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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