. On the other hand, discipline is holding your options position if you are winning, and not adjusting an options position when it is working in your favor.
It also entails doing a significant amount of preparatory work before market hours. This includes getting ready and situated before initiating a trade so that, in a focused state, you can monitor market events as they unfold.
Discipline can sometimes have a negative sound, but the way to freedom and prosperity is an organized, focused, and responsive process of trading. With that, and an arsenal of low-risk/high-profit options strategies, profits can indeed flow profusely. The consistent disciplined application of these strategies is essential to our success as professional traders. Plan your trade and trade your plan.
Finally, as option traders, in order to improve in the discipline arena we must identify and either change or rid ourselves of anything in our mental environment that doesn’t contribute to the strictest execution of our well-planned trading approach. We have to stay focused on what we need to learn and do the work that is necessary. Your belief in what is possible will continue to evolve as a function of your propensity to adapt.

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The IPO System

The equities market generates wealth in several different ways. As private companies expand, they come to a point where they need more capital to finance further growth. Many times the solution to this problem is to offer stock in the company to the public through an initial public offering (IPO).
To do this the company hires the services of a brokerage firm to underwrite its stock, which means the brokerage will buy all the shares the company is offering for sale. The brokerage then charges a commission for managing the IPO and generates cash by selling the shares to investors. The commission is usually about 10 percent of the total value of all shares.
There is a misconception among many people who believe a company makes money every time a share of its stock is traded after its IPO, but that simply is not true. Companies get the IPO money, and that is it. From that point on, the money derived from the buying and selling of a company’s stock is passed back and forth between the actual buyers and sellers.
The IPO is an avenue provided by the stock market for a company to fund expansion. If the expansion succeeds and the company prospers, it will hire more people and buy more raw materials from other companies. This process contributes to the expansion of the economy as a whole, generating wealth that would not have existed without the stock market.
Investors who profit from a successful IPO also create wealth for the overall economy. If they buy low and sell high, they have made a profit that improves their standard of living and their ability to buy goods and services. They also use stock profits to start small businesses, reinvest in the stock market, or add to their savings. This process of putting stock profits back into the economy helps the economy grow over the long term and is a vital component of economic prosperity.
If a company increases its profits year after year, its stock price will rise. The increase in price is the result of the law of supply and demand. When the company went public it issued a limited number of shares, called a float or the number of shares outstanding. As the demand for these shares increases, the supply decreases. In this situation, the price will rise.
Companies definitely benefit when their stocks are in great demand. A company’s market capitalization, the value of all shares of its stock, will go up. Market capitalization is computed by multiplying the current stock price by the number of outstanding shares. The equities market is a powerful mechanism of the capitalist system. It has an enormous influence on the business cycle, because it creates wealth and stimulates investment in the future.
This is also why it should be no surprise that the stock market is so sensitive to economic news such as an interest rate change. The economy is a fluid system, one that evolves through predictable ups and downs. Investors will buy stocks when it appears that companies will be able to use the capitalist system to improve their earnings. They will sell stocks when it seems that economic woes are on the horizon.
This buying and selling is prompted by economic news that provides the clues to the direction the economy is taking. All that said, the IPO market is one of capitalism’s greatest gifts because it provides a mechanism for companies to expand and create wealth in the future.

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Stock Classifications

Another way to classify a stock is by the nature of its objectives. The correct classification often is derived by looking at what a stock does with its profits. For example, if a company reinvests its profits to promote further growth, then it is known as a growth stock. A growth stock is a company whose earnings and/or revenues are expected to grow more rapidly than the average earnings of the overall stock market. Generally, growth stocks are extremely well managed companies in expanding industries that consistently show strong earnings. Their objective is to continue delivering the performance their investors expect by developing new products and services and bringing them to market in a timely fashion.
If a stock regularly pays dividends to its shareholders, then it is regarded as an income stock. Usually only large, fully established companies can afford to pay dividends to their shareholders. Although income stocks are fundamentally sound companies, they are often considered conservative investments. Growth stocks are more risky than income stocks but have a greater potential for big price moves. Don’t be lured into an income stock simply because it pays a high dividend. During the late 1990s, many utility companies paid high dividends. Then problems surfaced in the industry and stocks in the utility sector became extremely volatile. Many suffered large percentage drops in their share prices. Therefore, even though these companies paid hefty dividends, many shareholders suffered losses due to the drop in the stock price. Additionally, there has been a surge in the popularity of socially responsible or “green” stocks. Socially conscious investing entails investing in companies (or green mutual funds) that are socially and environmentally responsible and follow ethical business practices. Green investors seek to use the power of their money to foster social, environmental, and economic changes that will improve conditions on the earth.

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Common versus Preferred Stock

Officially, there are two kinds of stocks: common and preferred. A company initially sells common stock to investors who intend to make money by purchasing the shares at a lower price and selling them at a higher price. This profit is referred to as capital gains. However, if the company falters, the price of the stock may plummet and shareholders may end up holding stock that is practically worthless. Common stockholders also have the opportunity to earn quarterly dividend payments as the company makes profits. For example, if a company announces a $1 dividend on each share and you own 1,000 shares, you can collect a healthy dividend of $1,000.

In contrast, preferred stockholders receive guaranteed dividends prior to common stockholders, but the amount never changes even if the company triples its earnings. Also, the price of preferred stock increases at a slower rate than that of common stock. However, if the company loses money, preferred stockholders have a better chance of receiving some of their investment back. All in all, common stocks are riskier than preferred stocks, but offer bigger rewards if the company does well.

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Develop a Delta Neutral Trading Approach

Delta neutral trading is composed of strategies in which a trade is created by selecting a calculated ratio of short and long positions that balance out to an overall position delta of zero. The term delta refers to the degree of change in an option’s price in relation to changes in the price of the underlying security. The delta neutral trading approach reduces risk and maximizes the potential return. Effectively applying these strategies in your own personal trading approach generally requires four steps:

1. 1. Test your trading systems by paper trading. Paper trading is the process of simulating a trade without actually putting your money on the line. To become a savvy delta neutral options trader, you will need to practice strategies by placing trades on paper rather than with cash. Although it may not feel the same as putting your money on the line, it will help you to develop practical experience that will foster confidence in your abilities. This will come in very handy in the future. Since there is no substitute for personal experience, you should test all ideas and your ability to implement them properly prior to using real money.
2. Discuss opening a brokerage account with several brokers. Make sure you have a broker who is knowledgeable and fairly priced. Brokers can be assets or liabilities. Make certain your broker is an asset who will help make you richer, not “broker.” Do not sacrifice service by selecting the broker with the lowest cost. Shop around for the right person or firm to represent your interests. Your broker will play a crucial role in your development as a successful trader. Take your time, and if you are not satisfied, find someone else.
3. Open a brokerage account. It’s best to consider a brokerage firm that specializes in stocks, futures, and options. Then you can easily place trades in any market using the same firm. When it comes to trading, flexibility and precision are equally important. Today, some online brokers specialize in options. We provide examples in later chapters.

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Options on Indexes and Exchange-Traded Funds

An index option is an option that represents a specific index—a group of items that collectively make up the index. We have already discussed the index markets and exchange-traded funds. Options on indexes and ETFs fluctuate with market conditions. Broad-based indexes cover a wide range of industries and companies. Narrow-based indexes cover stocks in one industry or economic sector.

Index options allow investors to trade in a specific industry group or market without having to buy all the stocks individually. The index is calculated as the average change of the stock price of each stock in the index. Each index has a specific mathematical calculation to determine the price change, up or down. An index or ETF option is an option that is tied directly to the change in the value of the index or exchange-traded fund.
Index options make up a very large segment of the options that are traded. Why are so many options traded on indexes? The explosive growth in index trading has occurred in recent years due to the increase in both the number of indexes and the number of traders who have become familiar with index trading. The philosophy of an index is that a group of stocks—a portfolio—will diversify the risk of owning just one stock. Hence, an index of stocks will better replicate what is happening in an industry or the market as a whole. This allows an investor or trader to participate in the movement of a specific industry, both to the upside and to the downside.
It appears that index and ETF options will continue to proliferate and trading volume will increase in many of the instruments. A word of caution: A number of these instruments do not have much liquidity. However, used wisely, index options can be an important instrument in your trading arsenal. Also, it is important to understand the difference between the way ETF options and index options settle. Namely, exchange-traded funds, which can be bought and sold like stocks, settle for shares. Cash indexes cannot be bought or sold. They settle for cash.

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Reduce Your Stress Level

Successful traders have to find ways to reduce the stress commonly associated with trading. I reconstructed my trading style after experiencing more stress than I had thought I could ever handle. In a typical trading day with the S&P 500 (Standard & Poor’s 500 Index, which represents the 500 largest companies in the United States), I found myself buying close to the high of the day. Immediately the market started to tumble so fast that I was down 100 points even before I got my buy filled (i.e., before my order was executed). I finally was able to regain my composure just enough to pick up the phone in a panic to sell as fast as possible. By then the market had tumbled almost 200 points. Worst of all, I had purchased too many contracts for the money I had in my account; and, to top it all off, it was my first trade ever in the S&P.

That was the point in my trading career that I experienced the panic and stress of losing more than 40 percent of my account in three minutes— more than one month’s pay as an accountant. I did not trade again for more than two months while I tried to figure out whether I could really
do this for a living. Luckily, I did start trading again; however, I reduced my trading size to one contract position at a time for more than a year.
Many professional floor traders and off-floor traders have had similar experiences. However, these kinds of stressful events must be overcome and used as lessons that needed to be learned. Simply put, stress produces incomplete knowledge access. Stress, by its nature, causes humans to become tense in not only their physical being but also their mental state. For years, physicians have made the public aware that stress can lead to many illnesses including hardening of the arteries with the possibility of a heart attack or other ailments. Reducing stress
can lead to bigger rewards and can be accomplished by building a lowstress trading plan.
To create your own plan, follow this three-point outline:

1. Define your risk.
2. Develop a flexible investment plan.
3. Build your knowledge base systematically.

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Gain the Knowledge to Succeed over the Long Run For Success Trading

You have to have knowledge to succeed. Most new investors and traders enter this field expecting to immediately become successful. However, many have spent tens of thousands of dollars and many years in college learning a specific profession and still do not make much money. To be successful, you need to start your journey on the right path, which will increase
your chance of reaching your final destination: financial security. To accomplish this goal, learn as much as you can about low-risk trading techniques and increase your knowledge base systematically.
Successful traders have an arsenal of trading tools that allows them to be competitive in the markets. I have used the word arsenal purposely. I believe that as an investor or trader, you need to recognize that each and every day in the marketplace is a battle. You must be ready to strategically launch an attack using all the resources in your arsenal. Your first weapon—knowledge—will enable you to make fast and accurate decisions regarding the probability of success in a specific investment. Is it incongruous to suggest that trading is war and also that to trade successfully one must reduce one’s level of stress? I believe not. The most composed and well-armed opponents win wars. The same is true for traders. In most cases, winners will be more comfortable (less stressed) regarding their ability to win. Knowledge fosters confidence. If you are well armed, you will be confident as you go off to fight the battle of the markets. Increased confidence leads to lower stress and higher profits.

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A Brief Review and a Little Extra

• The reason for using a trendline or moving average is to get an objective assessment of the price direction.
• Disciplined trading is most important because it clearly tells you when to get out of your trade and take your loss.
• You can’t follow the trend and take profits at the same time. Profit-taking works with short-term trading, but profit-taking fights with the long-term trend. You can’t hold onto a trend trade to get a big profit and at the same time take a small profit when things go your way for a few days. You’ll need the big profits to offset lots of small losses.
• Trend analysis says (à la Yogi Berra) the market is going up when it is going up. There’s no hocus pocus. Fundamentals, or value investing, may say that the company is in great shape while prices are falling. You’ll do much better trading technically.

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LIMITING THE RISK OF A TRADE

A stop-loss works when you are using basic charting techniques to identify support and resistance lines. Stops can be used very effectively. There is an orderly process in deciding on how to apply a stop-loss, or whether to apply one for a specific trade.
Consider whether the natural buy and sell signals for your trading method provide adequate risk control. When the trade goes against your long position, does the system create a sell signal that gets you out with an acceptable loss? For example, you wanted to trade Amazon using a 200-day moving average, but when prices reached $90, the moving average was still lagging at $40. It finally turned down when prices broke below $50, capturing only onehalf of the profits. What could you have done?
1. Place a fixed dollar stop, the amount you can afford to lose.
2. Pick a support level on the chart that would signal a change of direction.
3. Draw your own trendline that would signal a change of direction.
4. Move the stop closer as profits accumulate in order to lose only a fixed amount of your peak profits.
All of these approaches have been used by traders, but not all of them are good solutions. The most important rules to remember are:

1. The best place to exit from a long position is the natural point where you would want to enter a short position.
2. The size of the stop-loss must be related to the speed of the trend. If you are trading a slow trend, then the stop must be farther away.
3. The stop should adjust to the volatility of the market. Your stop can be closer if the price changes are small or the market is quiet, and larger if prices are volatile.
4. A stop-loss must not be closer than 11⁄2 times the current volatility (the high to low range). If you want it closer, you should simply close out the trade.
5. You must first decide how you would reenter the trade once you are out.
   

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IMPORTANT CONSIDERATIONS ABOUT RISK

As a trend trader, using a moving average trendline, we don’t always think of risk clearly. We know that slower trends allow larger price swings without changing the direction of the trend. Faster trends respond quickly to price changes. Those risks are implicit in the use of a trend method and can’t be separated out.
One of the dilemmas of using a stop-loss to limit your risk to a “comfortable” amount can be shown best in an example. Suppose you’ve been following a trend system and you are long 1000 Amazon at $30 and now hold a $10 profit ($10,000 on your trade). You would like to protect those profits; therefore, you place a stop-loss at $28, risking only $2,000 of your gains. Sure enough, prices drop and you are stopped out. Prices continue down to $27.50, turn back up, and move above $40.00 to new highs. During the drop to $27.50 the moving average trendline never turned down. It would not have turned down until $22.00. You are now out of the trade but the trend is still up and prices are making new highs. What do you do? Do you jump back in and try to catch the rest of the upward move, or do you stand aside until there is a new trend signal?
None of these choices are good. If you going to trade the trend, then you must look at the risk in advance and decide how many shares you can buy and still hold the trade comfortably when prices move against you. A stoploss fights with the trend system. The trend system wants to stay long and you want to get out. It just doesn’t work.
You cannot trade more than you can afford to lose. Your position is too large if you are uncomfortable with the day-to-day risk.

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THE REALITY OF USING CHANNELS AND BANDS

Channels and bands both have the same objective—to put a framework around price movement. They tell us when prices are unusually high or low. We can turn that into trading by buying at the low end of the channel, or when prices penetrate the bottom band, and selling at the high end. It works most of the time. It is best when prices aren’t moving too fast.
By expanding the channel or band width and slowing down the trendline used to form the bands, we can identify more extreme price moves and be more selective about our buy and sell signals. This helps eliminate some bad situations, but it reduces the number of trades and increases the time you are in a trade. We know by now that the longer you hold a trade, the larger the price swing you will endure.
There is no perfect channel or band. They all have the same basic problem. When price begin moving quickly higher, selling is a mistake; when prices drop sharply, buying is a mistake. All trading methods will have situations in which they lose.

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Active as Opposed to Passive Management of Assets

The Wall Street establishment generally espouses the cause of passive investment management. Buy your favorite stocks or mutual funds or bonds, hold on through thick and thin, and hope that the stock and bonds markets are on upswings when you need the money. Not necessarily the worst of strategies—unless, of course, you happened to need to draw on your capital in mid-2002, at a time when stocks were more than 50%, on average, below their all-time peaks.
By the time you finish this book, you can be a successful active manager of your own investments and by so doing add to the returns available from the usual sources to passive investors. As an active manager, you will be able to do the following:

• Actively monitor the investment universe and select investment areas—and individual investments within those areas— likely to outperform the average investment of similar risk. In other words, you will have some idea as to when to emphasize bonds, stocks, gold, real estate, and international positions and when to opt for money market and other safe havens.
• You will have the ability to enter, and will enter, into investments relatively early in their rise and exit relatively close to their peak, either prior to or relatively soon after the final top is made. This does not mean that you have to be the first one in and the first one out. It does mean that you will be able to catch the major portion of up moves, while avoiding at least significant portions of the downswings that plague every investment at some time or other.
• And finally, you will be alert to special opportunities that develop from time to time in almost all investment areas and be able, ready, and willing to take advantage of such opportunities.
  

The benefits of active and successful management are self-evident.

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HOW TO PLACE AN ORDER

You need to be very careful and very precise when placing an order. This is true especially if you place the order by telephone. In the heat of trading, even experienced traders can make the mistake of buying when they wanted to sell. With electronic order entry you should not press the send button before you’ve checked and rechecked that you’ve entered everything correctly.
Terminology
You’ll need to get familiar with using the right words to enter an order. Long descriptions don’t work. The order clerk doesn’t care why you’re making this trade. Learn the following terms:
1. When you have no position and you buy, you are initiating (entering) a long position.
2. When you are holding a long position and you sell, you are liquidating (exiting) a long position.
3. When you have no position and you sell, you are initiating (entering) a short position.
4. When you are selling short, you are initiating (entering) a short position.
5. When you are holding a short position and you buy, you are liquidating (exiting) the short position.
In futures:
• If you are long 1 contract and you sell 2 contracts, you have closed out your long and you are now short 1 contract.
• If you are short 1 contract and you buy 2 contracts, you have covered your short and are long 1 contract.
• When you go from long to short, or short to long, you can say that you’ve reversed your position.

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THE IMPORTANCE OF A SIDEWAYS BREAKOUT

A sideways trading range occurs when there is no compelling news in the market. The range between the support and resistance lines actually shows the underlying market noise (volatility) caused by normal trading in and out of that stock or futures contract.
When prices move out of a sideways range, there must be news, or anticipation of news, to cause enough buying or selling to drive prices to a new level. This might be expectations of higher earnings, a possible acquisition, lower interest rates, or pending bad weather for crops.
A breakout of horizontal support or resistance will work successfully using daily closing prices (a conservative choice), daily highs and lows (an active choice), or even intraday prices (an aggressive choice). The risk of the trade is always measured by the distance between the support and resistance lines. This varies with the volatility of prices. Breakout systems are extremely popular because they:
• Are highly reliable even though they have high risk.
• Do not have a lag because signals come at the moment of breakout.
• Allow prices to move freely within the support-resistance band, imposing few restrictions.
Which Is Better, Using the Trendline or Breakout?
The breakout is more dependable because it recognizes an obvious change in the market at the time it occurs. The trendline shows the direction of prices based on their rate of increase or decrease. The breakout usually corresponds to a special event.
The breakout is reliable, partly because it has more risk. Remember that price moves are fickle. Prices may move up, but they do it in a very erratic way. It’s best to give prices room to flop around. Prices may break out of the trading range, make a new high, and then fall back into the sideways pattern for a while. The only thing we really know is that if we bought on a new high and prices then make a new low, something is wrong. Prices shouldn’t make a new low after making a new high. There is good, simple logic in a breakout system.

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THE MAGIC NUMBER IS 4

Whenever you are thinking of scaling into the market, remember that the magic number is 4. If you are trying to get an average price, you need to break your order into at least four equal parts. If you are trying to get a better than average price, then you cannot divide your order into more than three equal parts. Four or more equal parts gets you close to an average price, three or less gives you a chance to get a better than average price.

The best scenario is to buy your entire position at one time at the lowest price. We would all like that, but it’s unrealistic. Therefore, you decide how long you have to enter your position, a few hours or a few days, and look for opportunities during that window. Let’s say that prices are trading in a range from $35 to $40 and you expect good news to move prices through the $40 level to $50. It’s Monday morning and you think this will happen by the end of the week after dividends are announced. The price is now $38. What are your choices?

1. You could buy one-third of your position now, one-third on today’s close, and one third sometime tomorrow, for an average price.
2. You can wait for prices to test the low of $35, placing a buy order for your entire position at $35.50. However,what happens if you are right and prices move straight up to $50, never pulling back to $35? You’ve missed the move.
3. You can buy one-third now, one-third at $35.50, and one-third at $40.10 on a break above $40. That’s a bit better because you are sure of getting twothirds of your position at $39.05. If prices drop instead of rally, you have two-thirds of your position at $36.25. The only time you have a full position is if the price pattern is exactly as you predict—first declining to support, and then rallying up through resistance.

How realistic is case 3? Not very. If we knew how prices were going to move, we wouldn’t need all this planning. It’s difficult to forecast where prices will be in a few days; it’s even more difficult to predict the pattern prices will take to get to that goal. There is a very small chance you will be able do both.
Try the average price method. In the example above you might buy two of the three parts by averaging into the trade, and then add the third part on a breakout through $40 in order to have a confirmation. In that case you raise your average price, but have the comfort of knowing that you were right about your prediction.
Some traders would wait for the breakout before entering any of the position. They get a worse price but a better chance of success. Other traders would enter the entire position between $39.75 and $39.90 looking for the breakout and trying to get free exposure from the jump through $40—a little more risk, but a lot more reward.

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AN AVERAGE PRICE OR A BETTER PRICE?

It’s always safe to get an average price. If you’re concerned that you’ll buy IBM at $50 today and it will drop to $45 by the end of tomorrow, then you could just wait. Most likely, you’re not sure that it will drop. If the employment report comes out favorably and the economy looks strong, then IBM could even jump to $60 by the end of today.
If you don’t know what might happen in the next two days but you have a strong opinion that IBM will be going up, then average into the position. To get an average price, you buy equal amounts over equal time intervals. If you plan to buy 200 shares, then you buy 50 this morning, 50 this afternoon, 50 tomorrow morning, and the last 50 at tomorrow’s close. You now have a reasonable approximation of an average price.
When you’re trying to get an average price, breaking up your order into small pieces and feeding it into the market is the simplest way. You don’t need to do it one share at a time. If you separated your 200-share order into eight parts of 25, you would get very close to the average.

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EVOLUTION IN PRICE PATTERNS

A change has occurred in the market because of the ability to trade the S&P 500 index directly rather than individual stocks. S&P futures have become an active vehicle for both speculation and hedging. If you think that stock prices are about to fall because of a pending interest rate announcement by the Fed, you can protect your portfolio by selling an equivalent amount of S&P futures. Afterward, when you have decided that prices have stabilized, you can lift your hedge and profit from rising prices. It’s an easy and inexpensive way to achieve portfolio insurance.
When institutions and traders buy or sell large quantities of the S&P futures, that price can drop while the share prices of the stocks that comprise the S&P Index may not have fallen yet. Enter the big business of program trading. If you have enough capital and the difference between the S&P futures price and the S&P cash index is sufficiently large, you can buy the S&P futures and sell all of the stocks in the S&P 500 cash index. It is a classic arbitrage that brings prices back together.
How does program trading, or just the trading of S&P futures, affect the price patterns of individual stocks? The answer is that all the stocks in the S&P Index move together at the same time. It doesn’t matter whether IBM is fundamentally stronger the GE, or that Xerox is at a resistance level and Ford is at support, or even if Enron is under investigation. When you buy the the S&P you buy all of the stocks at the same time.
Today’s technical trader must keep one eye on the individual stock and the other eye on the index. Exxon may have moved above its recent resistance level but stops because the S&P Index is at its own resistance level, and there are more traders watching the S&P than Exxon. In today’s market, you can anticipate when a stock will find support and resistance by looking at the S&P chart rather than at the stock chart.
During times where there is no news, the stocks all move together. When there is positive news for a specific company, it will gain over other stocks, but it will still meet resistance where the S&P as a whole meets resistance. This change in the way stocks are traded reduces the ability to get diversification by trading across sectors and increases your risk. Short-term traders will not be as affected as those holding positions longer.

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COMPARING SIDEWAYS AND ROLLING BREAKOUT METHODS

There is no doubt that an intelligent technical trader could identify the sideways patterns better than the computer, but the computer can do it faster and give you the chance to trade a more diversified group of stocks and futures. That’s important and we’ll discuss that as we move forward. Let’s now try to follow the weekly S&P 500 prices during the strong upward move from 1994 to 1997 by drawing sideways ranges manually and comparing the results to a rolling breakout. It’s difficult to be objective when looking back at the entire picture, but let’s try:

1. The sideways period from April 1994 through February 1995 is very clear. The lows form a support line and the highs in March, September, and October (A, B, C) form resistance. The resistance line is drawn across the highest high, point B, but we could have lowered that to cross A and C, cutting the top off at B. Cutting the tops off is the better way.
2. We get a breakout to the upside in mid-February. The rolling 30-week breakout also gets a buy signal because prices move over point B, which is within the past 30 weeks.
3. The steady move up doesn’t require any decisions until the sideways period, beginning in July 1995, has a sharply lower move in October. We don’t see the sideways pattern until prices start to fall to point H, the lowest level of the pattern.
4. The decline to H stops at exactly the same level as D, but we may have sold when prices first broke through the line formed by F. We may have drawn a support line connecting the two lows on both sides of F. If we sold at the first line, we take a profit of about 115 points and then sell short.
5. If we’re fast, we sell at the thin support line crossing at F, and then see prices stop at the major support line drawn from D to H. Prices rebound higher, and we realized that support held and we need to get net long again. The new high is at 950, at which point we would be sure the uptrend has resumed but take a 60-point loss in the S&P.
6. You may have waited for the major support line at H to be broken and remained long. Prices would have dropped from 950 to about 870, a loss of 8.4 percent. Would you have been able to wait that long? Not likely.
   

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TRADING GAME TIPS 1

You made the wrong trade. Every trader makes mistakes, even buying when you meant to sell. Don’t try to manage the position; just get out. It’s the wrong trade, and you can’t manage it correctly. It will distract you from other trades and eat up your time. Close out the trade as soon as possible, and get on with your life.
The time of day to trade. There are two reasons to select the time of day to trade. Volume varies considerably during the day. The greatest volume is near the open; the second greatest volume is at the close. After the open the order flow steadily drops until its low point in the middle of the day. Many of the traders are off the floor—some actually eat lunch. During the middle of the day orders dribble in. If one large order hits the market, it could push prices higher or lower but have very little meaning with regard to price direction.
The open and close are the two most likely times to show the high or low of the day. If prices open and start to drop, then the open is most likely to be the day’s high. The middle of the day is the next most likely time to be a high or low. Prices drop from the open and quiet at midday while there is little activity. When traders come back onto the floor and activity increases, they
may move prices higher again. Then the midday price becomes the low. If they move prices lower, then the close becomes the low.

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TRADING GAME TIPS

1. It’s good to have a bias. You can have a fundamental opinion of where prices are heading and still be a technical trader. A bias can be very sensible. For example, when the Fed cut interest rates to under 2 percent, it removed a lot of profit potential from a long Treasury note trade. The potential profit fell to less than the likely risk of a trade. On the other hand, going short Treasury notes doesn’t guarantee a profit because prices can drift sideways for a long time, but you’ll want to trade only small positions long Treasury futures.
2. Try to distinguish between a bias and wishful thinking. The stock market is at very low levels, but a bias to the upside is wishful thinking. It may happen, but prices could still go lower. It’s not the same as interest rates, where they are approaching a bottom of zero. Hopefully, the stock market will never get to the point where it is so low that it can’t go lower.
3. Are you still confused about the use of limit and stop when you’re placing an order?
   A stop order is used in the following situations:
   • When you are long and you are selling at a lower price (usually to exit the trade).
   • When you are short and you are buying at a higher price.
   You will want to buy at a higher price at the point where the trend turns up. Remember that a stop becomes a market order when the price is touched. You must use the word stop in your order. A limit order is used in the following situations:
   • When you are long and you are selling at a higher price (to take profits).
   • When you are short and you are buying at a lower price.
   • When you a trying to buy at a support level or sell at a resistance level.
4. You can combine an MOC order with a price, but all conditions must be met to get an execution.

   • If you’re long IBM at $52 and want to exit if prices close lower, but below a specific price, then you enter SELL IBM 48 STOP MOC. You will be executed at the closing price if it is anywhere below $48. It is unlikely you will get $48 as your price, but you won’t be executed if prices dropped to $46 during the trading session, but closed at $49.
   • If you have no position and you want to buy IBM on an upward breakout above $55 but only if it closes above $55, then if IBM is at 52, BUY IBM 55 STOP MOC.
   • You wouldn’t want to use this order to take profits on your IBM position because you would prefer to get a higher price anytime during the day. If you wait for the close, prices may have fallen back from their highs. If you are long IBM at $48, you would want to place the order SELL IBM 53. That gives you a $5 profit if IBM trades at $53 or higher during the day.

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THE ROLLING BREAKOUT

We normally find a sideways period and the corresponding breakout levels by looking at the chart. However, computerized programs have taken a different approach by always looking backward by the same number of days. If we always use the highest high and lowest low over the past 20 days, we call that a 20-day rolling breakout or simply a 20-day breakout system. For each new day we drop off the oldest day and find the highest high and lowest low of the new 20-day period.
Is the “Rolling Breakout” Better Than the Old-Fashioned Method?
No, but it can be very profitable, and it can be tested on a computer. It has the same profit and risk characteristics as the handdrawn lines but sometimes gets fooled into using the wrong highs and lows. It’s a lot more practical than drawing lines on each of a large number of charts each day. A computer can calculate the breakout trends of all the markets in a few seconds. If you like the diversification of trading a number of markets, the rolling breakout is a good method to use.

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EVOLVING MARKETS

The market is dynamic. It is not the same as it was, yet it is driven by the same underlying economic forces.
What Has Changed?

• The equipment has changed, allowing instantaneous analysis, program
trading, electronic orders (smart order entry), high-momentum trading,
and unreasonable expectations.
• Methods have changed, with far more systematic traders, especially professional
fund managers.
• Participants have changed, with a larger influence from pensions, designer funds, and institutional investors. Day traders are common because commissions are low.
• Electronic exchanges and side-by-side trading are new. You can beat your competition by creating an electronic order the instant a system “signal” is triggered.
• Globalization has changed the way world markets move, with alternating leaders and followers.
• There are more trading vehicles, including ETFs for index and sector investing, and single stock futures.
• Markets are noisier because of more participation. Sometimes they have irrational swings because of piggy-backed orders. The frequency of extreme moves is increasing, causing greater volatility.
Will a system that worked in 1990 work in 2002? Probably not. Will the people who made money in the 1990s make money now? If they change, too.

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How Do We Normally Decide to Buy a Stock?

• We make a qualitative decision: Is it a good company?
• Is it profitable? Has it paid dividends regularly? Is the stock rising? Does it have a lot of debt? Is the P/E ratio high or low? In other words, is the company a good value?
• Is the company healthy? Is it in good strong hands? Is the management competent? Is there a large employee turnover? Are salaries reasonable?
• Is the company likely to be competitive in the future?
• Add to these concerns some new questions, such as: Does the CEO have a sensible exit package? Are there any accounting irregularities?

All of these questions and answers are important. They try to reach the vital areas that determine whether a company is sound and likely to remain that way. The problem is whether you can get answers to these questions, and whether those answers are reliable. Even when they appear to be answered, what is your level of confidence in a decision based on so many complex issues?

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TECHNICAL TRADING AND VALUE

A technical trader may also be influenced by fundamentals. A long-term trend follower—one who buys a stock when the trend is rising—is really tracking the increase in the value of the stock in an objective way. If Mrs. Hathaway was long Cinergy (a public utility) in 1997 based on a 100-day trend, she would be taking advantage of the Fed policy of lowering rates even though the reason for rising prices might not be important to her, and she may not have seen the close relationship between Cinergy’s stock price and interest rates.
The fast systematic trader could even profit if the stock or futures market were above value. He or she could be in a trade for a few hours or a few days. The value of a stock isn’t very important for a fast trader, only its volatility and short-term direction. Even when stocks were trending higher, as they were in 1997, the impact of the long-term trend on a one-day trade was very small. You could buy or sell and still return a profit. Value, or fundamental information, is of minor importance for short-term traders.
We choose systematic trading because
• It provides discipline.
• We can backtest (check the rules using historic prices) to see if the trades would have been profitable.
• We have confidence by knowing what results to expect both risk and return.
• We can monitor current performance to decide if the method is still working as we expected.

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TIME-DRIVEN OR EVENT-DRIVEN?

A moving average system is time-driven; that is, the moving average closes in on current prices when the price movement slows. In Figure Exxon (XOM) prices move sideways from January through mid-April 1997, before the sideways period. The moving average tracks rising prices smoothly, and then turns down at the beginning of March although prices only show a slight decline. Using the trendline for the buy and sell signals forces us to close out our trade at the March lows, although prices are $1 higher one month later.
This characteristic of the moving average can’t be removed. It is a benefit when prices turn slowly from up to down, and a problem when prices slow down and then continue in the same direction as in Figure
A clear example of an event-driven trend is the breakout. That a breakout that creates an up ward trend begins with a new high and ends with a new low. The trend doesn’t change unless prices move to new highs or new lows. You can consider a new high price as being caused by an event: a news release, an earnings report, or a change in government policy. Prices can drift up and down within a reasonably small range and the trend doesn’t change.
Using a 40-day rolling breakout applied to XOM, we see nearly the same trades as when we used the moving average except that prices failed to make a new low in March, and the breakout trend held its long position.
The rolling breakout is not entirely immune from time change. The rolling calculation period moves forward in time. If prices become less volatile, then the highs and lows that trigger a new buy or sell signal will get closer together. Two methods that are completely independent of time are swing charting and point-and-figure charting, and the trading signals that they generate.

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CHOOSING THE SYSTEMATIC WAY

It is not a choice between “which is better,” investing based on fundamentals or technical trading. They are two very different methods chosen for completely different reasons. The fundamental investor may be looking for a cheap price or good value on a piece of merchandise with the idea of holding it until it returns to value, or appreciates in value. You don’t want to overpay for real estate or stocks because it cuts into your returns.

The systematic trader is foremost a trader. A trader doesn’t hold a position based on value, but decides whether the price is relatively too high or too low, whether it is in a long-term or short-term trend, extremely volatile or quiet. For each of these technical qualities, the systematic trader has a clear rule to follow. The rules are based on common sense and then tested using historical data to be sure they actually work. We will learn how a spreadsheet or special computer program may be used to validate the rules. You will find that many of the rules that are based on charting methods have been handed down from one generation to another.

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EXTRA BENEFITS OF TRADING

When you actively trade a stock or a futures contract, you are not holding a position all of the time. That’s very important because stocks spend a lot of time doing nothing, or doing the wrong thing. To offset these sometimes prolonged periods of aggravation or boredom, we get an occasional price shock, such as September 11, 2001, the U.S. invasion of Kuwait, a presidential election, or a surprise interest rate increase by the Federal Reserve. A price shock causes an unpredictable, large jump in prices.
Note that the term unpredictable means that you can’t plan to make a profit, no matter how clever you are. When you are always in the market, you will always be tossed around by price shocks, most of them small, a few of them very big. We’re going to spend some time throughout this course looking back at price shocks. They are the rare random events that cause the greatest losses among traders. The longer you trade, the more you’ll see price shocks. You don’t ever want to make the mistake of thinking that it was skill that netted a big profit from a price shock. It was luck. Next time, or the time after, you won’t be lucky. It’s a 50-50 chance.

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TREND TRADING RULES FOR TRENDLINES

It may seem clear from the charting examples that the trendlines show where to buy to enter a trade and sell to exit; however, traders place their orders in a few different ways:
Entry Rules
• Buy when the price closes above the downtrend line (conservative).
• Buy when the intraday price penetrates the downtrend line (aggressive).
• Buy in an upward trend when prices decline to near the upward trendline.
Exit Rules
• Sell when the price closes below the upward trendline (conservative).
• Sell when the intraday price penetrates the upward trendline (aggressive).

Notice that the aggressive trader buys during the day when prices cross through the trendline. A more conservative trader will wait to see if the closing price is going to be above the trendline. Price action during the day can be very volatile and the direction of prices can change, and often does, from midday to the close. On the other hand, if important news reaches the market during the earlier trading hours, the first one that buys gains the most profit. You can only decide your style from practice. Start with the closing price as a measure of direction until you are confident that another way is better.

Getting Out of the Trade
When the upward trend is finished, prices will move down through the trendline. At that point you sell, closing out your trade, hopefully with a profit. However, not all trades are profitable. About two-thirds of all trend trades lose money, and yet trend trading is still a reliable, profitable way to trade.

Profits Through Persistence. The majority of times, a change of direction does not turn into a trend; however, when prices do continue in one direction, they produce good profits. Success is a matter of numbers. You can expect 6 to 7 out of 10 trend trades to be losses, some small, some a little larger. Of the 3 or 4 good trades you can expect one small profit, two medium-size profits, and one large profit. On average, a profitable trend trade should be about 2.5 times the size of a loss. With enough trades, that should result in a net profit in your trading account.
As an example, say we lose $100 on each of the 6 losing trades, for a total loss of $600. On the four profitable trades we get an average of $250 per trade for a total profit of $1,000. The individual profits are most likely $100, $200, $200, and $500. That’s a $400 gross profit less some slippage for entering and exiting and commissions on 10 trades. If instead of 6 losses there were 7 losses and 3 profits, we would net only $50. Expect the real results to be somewhere in between $50 and $400.


The Fat Tail
Trend trading is successful because losses are kept small and profits are allowed to grow. That technique is called conservation of capital. What makes trend trading profitable in the long run is the unusually large number of big profits compared to what is expected in a normal distribution. For example, in a normal distribution of 1000 coin tosses, half of them would be single runs of heads or tails. Half of those, 25 percent, would be a sequence of either two heads or two tails. Half of the remaining, 12.5 percent, would be sequences of three in a row, and so on. Therefore, in 1,000 coin tosses you can expect only one run of 10 heads or tails in a row.
Apply that to prices. In 1,000 days of trading (about four years) you would expect only one time that prices would go up or down 10 days in a row. However, that happens much more often than once; therefore, price movement is not normally distributed, and not random. It has a fat tail distribution. There are fewer days where prices turn from up to down, or down to up, and more longer runs. That’s what makes trend trading profitable.

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The Relationship Between the Moving Average Speed and Market Noise

The slower the moving average, the less it is going to be fooled by noise. The longer calculation period makes a single day less important and the average more able to hold onto the longer-term direction.
Some markets have more noise that others. The high-volume index markets have the most noise and, if you’re going to find the trend, you’ll need to take a very long view of those price moves. Foreign exchange markets and stock sectors have less noise and can be traded with a somewhat faster trend (medium speed is considered to be 25 to 60 days).
If you use a very fast trend, then you’ll want to take profits as often as possible since noise causes prices to change direction unexpectedly If you can’t expect prices to trend, then you must take profits often.
To summarize the way you need to look at a trading method based on long-term and short-term trends, remember that the short term is strongly influenced by noise, while the long term makes noise appear less important:
Short-Term Trend
Noise dominates short-term price movement.
Take profits often because noise causes sudden changes of direction.
Expect many small profits and a few large losses.
Use daily or intraday data.

Long-Term Trend
Noise is small compared to the length of the trend.
Stay with the trend, and don’t take profits. Take advantage of the fat tail.
Expect many small losses and a few large profits.
Use daily or weekly data.

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Application of Currency Option

The users of the option market are widespread and varied, but the main users are organisations whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers, where the standardisation of options contracts promotes tradability, but this is at the expense of flexibility.
In spite of the fact that options are becoming more and more popular with corporate clients, funds and private individuals, there is still some client resistance to using options as a means to managing currency exposures. Some clients consider options to be expensive and/or speculative.
When you buy an option, the most you can lose is the premium (price paid for the option). In some cases, options can help minimise downside risk, while allowing participation in the upside potential. One of the reasons a client may choose to use an option, instead of a forward to manage their downside risk, is this opportunity to participate in the upside profit potential which is given up with a forward contract. Clients who buy currency options enjoy protection from any unfavourable exchange rate movements.
Companies use currency options to hedge contingent/economic exposures, hedge an existing currency exposure, and possibly profit from currency fluctuations, while funds may use options to enhance yield.
Sometimes a strategy may involve more than one option and some option strategies employ multiple and complex combinations. Certain combinations can yield a low or no-cost option strategy by trading off the premium spent on buying an option with the premium earned by selling an option.

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HOW TO MAKE YOUR TRADING ADAPT TO CHANGING VOLATILITY

Enough of the theory. The best way to use volatility to improve your trading is to make your profit-taking objectives and your stop-loss targets get closer and farther away as volatility decreases and increases.
Changing Profit Targets Based on Volatility
If AOL is trading in a $1 range each day, you might want to target a short-term profit of $2. That would be reasonable if prices moved in one direction for about three or four days. If AOL was much more volatile, ranging $4 in one day, then an equivalent profit target would be $8. More important, if volatility dropped to $0.50 then a profit target of $2 would take much longer to reach and you’ll want to set your goal at $1.
When you set your profit target by finding a resistance level on a chart, the volatility of prices tells you where to look. Don’t pick a minor resistance level that’s $1 above the current price when the market volatility is $2 a day, and don’t expect a profit of $10 when prices only range $0.50 each day.
Changing Your Stops to Reflect Volatility
The same principle applies to stop-loss orders. If the stop is inside the normal daily trading range of AOL, then you can be sure that you’ll be stopped out. How far away should you place your stop? Look for a support level at about 3 times the volatility below where you enter your long trade and place your stop-loss on either side of that level—depending on whether you are looking for free exposure or confirmation.
If you’re a technical trader and you are not using charts, then you can set your profit target and stop based entirely on volatility. If you have just entered a long position in AOL at $15 and the stock has been trading in a $1 daily range, then:

Profit target = entry price + (profit factor × daily range)
= 15 + (2 × 1)
= 17
Stop-loss = entry price − (stop factor × daily range)
= 15 − (3 × 1)
= 12

You’ll note that the profit target is 2 times the volatility and the stop is 3 times the volatility. The profit target is closer than the stop-loss. This is the normal pattern when you’re a short-term trader. You want to be sure you capture profits as often as possible. To do that, you’ll need to take a larger risk on each trade. If you make your stop closer than your profit target, then you’re sure to be stopped out more often and end up as a loser. The closer order is most likely to be hit.

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Range Expansion Search Code

In creating a list of patterns for trading programs, there are two ways to proceed. The first method is to observe the markets and investigate hunches as to market behavior. Occasionally, using this method, useful trading patterns will be detected. This is the method I used until I came across the written opinions on the subject of star trader, Monroe Trout on this subject. Trout learned to trade while working for my former employer, Victor Niederhoffer in New York. Trout logically proposes the idea that a more efficient method of pattern research is to simply test all possible parameters and intermarket relationships to see if any of the results look statistically valid.
What I will present to you in this chapter is a sample program that you can use to test all possible patterns of a technique called range expansion. If you are unfamiliar with the concept of range expansion, let me explain. Range expansion refers to any system that takes the value of one chart point, subtracts the value of another chart point and then adds or subtracts this value from an opening or close to derive a buy or sell point.
In many cases, we will be using a percentage of the value we calculate and then add or subtract this value to tomorrow's opening for our buy and sell points. Since it is easy to run a comprehensive search of all volatility expansion patterns and then to consider the possibilities, we will demonstrate the technique.
Our Tradestation program to find volatility expansion sell signals reads as follow:

Inputs: cha(O), opt(O), per(O), tday(O);
Vars:voll(0), vol2(0);
voll=highest(high,cha) - lowest(close,opt);
vol2=highest(close,cha)-lowest(low,opt);
if day of week (date)=tday and
voll [ vol2 then sell tomorrow at open tomorrow -(voll*per) stop;
if dayofweek(date)=tday and
vol2 [ voll then sell tomorrow at open tomorrow - (vol2*per) stop;
Our program to search for volatility expansion buy signals looks as follows:
Inputs: cha(O), opt(O), per(0), tday(O);
Vars:voll(0),vol2(0);
Voll=highest(high,cha)-lowest(close,opt);
Vol2=highest(close,cha)-lowest(low,opt);
If dayofweek(date)=tday and
Voll [ vol2 then buy tomorrow at open tomorrow+(voll*per) stop;
If dayofweek(date)=tday and
Vol2 [ voll then buy tomorrow at open tomorrow + (vol2*per) stop;

This program will test every day of the week for volatility expansion trades. It alters the values that are searched as well. Since the highs, closes and lows are inputs, we can test all values from 1 -5 days ago and all days from 1 -5 (Monday to Friday) and all percentage expansions from 109& to 200%. We will use the lesser of the two values that we calculate. In addition, we will test all parameters of each of the three components to get a sense as to whether there is a range of values that shows some promise.
If we only find a single working value, we must suspect an over-optimized system and avoid it. Our general rule is to base our trading only upon pattern systems that have profit factors above 3 and percentage accuracy in the area of 70% or better and many similar profitability reading at different parameters.

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DOUBLE-SMOOTHED MOMENTUM

Originally, we saw that momentum was unbounded and erratic. It is similar to most other trends but not quite as smooth. There is a technique called double smoothing that will turn a questionable indicator into a very valuable one.

The success of double smoothing is that it creates a trendline that has less lag than a moving average. Less lag means that you can react faster to changes in the direction of prices. Double smoothing does this by averaging the momentum rather than the prices.

Momentum is speed. It shows faster movement and more sensitivity than prices. If you take the first difference in prices (a one-day momentum), then you speed up price movement. If you then average the momentum, you smooth out the prices and slow down the speed. First speeding them up and then slowing them down results in no lag.

However, a momentum indicator that is smoothed once is still not quite enough. If we now average the new result, we are averaging something that has already been averaged. We have smoothed it twice. For convenience we use percentage smoothing rather than a moving average. Figure 15.13 shows Microsoft with 20-day and 40-day momentum indicators in the center panel, and a double smoothing of the 20-day indicator in the bottom panel. The double-smoothed indicator begins with the one-day price differences and smoothes them with a 20-day period (smoothing value of .0476). It then smoothes the new values by .0476 again.

This first example of double smoothing does not produce a trendline that is as smooth as a moving average. It also has different value than the original prices; therefore, it can’t be plotted along with prices in the upper panel. That’s not a big problem because we only need to see the direction of the trendline to decide whether prices are going up or down. Most important, the new double-smoothed line does not have a lag. The highest point and lowest point of the trendline in the bottom panel correspond to the highs and lows of the price chart.

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IMPORTANT CONSIDERATIONS ABOUT RISK

As a trend trader, using a moving average trendline, we don’t always think of risk clearly. We know that slower trends allow larger price swings without changing the direction of the trend. Faster trends respond quickly to price changes. Those risks are implicit in the use of a trend method and can’t be separated out.
One of the dilemmas of using a stop-loss to limit your risk to a “comfortable” amount can be shown best in an example. Suppose you’ve been following a trend system and you are long 1000 Amazon at $30 and now hold a $10 profit ($10,000 on your trade). You would like to protect those profits; therefore, you place a stop-loss at $28, risking only $2,000 of your gains. Sure enough, prices drop and you are stopped out. Prices continue down to $27.50, turn back up, and move above $40.00 to new highs. During the drop to $27.50 the moving average trendline never turned down. It would not have turned down until $22.00. You are now out of the trade but the trend is still up and prices are making new highs. What do you do? Do you jump back in and try to catch the rest of the upward move, or do you stand aside until there is a new trend signal?
None of these choices are good. If you going to trade the trend, then you must look at the risk in advance and decide how many shares you can buy and still hold the trade comfortably when prices move against you. A stoploss fights with the trend system. The trend system wants to stay long and you want to get out. It just doesn’t work.
You cannot trade more than you can afford to lose. Your position is too large if you are uncomfortable with the day-to-day risk.

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Market Conventions : OPTION PRICE

How should one ask for an option price? The required pieces of information, in the preferred order, are as follows:

• The two currencies involved and which is the put and which is the call, e.g. dollar put, Swiss
  franc call;
• The period, e.g. two months or the expiry or delivery date, e.g. expiry 12 December, for
  delivery 14 December;
• The strike, e.g. 1.5010;
• The style, e.g. European or American style;
• The amount, e.g. 10 million dollars.

There are many ways of stating the period, but usually, if one date is stated, it is assumed to be the expiry date but it is much safer always to specify. In the same way, if a 10-day option is requested, it is assumed that the required option has an expiry date 10 days from the current date. If, however, an option is requested with a period in terms of months or years, e.g. three months, the dates of the option are worked out as follows:

• Calculate the spot foreign exchange date for that currency pair, using the same conventions as the spot foreign exchange market.
• Take the period, e.g. three months from that date, using the forward market conventions.

This gives the delivery date. The expiry date will then usually be two working days before that. The exceptions occur in any currency pair where spot is not two working days, for example the Canadian dollar, where the expiry date would be one working date before the delivery date.
Please note that with cross currencies and dates involving American holidays or in any cases where there may be confusion, it is always best to quote both the expiry and delivery dates required.
In asking for an option price, always state which currency is the call and which is the put. For example, does dollar/Swiss franc ($/sfr) put mean a dollar put or a Swiss franc put? On the option exchanges and in the OTC interbank market, this would usually refer to a Swiss franc put/dollar call. However, most corporations would probably mean a dollar put. For this reason, always state the case in full, e.g. dollar/call Swiss franc put or vice versa.

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Symmetrical Pattern

Traders trained in macroeconomic theory run the risk entering trades based upon superficial analysis of inter market price action. As many of you know, a sharp upward move in a commodity such as crude oil or gold can scare S&P 500 traders into selling their stock positions or going short. Commodity prices are perceived as having an inverse relationship with stock prices.
The reasoning of many traders taking short positions springs from the following logical chain: 1) commodity prices rising means that inflation is growing and therefore the Federal Reserve is more likely to raise short-term rates. 2) This monetary tightening will be bad for stocks and therefore S&P's should be sold based upon the commodity price rise. This macroeconomic logic, used at the wrong moment, leads to what I call the commodity fakeout trap. This chapter should get you to steer clear of this trap.
The psychology behind the average trader's decision to trade must be studied. It is this psychology that will take the poor trader into the wrong positions over and over. The methods that I teach you are designed to move the average trader's losses into the credit field of your account statement. Remember, in a field as complex as leveraged trading, decisions of the average trader will nearly always prove incorrect. I am about to show you one situation in which intuition may lead you astray.
What I have done is identify intermarket patterns that trick the average trader into making a mistake. By acting in a counterintuitive fashion and by taking the opposite side of the trade, we will move ourselves into the small camp of winners.

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The Main Instruments For Foreign Exchange Trading

The main instruments for foreign exchange trading include both traditional products such as spot, forwards and swaps, and more exotic products such as currency options and currency swaps. The beauty of the foreign exchange market is its ability to accommodate new products, for instance currency options come in all shapes and sizes, all tailor made to serve a specific purpose.

The products used today are described as:

• Spot – a single outright transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) within two business days.
• Forward – a transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery at some time in the future (more than two business days).
• Swap – a transaction which involves the actual exchange of two currencies (principal amount only) on a specific date, at a rate agreed at the time of conclusion of the contract (the short leg) and a reverse exchange of the same two currencies at a date further in the future, at a rate agreed at the time of the contract (the long leg).
• Currency swap – a contract, which commits two counterparties, to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.
• Currency option – a contract, which gives the owner the right, but not the obligation, to buy or sell a currency with another currency at a specific rate during a specific period.
• Foreign exchange futures – this is a forward contract for standardised currency amounts and for standard value dates. Buyers and sellers of futures are required to post initial margin or security deposits for each contract and have to pay brokerage commissions.
  
  

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Spiders: Where Are the Bugs?

One of the clearest trends in asset management is the rapid increase in the amount of individual and institutional money invested in indexed products. By far the most popular index which investors want to replicate is the S&P 500 index. While many academic studies have examined the characteristics of two instruments frequently used to replicate the S&P, index funds and futures, very little has been written about the newest way to replicate the S&P 500 index: Standard and Poors Depository Receipts (SDPR) commonly referred to as Spiders. The importance of Spiders can be seen by the fact that at the end of 1999 there were 19.8 billion dollars invested in Spiders and that in 1998 daily shares traded in Spiders exceeded any other stock except Compaq and daily dollar volume was the highest of any share traded. This is all the more surprising given the fact that Spiders have not been around very long.
There are three major reasons why this analysis is useful. First, the principal advantage of Spiders versus index funds is that they can be purchased and sold at prices which exist at any time during the trading day. As we will show, low-cost index funds produce higher returns than Spiders. Given that investors can use either vehicle, the difference in return gives a measure of the value of immediacy. The value of immediacy is an important issue in the literature on market microstructure. Second, since Spiders have become an important investment vehicle in terms of both trading volume and dollar value outstanding, their performance and characteristics are of interest by themselves. Third, the organizational form of Spiders is seen
as the prototype for index funds of the future, and thus it is important to understand both their performance and the affect of the organizational structure on that performance.
Before analyzing Spiders, we will briefly review their history and important characteristics. Each Spider represents an ownership interest in the SPDR Trust. The Trust as stated in the prospectus holds all of the common stocks in the S&P 500 composite stock price index and is intended to provide investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index. Spiders are traded on the American Stock Exchange and can be bought and sold like any stock at any time during the day. One Spider has a price equal to approximately 1/10 of the price of the S&P Index. The initial deposit creating Spiders was made on January 22, 1993. The Spider was organized as an investment trust and has a mandatory termination date of January 22, 22183. Any trust is governed by a trust agreement and there are certain aspects of the trust agreement governing Spiders which are important to understand. First, Spiders charge an expense ratio to holders of the Spider. This has historically been 18.45 basis points per annum. Second, a specific mechanism exists
for changing the number of Spiders outstanding. Investors can create or delete Spiders in minimum units of 50,000 shares by engaging in transactions in kind plus getting or receiving certain sums of cash. For example, investors can turn in a bundle of stock matching the S&P Index plus cash equal to the accumulated dividends less management expenses and receive Spiders in return. Investors can do so for a payment of $3,000 (regardless of the size of the transaction).
There is another peculiar aspect of Spiders that arises from their organizational form. Spiders pay out the dividends the trust receives on the stocks that it holds quarterly; on the last business days of April, July, October and January (though the ex-dividend day of the trust occurs in the previous month). What is unusual is that the dividends the trust receives from the
underlying stock is held in a non-earning account between the time it is received and the time it is paid out.
Having provided background on Spiders, we turn to the purpose of this article: to study the performance of Spiders and to compare Spiders with other methods of indexing. This paper proceeds as follows: In the first section we examine the performance of Spiders as an investment vehicle. We start by examining the return from holding Spiders compared with the return from holding the S&P Index. In this section we first examine Spider returns as if Spiders could be bought and sold at their net asset value. We then examine the magnitude and time path of the differences between Spider price and NAV. Since Spiders are not the only way of holding an index, we next compare the return on Spiders with the return on other methods of indexing, index funds and futures. One of the unique aspects of Spiders is the ability of investors to create and delete them by turning in or receiving bundles of securities.

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