The Best Forex Solution

Psychological Challenges of Speculative Trading 2

2008-07-23T23:00:00.000-07:00

After such a loss, traders blame themselves, repeatedly going through the details of the unsuccessful trade. They blame the market for the “wrong behavior” or themselves for errors in what then seems an absolutely clear situation. Sometimes, the trader-market relationship takes
the form of a vendetta. Traders consider the market as their personal enemy, treat it in an unfriendly way (even with hate) and dream of immediate revenge. Doing so, they miss the fact that they are essentially blaming nature for changing sunny weather to rain. It is very important to be prepared beforehand for this change. Trades should always have close at hand one or a few options in case of sudden change of the situation/weather, so that their foresight assures their good time or good profit.
The third main psychological problem is trader uncertainty, especially when traders are inexperienced in abilities and skills—specifically about each market position they hold. Immediately after each position is opened and a money contract is bought, traders start questioning their choices. This is revealed most vividly in the case of a moderately active market at the moment of fluctuations close to the opening price of the position. Any movement (even insignificant) against their position causes traders to have an irresistible desire to sell the recently acquired contract to limit losses, until it is too late and the market does not shift too far away from their position opening price. On the other hand, an insignificant market shift in the desirable direction causes the same desire to eliminate the position, until it provides for any (even tiny) profit and before this profit does not turn into losses.
Scared and troubled traders rush and race about. They open and liquidate their positions too often, and experience many small losses and gains. Within a short period of time, they turn intermittently into bulls or bears. As a result, they suffer losses on a dealer’s spread and/or commissions when there were no significant market changes, and all the market fluctuations were no more than just regular market “noise.” Such losses are typical for beginners and individual traders with small investment capital or little experience and insufficient psychological preparation.
Not uncommon are cases of traders’ impulsive decisions on trading, without any plans or serious preliminary market analysis. The position is opened under an impulsive, invalid emotional reaction. Often, it can be explained by traders’ fears of losing a brilliant opportunity to earn money they think is being offered by the market at that moment. I have witnessed these attempts to jump onto the last carriage of a departing train, and such attempts have ruined a lot of traders. Many traders cannot calmly watch any kind of market movements. Some of my students have confirmed this reality. If they have no positions at the moment of more or less
significant market movement, they consider it as a lost opportunity to gain profit. This can inflict a serious shock to them. When they have no position, they seem unable to realize that each market movement can be considered both ways, and the opposite situation can quite possibly develop. Statistics show that, at each market movement, the chances to lose are much higher than to profit. How does it happen that reasonable people (who in everyday life, without any emotion, can watch a bank cashier counting other people’s money) consider the fact of market movement as a threat to their own pockets? Why is other people’s money in the hands of a bank cashier not considered as a lost profit, whereas capital shift on the market and the corresponding quote fluctuations are the causes of negative emotions? I think the answer is in the illusory simplicity of business itself, which is considered by many people as a good and simple opportunity to earn a lot of easy money. Similar notions are widely spread among novice currency traders. The soon traders abandon such ideas, the sooner they become professionally efficient traders.
The most difficult problem for every trader (regardless of their experiences) is to learn as quickly as possible how to recover quickly from losses, which are inevitable in this business. At the same time, they must learn to handle shocks and psychological damage inflicted by the losses, because these situations could negatively influence their future work. The losses themselves and the fear of losing, both of which permanently torture traders, negatively influence their ability to make reasonable decisions in a complicated situation. These factors also undermine traders’ ability to follow their own rules about trade strategies and systems. I have become personally acquainted with hundreds of traders and have watched their activities. I have taught many students, and have had my own experience as a trader at various steps of my career in the currency market. Therefore, I have come to the conclusion that the main causes of trader failures in speculative operations in the FOREX market are without a doubt those associated with psychological trauma—the inability to control their own emotions and to find an adequate way to fight stress.
I have explored ways of solving the psychological problems that arise from operations in the FOREX market, with the focus on increasing selfresistance to stressful situations and increasing trade effectiveness. As a result of my research, I have managed to develop a trading method that also helps to withstand shocks and keep emotions under control. To solve the problem of stress, I had to separate the problem into several parts and solve them one by one. First, it was necessary to develop the philosophical conception of my attitude toward market situations. By this I mean not only the general trade methods, which are discussed in the second part of the course, but also my own conception of the market and associated psychological problems, which most traders (including myself) have to overcome daily.

Psychological Challenges of Speculative Trading 1

2008-07-22T22:54:00.000-07:00

Asuccessful trader’s career mainly depends on his or her psychological stability in stressful situations, which are common in the process of trading. Theoretical knowledge can be acquired by reading professional literature; practical skills and experience are acquired in the process of actual trading. The most difficult process is adjusting psychological stress, because in real life it is impossible to completely eliminate the stress factor influencing human activity. Underestimating the stress factor could play a mean trick on traders and even completely block their abilities to make reasonable decisions in real trading situations. The psychological stress of those trading in the FOREX (and any other) market is extremely high. Traders must work under permanent psychological pressure, making decisions in highly unpredictable and uncertain market situations. Each trader goes through mistakes, failures, and losses in his or her own way, in accordance with his or her personality and temper. Some might blame their failures on the market’s “wrong behavior,” which didn’t comply with the trader’s brilliant forecast and caused the failure of the magnificently planned speculative combination. Others blame themselves and their own inabilities to make right decisions in situations, which afterwards seem to be simple. It is an interesting fact that, in hindsight, traders usually find the decision that should have been made at the lost critical moment and can reasonably prove their point of view. Why can they find
the right decision so easily and quickly in hindsight? Was the trader unable to do so at the right moment? I don’t think it can be simply explained by looking at yesterday’s situation from today’s point of view. I do notthink it can be explained by the fact that classical technical analysis allows for multiple explanations of almost any market situation. It is always possible to find an appropriate basic explanation for any market shift after the event takes place. In the heat of the moment, however, the trader was influenced by stress, and that stress caused the error. This is proven by the fact that most novice traders show exceptionally good (and even phenomenal) results trading dummy accounts but can’t even come near those results when trading with real money.
Being permanently under stress, a trader can often make insufficiently considered, impulsive, and, therefore, wrong decisions that result in losses or premature liquidation of profitable positions, that is, in lost profit. Sometimes, after a few successive failures with various trades, traders becomes fearful of the market. They are in a state of psychological stupor, and even a simple market situation may cause panic. They cannot overcome their emotions or soberly evaluate the current situation, and they are unable to make any decision—reasonable or otherwise. In many cases when the market situation shifts against the trader’s position, they can only passively watch the growth of their losses, because they are unable to make any decision at all. Often, after the market stabilizes and traders have the opportunity to calmly analyze daily diagrams of currency fluctuations, they come to the conclusion that the main cause of failure was not the lack of knowledge or training but their own emotions. However, the situation cannot be reversed. Time has passed, money has been lost, and everything should be begun again.
Another problem that causes severe and even catastrophic consequences is the trader’s wishful thinking. In this case, traders are sure that their forecast of market trends is solely correct. They feel the market cannot and should not give any surprises. They do not consider other options that could be helpful or they think of other options in a vague and uncertain form. Sometimes, traders consider a market shift against their position as short-term and temporary. They begin to average their positions.
They acquire new contracts at a lower price in the hope that the market situation will come back, and all the positions will become highly profitable. Afterwards, as the situation worsens, they will be able to come out of the market without serious losses. Being sure they are right, traders lose the ability to critically evaluate the condition of the market and accordingly their own position in the market. In this case, they consider only those basic and technical features that justify their wishful thinking, and they discard the contradicting features. This wishful thinking costs them dearly and can lead to psychological frustration. The market’s “wrong behavior” not only deprives traders of a certain amount of money and often ruins their trading account, but also undermines their self-esteem and their hopes of being a winner in the trading battle.

Developing a Trading Method

2008-07-21T22:50:00.000-07:00

The most difficult process is adjusting the human psychological factor, because in real life it is impossible to completely get rid of the psychological factor influencing human activity. I think it is very important for the reader of this book to follow me in creating the method, beginning with the definition and identification of the problems that need to be solved. Then, after initial ideas are formed, we will continue to the development of effective trade principles and the creation
of an integrated conception of systematic trading methods. I would like each trader to understand the essence and logic of my method, which allows a transition from vague emotions and desires to specific targets, in order to develop an effective trading technique. I think this approach to training is the best. It allows the trader to not only follow my line of thought but also, using the information acquired in this book, to extend each trader’s individual (not only professional) experience, with the aim of critically evaluating the acquired information. For this reason, I decided to violate the traditionally taught sequence of many books, manuals, and training aids, and state my book in the sequence of the development of my method. The psychological problems shared by many traders will be addressed, and the conclusion will be proven that it is necessary to switch to a systematic trading method without forming a rigid mechanical trading system. This desire, and the necessity to get rid of the excessive and permanent psychological stress that negatively influences the results of my everyday trading inspired me to develop the new systematic trading method. The initial requirements for the optimal trade methods and the consequent trade systems are formulated. Next, some basic elements for the trade method development are described - using trading tools corresponding to the basic principles of effective trading. Along with my own ideas and elaboration, they will be used as the basic components of effective trading. Each trader goes through mistakes, failures, and losses in his or her own way and in accordance with his or her personality and temper.

choose dealer : RECENT INDUSTRY DEVELOPMENTS

2008-07-20T22:45:00.000-07:00

Some significant changes, both positive and negative, took place in the FOREX trading world over the past few years. First let me mention three positive changes:
1. By the year 2006 the industry of FOREX trading had become more government regulated in the United States. Nowadays, the NFA regulates most of the dealers and introducing brokers conducting business in the United States, including foreign dealing companies providing services to U.S. customers. So, now the probability for a trader or an investor to become a fraud victim has greatly decreased.
2. Stronger competition among numerous dealing companies has made them offer their customers better services that include more sophisticated trading software, lower spreads, and faster and more accurate trade execution.
3. Reputable dealers now offer their customers the opportunity to trade contracts as small as $10,000. This is good for beginners, who today can make real trades without risking too much money while learning the business.
However, along with positive changes there also were two negative ones:
First, the same competition among dealers that improved quality of their services overall led to the situation that now almost every dealer could be considered a bucket shop. Today the dealers routinely trade against their customers, especially those individuals with smaller trading
capital. In order to increase their revenues, some of the larger dealers on a daily basis carry an uncovered exposure totaling well over $100 million of the positions taken by their customers. At first glance it seems that there shouldn’t be a problem. The rule of the game is that the house must always win and there are reasons to believe that most of the clients’ trading capital sooner or later ends up in the dealer’s pocket anyway, pretty much like in the gambling industry. (Dealers’ back office statistics show that approximately 60 percent of their clients’ total trading capital is being lost in trading annually.) However, unlike in the casino business where the house
is always able to control each and every aspect of the game, there could be some very dramatic and fast changes in the market that wouldn’t allow the dealer to cover its exposure before it becomes too late. Unexpected, almost instantaneous, and sizeable shifts in currency exchange quotes could be damaging to the point where a dealer would not be able to fulfill its financial obligations toward its customers. The other change that I consider to be rather negative is the trend of most dealers lowering their margin requirements. Today it is quite possible to find a dealer offering to its customers a margin as low as 0.5 percent. Dealers present low-margin trading as an opportunity for customers to achieve greater profitability with smaller investment capital. It is true, but trading on full leverage also could easily cause the loss of the entire trading capital in a single trade in a matter of minutes. It looks like trading in the financial market is turning into a casino-style business, which is not good in my view.

IS IT NECESSARY TO PAY COMMISSIONS AND OTHER PAYMENTS AND DUES?

2008-07-19T22:39:00.000-07:00

The most reputable dealer companies charge no commissions for transactions executed by their clients. Others charge some commissions, but usually not very high ones. Personally, I cannot excuse some dealers charging so-called storage fees. In the financial world, the client is usually
paid when he stores his money—not the dealer. Reputable dealers transferring an open position to the following day execute the rollover operation in accordance with the current LIBOR rates and reflect it in a daily statement.
Depending on the currency pair and direction in which the position was opened at the moment of its transfer to the next day, the client could actually win as a result of the transfer. A certain amount would be added to his account just for holding the position open for more than one day.
Other dealer companies do not bother themselves with such calculations but simply charge the client for the interest on the position transferred to the following day. There are numerous discussions about the possibility of holding two opposite positions open when both long and short positions exist simultaneously. At a dealer’s statement in such case, both positions are shown to exist in reality. Each one generates profit and/or loss, and in such form they could be transferred to the following day. I have met a few traders whose manner of trading envisaged such a condition or who used it as an important part of their trading strategy.
I think such arguments are useless and senseless. The positions cannot voluntarily be divided into new and liquidation—depending on a trader’s will. The market functions in accordance with certain rules, and it is arranged in such a manner that positions of the opposite tendencies for the same currency pair and of the same size are offset automatically. The spot part of the FOREX market provides the offset and self-liquidation of all open positions by the end of each trading day. At the beginning of the next day, only those positions are recovered that had not been offset due to the lack of opposite (with opposite sign) transactions of corresponding size. For example, if the trader during the day executed USD/CHF transactions for the total amount of $600,000 to buy and $400,000 to sell, then the long USD/CHF position for the remaining $200,000 would be transferred to the next day. As you can see, this is accompanied by the offset of the opposite positions, and the corresponding gain/loss was deposited into or deducted from the trader’s account. There is a simple reason that some dealers allow and even encourage their clients to keep opposite positions for longer than one day. A dealer company can charge interest for practically nonexisting positions. A dealer company can also create the illusion for the trader that the trader is present at the market and should find a way out of the situation and liquidate
both opposite positions, whereas, in reality, they are nonexistent.
Many traders consider the possibility of keeping these opposite positions an advantage. This advantage allows them to hedge (or lock) their losing trades and to limit their losses in case the market moves against their initial position. At the same time, this possibility creates the illusion that loss of money is not final and that the money could be returned if the “right” way out of the situation was found. If you cannot stand the psychological stress of trading without such useless “placebo” methods, then it is better to reconsider further participation in this business.

WHAT ARE THE RISKS OF DOING BUSINESS WITH “BUCKET SHOPS”?

2008-07-18T22:42:00.000-07:00

Legal issues (i.e., a set of acts governing and controlling the functions of
banks, dealers, and broker companies in the FOREX market, established
by government agencies) are of primary importance because traders have
to entrust their money to the dealers. First, it is better for traders to make
sure that their money is safe and that the breach of trust is impossible for
the dealer.
I am not a lawyer, so I have no right to advise my clients on legal matters.
The vast majority of dealer companies function in many countries,
with various rules and regulations of which I am not aware. My recommendations
are, therefore, based on my personal experience and preferences.
In any case, you had better survey the problem yourself and
preferably ask a lawyer for legal advice. The following sections outline my
personal opinion concerning dealer choice, considering the security of
capital invested in FOREX operations.

WHAT IS THE OPPORTUNITY FOR ON-LINE TRADING USING THE INTERNET AND ADDITIONAL SERVICES.

2008-07-17T22:36:00.000-07:00

Many dealers now offer the opportunity for on-line trading, and more will do so in the future. Internet trading has certain advantages over the traditional telephone communication with a broker or a dealer. The main advantages of on-line trading are:
• The opportunity to monitor market movements by following current real-time prices, graphics, and even news on a PC monitor. Usually, it is free and is included in the service and trading software offered by a dealer.
• Dealer trading software as well as other options often provide the trader with the opportunity to manipulate, modify, and customize graphics; conduct technical analysis using indicators; and draw trend lines, support, and resistance lines. In addition to being convenient, this provides substantial money savings. It eliminates the necessity of buying an expensive market-quotes service, and analytical and charting software for conducting technical analysis.
• Internet trading is supported by safe electronic registration data, which provides the necessary security and lowers the possibility of conflict situations between a trader and a dealer. These conflicts are due to probable human errors and slips of the tongue, which are common during live phone communications.

choosing Dealer :WHAT ARE THE REQUIREMENTS FOR THE OPERATION ACCOUNT SIZE (MINIMUM DEPOSIT)?

2008-07-16T22:30:00.000-07:00

Evidently, the more the investment capital, the easier, safer, more flexible and more effective should be its management. The investment and financial means of traders differ. It is a common situation when somebody willing to participate in speculative trading in a currency market simply does not have enough funds to open an account corresponding to the required safety rules. Each trader has his or her own security level, but I think (although it is a debatable issue) that the operable account size for the individual speculative trader begins with a minimal amount of $30,000, assuming that the initial margin is 2 percent and the minimal contract size is $100,000. I think $30,000 is the required minimum amount corresponding to FOREX market conditions, considering the following:
• If trading a single minimal contract of $100,000, a trader loses a pip amount equal to an average daily swing corresponding to $600 to $1,000 (depending on the selected currency pair), then the loss of 2 to 3 percent of the account per single transaction is rather painless. This loss cannot ruin the account, even in the case of a few consecutive losses.
• Traders must consider that the market “noise” amplitude approximates the amplitude of the average daily exchange rate fluctuation. Therefore, setting shorter stops while trading on a medium or longer term is unreasonable, because these stops can be offset by incidental
oscillation ticks.
• Some trading strategies recommended in this course suggest position reversal and doubling the contract size at the same time, which demands some additional margin for the safety of the corresponding working capital.
• Traders should take into consideration that the trader’s job should be adequately reimbursed, including psychological stress, time, and effort spent. There is no reason to spend up to 14 to 16 hours per day trading if you can earn the same money in a less stressful job. Simple calculation shows that even doubling of trading capital in one year can provide you with a secure income, but only in the case of an adequate initial investment.

Choosing the Right Dealer

2008-07-15T22:22:00.000-07:00

After a positive decision is made to participate in speculative trading
in the FOREX market, a newcomer should first choose the dealer
for conducting a trade. The right choice greatly influences the final
success of the whole enterprise. Nowadays, the market is overcrowded
with companies and banks offering their services to individual traders and
investors to access the currency market. It is not easy to make the right
choice without a certain set of criteria. These criteria best correspond to
the interests, preferences, and means of each individual trader, and to the
trade strategy and tactics chosen by him.
The best way to find the right dealer is to compose a list of questions
to ask the dealer, before making a final decision in favor of the preferred
company or bank. The following are suggested questions that should be
answered by the dealer before you make the decision to open a trading account.

YOU MUST DETERMINE THE LIMITS OF YOUR RISK IN ADVANCE

2008-07-15T22:14:00.000-07:00

Overtrade most often reveals itself when the trader (hoping to receive the maximum possible profit) acquires an oversized contract, risking the larger part of his trading capital in just a single transaction. In case a market starts moving against the trader’s position, possible losses can exceed the acceptable limit. The result can be irreparable damage to the working capital, bringing the trading account to a condition unusable for further trade. The account will be unusable in a timely manner in the future, due to the impossibility of covering those losses that occurred during just one transaction. Under current conditions, many banks and dealers offer their clients margin trading terms at a leverage ranging from 20:1 to 50:1 (and even higher). The initial margin as an industry’s average is only 2 to 5 percent.
Considering the average market activity during one day, it is easy to lose half or even a larger part of the trading capital. In order to avoid this occurrence, it is desirable to use certain margin self-limitation and not to use more than 5 to 10 percent of the trading capital during one trade.
Traders should establish their individual limitation for the margin, and possibly keep this limitation not below 10 to 20 percent as compared to the size of the trade contract. In other words, for each $10,000 to $20,000 of the size of your trading capital, only one contract of $100,000 should be traded at any time.
Recommendation
From the very beginning, it is useful to remember that there is no capital so large that it is impossible to lose during speculative operations in the FOREX market. The risk of losing part of or the entire investment capital is always present where there is the possibility to earn. The currency market is not an exception to this rule. In order to earn, the trader must take the risk of loss. In risking, though, traders must determine in advance the limits of their risk. They should never risk all or the largest part of their trading capital at once. They should risk only that part whose loss they are sure will not result in catastrophic consequences for their trading accounts and the resulting inability to further participation in trading.

A New Way of Thinking about Stock Selection

2008-01-24T08:37:00.000-08:00

Aparadigm is a framework or model. As we learn and experience, we begin to establish various paradigms relating to all aspects of our lives. Eventually, we establish a framework with which we’re comfortable. We begin to expect that certain ways of thinking or behaving will bring certain results, and we reach a certain comfort level between our actions and the reactions they will create. Sometimes the paradigms we establish serve us well for our entire lives. Other times,
we become dissatisfied with the results our actions create and it becomes necessary to create a new paradigm. When it comes to selecting individual stocks, 99.9 percent of investors and Wall Street analysts are operating using a dog-eared, shop-worn paradigm that is coming apart at the seams. They are all looking for the same thing: growth stocks with earnings momentum that will deliver strong earnings gains indefinitely into the future and enable these companies to justify their sky-high stock prices.
There are two problems with this paradigm: First, it’s been in existence for nearly 20 years and it’s getting a bit creaky. In fact, it’s probably on its last legs. The second problem with this paradigm is that it’s not new; it’s only a new version of other paradigms that have come and gone over the years. The late 1960s version, for example, was called the “One-Decision Stock Paradigm.” In this version, certain stocks had earnings that would grow forever, which meant their stock prices would go up forever. That, in turn, meant that investors would never have to sell the stocks. Thus, only one decision was necessary—to buy them.
That paradigm eventually collapsed when it turned out that some perpetual growth industries (like bowling) reached their saturation points far sooner than analysts expected; other perpetual
growth industries attracted competitors and price competition, thereby reducing profit margins (like calculators and CB radios); and economic recessions still surfaced from time to time, which had a tendency to affect all industries, turning growth stocks into normal, run-of-the-mill cyclical stocks. This way of thinking is new paradigm territory for 99.9 percent of investors and analysts. At first it may seem difficult and unusual, but if you have the courage to enter this new paradigm, you will find yourself in a fascinating new world where all sorts of new and exciting stock ideas will present themselves. You’ll also find that this new paradigm is sparsely populated, which at first may be uncomfortable. But eventually, seeing things that others do not see will eventually turn out to be the source of great excitement and satisfaction. You will understand things that others do not understand. At times, you’ll feel almost as if you can see the future, and
you will marvel at the inability of others to do the same.

THE BULLS, THE BEARS, AND THE HORSES

2008-01-24T08:32:00.000-08:00

The recent trend toward microanalyzing the stock market on a minute-by-minute basis has less to do with investing than it does with providing a “fix” for stock market addicts. In his classic book The Money Game, author George Goodman, writing under the name “Adam Smith,” says that most people are not in the stock market to make money; they are in it for the excitement. And if you were to catch a stockbroker in a moment of candor, you would probably discover that many have reached the same conclusion. A large part of the stock market’s explosive popularity in recent years is that the advent of financial television and the Internet has turned investing into a form of entertainment that provides a welcome diversion from the predictability of day-to-day life.
I completely understand this, of course, having spent 25 years of my life transfixed by the stock market. Watching the minute-by-minute analysis on financial television and having a real-time quote system on your desk is part of the appeal of the whole business. Nothing wrong with that, although this book is a way of pointing out that there is another way to approach the business of picking stocks, one that allows you the opportunity to get up from in front of your television set to get a glass of water and maybe even do a little gardening.
There are many people who will tell you that the stock market is actually just like horse racing, and if you stop to think about it, they may have a good point. As every horse bettor knows, there is nothing quite like the adrenaline rush one gets when your bet is down, the bell rings, the starting gate opens, and the track announcer says, “They’re off!”
This, of course, is precisely the feeling a day trader gets at ninethirty each morning when he or she is tuned in to CNBC. The only difference is that the chairman of Time Warner is not standing at the starting gate ringing the bell.
It is probably no accident that as the stock market has become increasingly popular and accessible to the masses over the past 15 years, the horse-racing industry has gone into a steady decline.
Financial magazines are multiplying like rabbits while the Daily
Racing Form has been sold and resold several times as its circulation
eroded year after year.
Let’s face it: Wall Street is beating the horse-racing business at its own game. While a horse race can provide periodic bursts of entertainment and excitement, each race lasts only a minute or two and is followed by a period of boredom and slowly building anticipation until the next race begins. On Wall Street you get nonstop action for 61⁄2 hours 5 days a week, and if you’re a real glutton for punishment, you can buy a sophisticated quotation system that allows you to sit around all night watching after-hours trading, and the opening of the Asian markets and the start of European trading in the predawn hours.
Wall Street never stops. How can horse racing compete with this? For one thing, they might try out the concept of horse brokers. In New York State there are Off Track Betting parlors scattered all over the place. What’s the difference between this and brokerage
firm branch offices? There are no horse brokers. The only thing these OTB parlors lack are salesmen with clients who can be badgered over the telephone to bet on the horses and generate some commission business. And why stop there? To support the sales force—excuse me, the horse brokers—OTB could even hire analysts to write research reports. If you are a “value” investor who concentrates on fundamentals, your horse broker could send you a report on the pedigree and training performances of a good-looking prospect in the seventh race at Belmont Park. Or if you are a “momentum” player who concentrates on technical analysis with a preference for following the “smart money,” you could get a frantic call from your horse broker doing his best James Cramer imitation moments before post time about some mysterious movement in the odds that could indicate somebody knows something.
“Who cares why the odds are going down?” he would scream into the telephone. “This is a momentum horse! Get your money down now, before it’s too late!” The similarities are endless. Was the jockey holding his horse the last time out so the trainer can turn him loose today and cash a big bet at large odds? Has that corporation been overstating its earnings to keep the stock price up so insiders can bail out at high prices? You want to take a shot at big money? Forget options—play the daily double—here are our top picks, for speculators, of course. What’s that? You’re wondering what to do with your pension funds? Why, that calls for a more conservative approach—how about allocating 5 percent of your account on the favorite, to show? One reason the stock market fascinates so many of us is that there are so many ways to approach it. This frantic moment-tomoment approach, in which the market is treated as though it were a racetrack or a casino, is certainly a valid way.

( ETF ) Creation and Redemption Process

2007-12-26T14:17:00.000-08:00

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).

ETFs – A Leading Financial Innovation

2007-12-26T14:13:00.000-08:00

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.

introducing ETF ( exchange trade fund )

2007-12-26T13:53:00.000-08:00

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.

What Creates Trends?

2007-12-24T16:39:00.000-08:00

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.

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

2007-12-24T16:34:00.000-08:00

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.

The VIX Index Timing Model

2007-12-24T15:58:00.000-08:00

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.

TYPES OF VOLATILITY RE-EXAMINED

2007-10-25T10:29:00.000-07:00

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.

Options-Trading Discipline

2007-10-25T10:21:00.000-07:00

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.

Options-Trading Discipline

2007-10-25T07:14:00.000-07:00

The IPO System

2007-10-24T07:21:00.000-07:00

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.

Stock Classifications

2007-10-21T05:40:00.000-07:00

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.

Common versus Preferred Stock

2007-10-21T01:54:00.000-07:00

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.

Develop a Delta Neutral Trading Approach

2007-10-20T10:21:00.000-07:00

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. 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.
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.
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.

Options on Indexes and Exchange-Traded Funds

2007-10-18T23:55:00.000-07:00

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.

Reduce Your Stress Level

2007-10-18T18:46:00.000-07:00

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.

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

2007-10-17T08:37:00.000-07:00

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.

A Brief Review and a Little Extra

2007-10-17T08:16:00.000-07:00

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.

LIMITING THE RISK OF A TRADE

2007-10-16T00:23:00.000-07:00

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:

The best place to exit from a long position is the natural point where you would want to enter a short position.
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.
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.
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.
You must first decide how you would reenter the trade once you are out.

IMPORTANT CONSIDERATIONS ABOUT RISK

2007-10-16T00:10:00.000-07:00

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.

THE REALITY OF USING CHANNELS AND BANDS

2007-10-15T09:08:00.000-07:00

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.

Active as Opposed to Passive Management of Assets

2007-10-13T22:02:00.000-07:00

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.

HOW TO PLACE AN ORDER

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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.

THE IMPORTANCE OF A SIDEWAYS BREAKOUT

2007-10-05T04:31:00.000-07:00

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.

THE MAGIC NUMBER IS 4

2007-09-28T14:19:00.000-07:00

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?

You could buy one-third of your position now, one-third on today’s close, and one third sometime tomorrow, for an average price.
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.
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.

AN AVERAGE PRICE OR A BETTER PRICE?

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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.

EVOLUTION IN PRICE PATTERNS

2007-09-25T07:09:00.000-07:00

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.

COMPARING SIDEWAYS AND ROLLING BREAKOUT METHODS

2007-09-24T09:51:00.000-07:00

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:

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.
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.
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.
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.
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.
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.

TRADING GAME TIPS 1

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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.

TRADING GAME TIPS

2007-09-22T01:04:00.000-07:00

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.
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.
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.
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.

THE ROLLING BREAKOUT

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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.

EVOLVING MARKETS

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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.

How Do We Normally Decide to Buy a Stock?

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• 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?

TECHNICAL TRADING AND VALUE

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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.

TIME-DRIVEN OR EVENT-DRIVEN?

2007-09-14T23:18:00.000-07:00

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.

CHOOSING THE SYSTEMATIC WAY

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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.

EXTRA BENEFITS OF TRADING

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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.

TREND TRADING RULES FOR TRENDLINES

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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.

The Relationship Between the Moving Average Speed and Market Noise

2007-09-10T03:49:00.000-07:00

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.

Application of Currency Option

2007-09-09T16:34:00.000-07:00

HOW TO MAKE YOUR TRADING ADAPT TO CHANGING VOLATILITY

2007-09-08T06:48:00.000-07:00

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.

Range Expansion Search Code

2007-09-07T22:07:00.000-07:00

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.

DOUBLE-SMOOTHED MOMENTUM

2007-09-06T02:33:00.004-07:00

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.

IMPORTANT CONSIDERATIONS ABOUT RISK

2007-09-05T02:05:00.000-07:00

Market Conventions : OPTION PRICE

2007-09-04T14:25:00.000-07:00

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.

Symmetrical Pattern

2007-09-03T06:46:00.000-07:00

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.

The Main Instruments For Foreign Exchange Trading

2007-09-02T01:26:00.000-07:00

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.

Spiders: Where Are the Bugs?

2007-08-31T07:59:00.000-07:00

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.

THE SINGLE CURRENCY

2007-08-28T22:48:00.000-07:00

In January 2002, euro notes and coins were actually being circulated in the different countries and by the end of the first quarter, national notes and coins no longer existed. This change had an impact on everyone, from manufacturers, importers and exporters with trade flows to hedge, central banks with reserve asset and debt management concerns, to financial institutions and pension funds with international portfolios. In fact, even though this event was specific to Europe, the impact affected the world’s currency market community from American to Japan. The single currency in Europe formed one corner of the new triangular world of the dollar, the yen and the euro.
The conversion of national legacy currencies meant that organisations had to have the ability to accept both forms of transaction. It has been quite complicated because, for instance, to convert sterling to francs you had to have a conversion via the euro. This is because the national legacy currency no longer existed in its own right but was a denomination of the euro, fixed by the conversion rate. The European currencies have always fluctuated against the dollar, even as the debate about the euro raged. This can be shown by:
Birth of European Monetary System – it was the economic crisis of the 1970s that led to the first plans for a single currency. The system of fixed exchange rates pegged to the dollar was abandoned. European leaders agreed to create a “currency snake”, tying together European currencies. However, the system immediately came under pressure from the dollar, causing problems for some of the weaker European currencies.
Kuwait crisis – on 2 August 1990 Iraq invaded Kuwait. On the same day, the UN Security Council passed a resolution condemning the invasion.
Maastricht Treaty – in 1991, the 15 members of the European Union, meeting in the Dutch town of Maastricht, agreed to set up a single currency as part of a drive towards economic and monetary union. There were strict criteria for joining, including targets for inflation, interest rates and budget deficits. A European Central Bank was established to set interest rates. Britain
and Denmark, however, opted out of these plans.
ERM crisis – the exchange rate mechanism was established in 1979 and was used to keep the value of European currencies stable. However, fears that voters might reject the Maastricht Treaty led currency speculators to target the weaker currencies. In September 1992, Britain and a few of the other EU countries were forced to devalue. Only the French franc was successfully defended against the speculators.
Asian crisis – the turbulence in the Asian currency markets began in July 1997 in Thailand and quickly spread throughout the Asian economies, eventually reaching Russia and Brazil. Foreign lenders withdrew their funds amid fears of a global financial meltdown and the dollar strengthened. ManyEUcountries were struggling to cut their budget deficits to meet the criteria
for euro membership.
Euro launch – the euro, of course, was launched on 1 January 1999 as an electronic currency used by banks, foreign exchange dealers and stock markets. The new European Central Bank set interest rates across the euro zone. However, uncertainty about its policy and public disagreements among member governments weakened the value of the euro on the foreign exchange markets.

Central bank intervention – after just 20 months, the euro had lost nearly 30% in value against the dollar. The European Central Bank and other central banks finally joined forces to boost its value. The move helped put a floor under the euro, but it has still not recovered its value. A weak euro has helped European exports, but it has also undermined the credibility of the currency and has fuelled inflationary pressures.

Terrorist attack on New York and Washington – this attack in New York severely tested the currency markets. Money flowed out of the dollar into safe havens like the Swiss franc and, for the first time, into the euro. The central banks tried to calm the markets and interest rates were cut across the globe. Many observers believe it may have marked the coming of age of the euro as an international currency.
Euro becomes cash currency – on 1 January 2002, the euro became a reality for approximately
300 million citizens of the 12 countries in the euro zone. The arrival of the euro as a cash currency may foster closer integration and greater price competition within the euro zone. It may also help boost its international role, as doubts grow over the strength of the dollar, especially as American economy continues to slow.

Short-Term Reversal Systems

2007-08-27T20:17:00.000-07:00

Reversal systems are among the most effective systems that you can find for trading the stock index futures contracts. One of the most pronounced tendencies of the stock market is for the indices such as the S&P 500 to travel from a relative low to a relative high and from a relative high to a relative low. By this we mean that the market will often swing from the lowest close in x number of days to the highest closing price in x number of days.
The focus of my reversal system is a short-term move that reverses a recent extreme in price. You await the onset of a reversal from a relative high or low before trading in the direction of this counter-swing. The historical results of our system are high enough to warrant the use of such vehicles as OEX put and call options. We do not recommend futures positions leveraged far .beyond your cash. Rather, the safety net provided by slightly out of the money hedging options against futures positions can be crucial to your survival when the unexpected strikes.
In the S&P 500 futures market, many traders employ stochastics, RSI and other trading oscillators. Normally these traders will buy at the close when the oscillators move from oversold to overbought and sell when the reverse occurs. I refer you to my chapter on the "Market Wizard" method for more detail on this type of strategy. The prevalence of oscillator trading strategies can provide an edge in using intraday reversal systems. Indeed, I will show you how oscillator traders will actually push our reversal system trades in the direction we want.

THE IMPORTANCE OF TIMING

2007-08-26T16:46:00.000-07:00

A few thoughts about timing are important before we move forward. We would like to think that we can profit from the news if we act faster than others. It’s not true.

The market moves on anticipation. “Buy the rumor, sell the fact.” If you bought on every piece of good news published in the Wall Street Journal, you would be broke.
The market responds to the difference between the actual news and what was expected. The unemployment rate could have dropped 0.2 percent, and the market falls because it expected a drop of 0.4 percent.
Action does not always mean immediate reaction. When did the Fed start lowering interest rates? When did the market start to respond? In the case of interest rates, it always takes more than one move by the Fed before you see a reaction in the economy.

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?

STRIKE PRICE AND STRIKE SELECTION

2007-08-24T22:30:00.000-07:00

The preset price is called the strike price or the exercise price, which is the predetermined rate of exchange at which exercise takes place. The strike is usually chosen at a level close to the current foreign exchange spot of forward rate but may be at any reasonable level. The premium (price) of an option is very sensitive to the relationship of the strike to the current spot foreign exchange rate. However, in general, both buyers and sellers of options will select a strike based on several factors, including their forecast or expectations of the value of the underlying currency during the lifetime of the option and the option’s payoff (profit/loss) profile.
The strike price is the exchange rate at which the option may be exercised.
For example, a market participant with a bullish view for the dollar against the Swiss franc may choose to purchase the dollar in the forward foreign exchange market because there is a belief that the value of the dollar will appreciate against the Swiss franc. A long position in the underlying (dollar) represents the most bullish view of the underlying. However, a long dollar forward foreign exchange position has a payoff profile of unlimited gains if the dollar increases in value and unlimited losses if the dollar decreases in value. If the market participant wishes to eliminate the potential loss while keeping the potential gains, this participant may purchase a dollar call/Swiss franc put instead of purchasing the dollars in the forward foreign exchange market. Thus, a long dollar call represents a bullish view of the dollar but with protection. The cost of the protection is the upfront premium, thus there is a trade-off between the premium payment and the payoff profile.
The market participant now needs to select a strike rate. Should it be in-, at- or out-of-themoney?. In order to make this decision, the market participant will need to consider the upfront premium payment, the breakeven point (the point where the gains begin), and the leverage of the given risk. If the market participant has limited funds to spend on the premium, then an out-of-the-money strike, which is relatively inexpensive, reflecting less protection and higher leverage will be chosen. Thus, the purchaser is willing to accept less protection because of a strong view that the dollar value will increase. The breakeven point will not be as favourable as a strike that is further in-the-money because it will represent the premium and the difference between the forward rate and the strike.

Applications of Currency Options

2007-08-22T05:07:00.000-07:00

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.
Hence, in buying a currency option, it may help the purchaser by:
Limiting downside currency fluctuation risk while retaining upside potential;
Providing unlimited potential for gain;
Providing a hedge for a contingent risk; and
Enable planning with more certainty.
Selling currency options may assist the writer (seller) by:
Providing immediate income from the premium received; and
Providing flexibility when used with other tools as part of an exchange rate strategy.
For a hedger, in terms of exchange rate risk management, currency options can be used to guarantee a budget rate for a transaction. By buying a call (the right to buy) the maximum cost can be fixed for a purchase and by purchasing a put (the right to sell) the minimum size of a receipt can be fixed. The purchase of the option involves paying a premium but gives the buyer the full protection against unfavourable moves while retaining full potential to profit should rates subsequently move beneficially. This contrasts with a forward contract, which locks the hedger into a fixed exchange rate, where no premium is payable but no benefit can be taken from subsequent favourable moves.
In the case of trading, to assume risk in order to make a profit, traders use options to benefit from both directional views and/or changes in volatility. (This allows profit to be made from expecting volatility either to increase or decrease over a period of time.) For example, in order to take a directional view, an options trader might feel strongly that the dollar will strengthen against the Swiss franc in the next three months from its current level of $/sfr 1.66. The trader buys a dollar call (right to buy), Swiss franc put (right to sell) option with a strike price of 1.6835, with expiry in three months’ time.
The trader has two choices:

To hold the option to expiry and if the spot rate has risen to, for example, $/sfr 1.73, the trader would exercise his right to buy dollars and sell Swiss francs at 1.6835, and hence, make money. If the spot rate is below $/sfr 1.6835 at expiry, then the maximum loss is limited to the premium paid for the option.
Alternatively, if the spot rate rises, say one month after the trader has purchased the option,the trader could choose to sell the option back. By doing this, the trader will recoup both the time value and intrinsic value of the option.

CURRENCY OPTIONS

2007-08-22T03:51:00.000-07:00

The essential characteristics of a currency option for its owner are those of risk limitation and unlimited profit potential. It is similar to an insurance policy, whereby instead of a householder paying a premium for insuring the house against fire risk, a company pays a premium to insure itself against adverse foreign exchange risk movement. This premium is paid upfront and is the company’s maximum cost. Exchange of currencies in the future may take place at the strike price or, if it is more beneficial, at the prevailing exchange rate.
Options can be obtained directly from banks, known as over-the-counter (OTC) options, or via brokers from an exchange (exchange traded options). The essential characteristics of over-the-counter options are their flexibility. The buyer can choose the currencies, time period, strike price and the contract size, in order to match the particular exposure requirements at the time. Against this, exchange traded options have standardised time periods and strike prices and only a certain number of currencies are traded, thus limiting choice. This standardisation of option contracts promotes tradability, but this is at the expense of flexibility.
The main users of options are organisations whose business involves foreign exchange risk and may be a suitable means of removing that foreign exchange risk instead of using forward foreign exchange. Against this, in general, the exchange traded options markets will be accessed by the professional market makers and currency risk managers. The over-the-counter option market has as its market makers banks, who sometimes use the exchanges to offset risk.
Options can be and are used in many different circumstances, but essentially in times of uncertainty. For example, a British company wanting to make an acquisition in Japan is faced with a possible uncertainty in the timing of a foreign exchange cash flow. The British company does not know exactly when the acquisition will take place as there are so many factors to be put in place, but it does know that at some stage the company will have to buy Japanese yen and sell sterling. The foreign exchange risk is obviously key to a successful acquisition. By using a currency option, the treasurer would know exactly the maximum cost of the acquisition but would also have the potential for greater profit if the Japanese yen weakened.
Another example would be in a tender-to-contract situation, where a company is uncertain as to whether there will be an exposure at all. By using options, the company will know with certainty the worst rate at which it can exchange one currency for another should the company win the contract. If the exchange rate moves in its favour, the company can deal at the better prevailing rate. If, however, the company loses the contract, it will either have lost the premium, which is a known cost paid upfront, or it may have the potential for gain if the prevailing exchange rate is better than the rate agreed under the option.
Thus, normal foreign exchange transaction risk obviously gives rise to uncertainty. Using options as an insurance policy can result in peace of mind for the user. The cost, the premium, is
known and paid upfront. The treasurer then knows what the worst rate would be and can budget accordingly knowing that there may be a windfall gain. Translation risk is always a difficult problem for a company. If an unrealised exposure is hedged using an option, the maximum cost is known upfront. If it is hedged using a foreign exchange forward, then there is potential for a realised loss when the foreword contract is rolled.

Reactive Day Trading of the S&P 500

2007-08-21T00:06:00.000-07:00

By using daily pattern analysis to determine our short- term trades, we accomplish several worthwhile goals. First of all, we insure that our performance as traders reflects the quality of our statistical research and not just the trend of the market. Second of all, we create a diversified portfolio of trading methods, which when united, create a lower risk profile than any one method can yield. To trade one method alone is to base our results on certain random factors and certain elements beyond our control. Finally, by entering and exiting our positions rapidly, we create an environment that will tolerate our missing a move.
As a trend follower, I cannot make an error or take time off from trading. If a signal occurs and I am not watching, I may not be able to get back into the market at the system entry price. Short term pattern trading helps solve this problem. Many of the greatest money managers trade exclusively in this fashion but will never reveal to you the basis of their success. Every statistical trader has a bunch of pet patterns that are used each time certain conditions take place. I am giving you a sample library of pet patterns, but you must have experience in other areas to make money trading this way.
One great secret of many professional traders will really shock you. They almost never use stop orders to exit losing positions. Contrary to the advice of most trading manuals, the dozen or so large fund traders that I have worked with do not use intraday protective protective stops end up degrading their systems. The stops tend to get triggered at the extreme price levels of the day, thus giving up positions at the very worst possible moments. A large trader with a protective stop in the market becomes extremely vulnerable to manipulative strategies. We will hang onto our trades until time runs out on our patterns. We will not use leverage that will force us out of the market upon adverse price movements. If we do use leverage, then we will buy out of the money hedging options to trade against repeatedly without requiring our using protective stops.
Without further comment, let me present you with a collection of S&P daily trading patterns that I found through extensive computerized searches of historical price behavior. So that this chapter did not turn into a mindless exercise in data mining, I have only included patterns that contain common sense reasons for their effectiveness.
The patterns are presented in a way that a professional computer based trader might use them. They need to be entered into a real time system monitoring machine such as Tradestation™ by Omega Research. When Tradestation signals that one of these patterns has fired, the code will tell you what signal has occurred and what orders you must place. Response time must be fast and furious. In cases in which entries or exits are based upon the closing price, you must know your systems' rules and not depend upon the computer alerts. A bell ringing at the close and telling you to enter your position tells you too late what you should have done. I have provided the Tradestation™ code for each pattern so that there will be no ambiguity caused by my written descriptions.>/span>

Trading the Options Expiration Method

2007-08-20T23:59:00.000-07:00

As you may know, on option expiration day each month in the stock market, volume and volatility have a tendency to swell. Very small moves in the stock indices may determine whether or not vast sums are won or lost in the options markets. Indeed, there is an overwhelmingly powerful motive for large traders to act to make their positions profitable at expiration. In this chapter, you will learn how market makers and large traders act in ways that create profit opportunity for savvy professionals.
Specifically, I will teach you how and when professionals have been taking positions to profit from the expiration shenanigans. The mechanical entry into the S&P 500 futures contract provided has made approximately $115,000 with 76% accuracy trading a single contract. I encourage you not to fear to trade the expirations, but to study them instead.
Predatory trading tactics at expiration
One tactic that can sometimes be seen on expiration day in stock indices is nicknamed the "Paris March" by top hedge fund traders. The nickname comes from the famous pictures of the Nazis marching by the Arc de Triomphe in Paris during WWII. In the photo, heavily armed bullies storm the city while the residents stand by defenselessly.
Similarly, in the stock market, major players will buy large positions in individual stock call options before expiration day. Traders are happy to sell these short-term options to the big players because the time decay is so extensively close to expiration that the sale looks like a good bet. However, the trick that follows can end up putting the seller out of business.
To carry out the Paris March, the large house that bought the calls buys the underlying stock(s) just an hour or so before expiration to force the calls into the money. Call options that were slightly out of the money suddenly go into the money and force the brokerage houses to scramble to buy stock to meet the exercises. This strategy creates a short-term buying surge and the buying looks to be coming from many sources—a powerful psychological driver in the market. The trading house profits on its long cash position and its calls or short puts at expiration. Naturally, the market has a tendency to go down the morning following expiration as the artificial demand for stocks disappears.
I have created a historical calendar for you of options expirations from 1981-1997 so that you may conduct your own research into expiration phenomena. But now, I will give you my best trading strategy for exploiting the upward bias of many pre-expiration periods.

Crash Filters For The Stock Market

2007-08-20T23:38:00.000-07:00

Though the topic may seem a bit unusual, it may end up being the most important chapter in the book for many of you. The information contained is crucial. Indeed, recognizing the pattern I will show you may very well end up saving your career as a trader. It may also make your career as a trader if the pattern unfolds, and you take aggressive positions for a smash. In fact, in 1994, this model gave a signal that I relayed to my fund manager. He took immediate action in the OEX Put market and saved the fund millions of dollars over the next month. The subject of this report is panic liquidation of the stock market, when it has happened, how to predict it, and how to profit from it.
My crash filter pattern does not get tripped too often. Usually the market goes up. In fact, on only 235 days has the trade called for a short position in the market since 1986. Even when the pattern does occur, there have been times when no panic liquidation has taken place. Do not panic yourself when the pattern appears imminent. No market move can be called inevitable. However, taking protective measures with your money and making a speculation in put options seem warranted.
Many commentators have theorized that drops in the price of Treasury instruments such as bonds, notes or bills can be very negative for stocks. Similarly, other researchers have found a link between the U.S. dollar's price momentum and stock prices. A falling dollar normally is negative for stocks while a rising dollar is positive.
What this report will show you is a completely mechanical method for gauging the weakness of Treasury notes and the trade-weighted U.S. dollar for use in S&P trading. My studies show conclusively that panic liquidation of stocks occurs most readily when a simultaneous deterioration of intermediate/long term government bonds and the tradeweighted dollar is taking place. Sometimes just one of these conditions can be met and stocks drop, but the combined meltdown has carried more dire consequences.

Our Winning Expiration Trading Method

2007-08-19T08:43:00.000-07:00

I look for an unusual disturbance in volatility patterns 4-5 days prior to options expiration to tip me off that a tradable expiration move is on the way. This system takes positions at the close of the "tip-off day and holds until the close of the expiration day.

Rules:

If the range of the day five trading days before expiration day is less than 70% of the average range of the previous three days or is greater than 140% of the average range of the previous three days then an unusual volatility disturbance has taken place.
Given an unusual volatility disturbance five days before expiration, buy the S&P 500 futures on the close of the unusual disturbance day.
Hold the long futures position until the close of options expiration day.

We have tested results of trading on a volatility disturbance four days before expiration with very similar results. However, for the record, we will use five days as our model pattern. The expiration system has traded 66 times since 1982. Total net profit of $122,530 has been achieved trading only one lot. Profitability for this model has increased sharply in recent years as the phenomenon has become more pronounced.
The system has also tallied up an extraordinary win/loss ratio of 2.43 and an impressive profit factor of 7.30. You would have been in the market for only 340 days using this model. Therefore, being long less than 10% of the time since the inception of the S&P contract, this model has captured approximately 51 % of the total index points of buy and hold. This statistical
phenomenon is very powerful. If you think likewise, maybe you will conduct your own research into this type of trading.