Psychological Challenges of Speculative Trading 2

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.

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Psychological Challenges of Speculative Trading 1

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.

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Developing a Trading Method

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.

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choose dealer : RECENT INDUSTRY DEVELOPMENTS

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.

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

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.

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

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.

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

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.

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

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.

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Choosing the Right Dealer

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.

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YOU MUST DETERMINE THE LIMITS OF YOUR RISK IN ADVANCE

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.

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What Creates Trends?

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

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

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

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

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

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

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The VIX Index Timing Model

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

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TYPES OF VOLATILITY RE-EXAMINED

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

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Options-Trading Discipline

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

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The IPO System

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

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Stock Classifications

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

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Develop a Delta Neutral Trading Approach

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

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

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Options on Indexes and Exchange-Traded Funds

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

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

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Reduce Your Stress Level

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

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

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

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