Wednesday, May 31, 2006

Covered Calls


When you embark upon your first adventure into options trading, there are those who will tell you that covered call writing is the safest strategy. Even brokerage firms allow novice option traders to trade covered calls in their IRA accounts. Little do they know. Or, if they really do know, little do they care.

Once upon a time there was an investor. All of his life he was taught that, if you buy a stock and hold onto it forever, the stock will go up, you make a lot of money and live happily ever after. Its the American dream. As we have come to learn, those dreams and Mother Goose have a lot in common. They are fairytales. The harsh realities of the market have resulted in a rude awakening. The internet bubble, bear markets, and an abundance of corporate improprieties, have systematically demolished hordes of retirement accounts. The buy-and-holders are still holding. Old habits die hard. Only, what they are holding is not hard anymore.

Some folks have portfolios of stocks they might like to use a program of selling covered calls to generate some additional income. There are good and bad points to this strategy. Lets start with an overview of covered call writing along with a basic example. Then, we have to delve into the nitty-gritty of it.

Covered Call: The Stock

For our example, we will say you currently own 1,000 shares of Juniper (JNPR) trading at $21.30. How you came to own this stock is anybodys guess. Maybe you bought and held, maybe you inherited it, maybe you won the lottery. Its not really important. The question is - how can you best use this asset to make money? You have a neutral to bullish outlook on JNPR. You project that it will trade flat or possibly up a little in the next few months. If your projection is just wishful thinking and you have nothing substantial to base your opinion on, you have no business owning a stock, let alone trying to trade options.

Covered Call: The Option

Well, if you have read my previous columns, you know that there is a bottomless pit of speculators out there. Speculators is the nice word. Gamblers is more accurate. There is, and will always be, someone out there who is willing to buy an option - betting that JNPR will rise substantially in the next month. He is willing to buy the right to buy JNPR from you at $22.50 anytime between now and July expiration (about 6 weeks). For that right hes willing to pay you $1.50 per share. That translates into $1,500 worth of dead presidents into your pocket.

The speculator is buying the JNPR July $22.50 call option. Hes buying the right, but not the obligation, to buy the stock from you at $22.50. He's expecting that JNPR is going to appreciate well beyond $22.50. If he's buying the stock at $22.50 and the option costs him $1.50, his breakeven is $24.00.

The nice part about all this is that the $1,500 he's paying you is yours to keep - regardless of what happens to the stock. It shows up in your brokerage account the very next business day. What you have to be willing to accept is the fact that, if JNPR does happen to move up, you have agreed to sell it at $22.50. You will not participate in any gains above and beyond $22.50. You are trading the upside potential for the immediate, and guaranteed, $1,500. See, everyone has his price.

More Profit Than You Think

Once you have accepted the possibility that your 1,000 shares may soon leave home, you can focus on the potential profit in the trade. If JNPR finishes above $22.50, there are two ways you will profit.

1) You took $1,500 when you sold the call. Thats a good start.

2) If your stock is called away at $22.50, you will have made another $1,200 in profit from the appreciation of the stock price. Remember, this all started with JNPR trading at $21.30. When the stock is sold, you get the $1,200 difference ($1.20 x 1000 shares). You took in $1,500 from the sale of the option plus another $1,200 profit from the sale of the stock - a total of $2,700. Thats a better than 13% return for a little over a month. If you used margin to purchase the stock, it would be about a 26% return.

If, at expiration, JNPR finishes below $22.50, you will still own the 1,000 shares of stock and, if you choose, will be able to sell another call for a future expiration cycle. In an ideal world, you would be able to repeat the strategy month after month. But, as we all know, we do not live in an ideal world.

The Good, The Bad & The Ugly

You now know the good. Get ready to learn about the bad and the ugly. The main risk in covered call writing is the fact that you do own the stock. And, contrary to popular optimistic thinking of the masses, the shares of JNPR could go down just as easily as it can go up. The $1.50 taken in from the option purchase provides a little cushion - a damn little cushion.

The same principles apply to covered call selling as to all other trading and/or investment strategies. The main principle, and the toughest one to live with, is that you must have an established exit point - and the self-discipline to act on it when necessary. Of course, that means having to admit that you are wrong when JNPR turns south instead of going up.

How do you figure out your exit point? There are a few ways.

1) Use a specific dollar stop. Your account management techniques tell you that you have a maximum limit of a $2,000 loss per position. That would dictate that you have to close out your entire position by selling your stock and buy back your short JNPR $22.50 option when it costs you a total of $18.90 ($18,900).

2) Check for support levels. There may be a support level at $20.50. Maybe there's a 50-day moving average at $19.55. You can establish an exit point if one, or both, of these support levels are violated.

For those of you who are chomping at the bit to start trading, hang in there. There is a lot more to know about these covered calls - and we will go over it thoroughly in upcoming columns.

For complete options trading training, click the "Covered Calls" header link above for more information.

Good day and good trading.

Tuesday, May 30, 2006

Risk and R-Multiples


Dr. Van Tharp - International Institute of Trading Mastery

Knowing when you are going to exit a trade is the only way to determine how much you are really risking in any given trade or investment. If you do not know when you are getting out, then in effect you’re risking 100% of your money.

Van says that risk is the amount of money you are WILLING TO LOSE if you are wrong about the market. So his definition of risk is how much you will lose per unit of your investment (i.e., share of stock or number of futures contracts) if you are wrong about the position that you have taken.

This is called the initial Risk or (R) for short.

One of the key principles for both trading and investing success is to always have an exit point when you enter a position. Trading without a pre-determined exit point is like driving across town and not stopping for red lights, you might get away with it a few times but sooner or later something nasty will happen.

In fact, the exit point that you have when you enter into a position is the whole basis for determining your risk, R, and the R-multiples (i.e., risk /reward ratios) of your profits and losses.

Your exit point can be either a percentage, in points or in dollar terms. For example, William ONeal says that when you buy a stock, you should get out when it loses 7-8%. Another trader proposes a philosophy of getting out of a stock when it moves 1-2 points against you.

Lets talk more about stops.

A stop is basically a preplanned exit. Van says that having stops prevents disaster even though this strongly goes against the grain of the long-term buy and hold philosophy.

When the price goes beyond your stop point, you exit the market. A trailing stop, basically adjusts that stop when the market moves in your favor, thus giving you a profit-taking exit as well.

For example, if you buy a stock at $30, and have a 25% stop, then you would exit the trade if the price drops 25% to $22.50.

In a trailing stop example, you buy the same stock at $30 (with the initial stop at $22.50) but if the stock moves up to $60, your 25% trailing stop would also move up with it and would be placed at 25% of $60, which is $45.

In other words, you would get out of the trade if the stock turned and dropped to $45.00 but because you bought it at $30, you would have locked in half your profit or $15. The trailing stop, in other words, moves the exit point in your favor as the price moves in your favor. BUT you must never move it backwards. Thus, if your stock moves down from $60 to $50, you would still keep your exit at $45, 25% away from the high of $60.

In Vans opinion, this kind of stop is a safe form of buy-and-hold. You could be in a stock for a long time, but if something fundamental changes, it gets you out.

As an example, JDSU went from about $12 in February 1999 to a high of nearly $150 in 2000 (prices are adjusted for a number of share splits). A 25% stop would have kept you in the entire move. You would have been stopped out in April of 2000 at a substantial profit. However, if you had used a buy and hold philosophy, the same stock hit a low of $1.58 in October 2002. You might never get back to breakeven (an 800% gain from current prices) in your lifetime, but the stop would have totally allowed you to avoid that fall. In addition, it would have gotten you out of stocks like Enron and WorldCom before any of them became headlines.

There are many reasons for using tighter stops and you will probably need to use them for a variety of different trading styles. We are simply suggesting 25% stops as a substitute for the “buy and hold” philosophy.

We are not going to get any further into stops at this point because we want to get back to talking about risk. Just remember, you need to know when you are getting out of a position (your exit point or stop) to determine your risk.

Tell me more about Risk or (R).

Risk to most people seems to be an indefinable fear-based term. It is often equated with the probability of losing, or others might think being involved in futures or options is risky. Vans definition is quite different to what many people think.

As far as Van is concerned, risk is definable.

Many people in the investment world are overly optimistic about the trades that they make. They dont understand their worst case risk or even think about such factors.

Instead, people are seduced by trading terms such as options, arbitrage, and naked puts. Or, they buy into the academic definitions of risk such as volatility, which make for good theoretical articles by academicians, but they totally ignore two of the most significant factors in success. The golden rules of trading...

Never open a position in the market without knowing exactly where you will exit that position.

And

Cut your losses short and let your profits run.

So lets look at the first golden rule in much more detail. That rule is to always have an exit point when you enter a position. The purpose of that exit point is to help you preserve your trading/investing capital. And that exit point defines your initial risk (1R) in a trade.

Lets look at some examples.

Example 1:

You buy a stock at $50 and decide to sell it if it drops to $40. Whats your initial risk?

The initial risk is $10 per share. So in this case, 1R is equal to $10.

Example 2:

You buy the same stock at $50, but decide that you are wrong about the trade if it drops to $48. At $48 you will get out. Whats your initial risk?

In the second example, your initial risk is $2 per share, so 1R is equal to $2.

Example 3:

You want to do a foreign exchange trade, buying the dollar against the euro.

Let’s say that one hundred dollars is equal to 77 euros. The minimum unit you must invest is $10,000. You are going to sell if your investment drops down by $1000.

What’s your risk? What’s 1R?

We made this example sound complex, but it isnt. If your minimum investment is $10,000 and you would sell if it dropped $1000 to $9000, then your initial risk is $1000, and 1R is $1000.

R represents your initial risk per unit. R is simply the initial risk per share of stock or per futures contract or per minimum investment unit.

However, its not your total risk in the position because you might have multiple units.

Whats my total risk?

Your total risk would be based on your position sizing and how many shares or contracts that you actually buy.

For example, you may buy 100 of the shares in Example 1, which would be 100 multiplied by the share cost of $50 each. So your total COST would be $5000. But you are only willing to risk $10 per share. So $10 multiplied by 100 shares = $1000 total risk for this position.

In example 2, you also buy 100 shares at the $50 price for a total COST of $5000. However, in this scenario you are going to get out if it reaches $48. So your risk is $2 per share multiplied by the 100 shares - you are only risking $200 of your $5000 investment.

Understanding R-multiples
The next key point for you to understand is that all of your profits and losses should be related to your initial risk. You want your losses to be 1R or less. That means if you say you will get out of a stock when it drops $50 to $40, then you actually GET OUT when it drops to $40. If you get out when it drops to $30, then your loss is much bigger than 1R.

Its twice what you were planning to lose or a 2R loss. And you want to avoid that possibility at all costs.

You want your profits to ideally be much bigger than 1R. For example, you buy a stock at $8 and plan to get out if it drops to $6, so that your initial 1R loss is $2 per share. You now make a profit of $20 per share. Since this is 10 times what you were planning to risk we call it a 10R profit.

You try it:

1. You buy a stock at $40 with a planned exit at $35. You sell it at $50. Whats your profit as an R-multiple?

2. You buy a stock at $60 and plan to get out if it drops to $55. However, when it goes that low, you dont sell. Instead, you just stop looking at it and hope it will go back up. It does not. It becomes part of the headline business news involving corporate scandal and eventually the stock becomes worthless. Whats your loss as an R-multiple?

3. You buy a stock at $50 and plan to sell it if it drops to $49. However, the stock takes off and jumps $20 in three weeks when you sell it. What is your profit as an R-multiple?

Answers

1. A 1R loss is $5. Your profit per share is $10, so you have a 2R profit.

2. A 1R loss is $5. Your loss per share is $60, so you have a 12R loss. Hopefully, you can understand why you never want to let this happen.

3. A 1R loss is $1. You profit per share is $20, so you have a 20R profit. And hopefully, you understand why you want this to happen all the time.

Whats really interesting is that once you understand risk and portfolio management, you can design a trading system with almost any level of performance. For example, you can design a system to trade for clients that would make about 30% per year with only 10% draw downs.

On the other hand, if you want to trade your own account and be a little more risky, you can design a system that will produce a triple digit rate of return as long as you have enough money to do so and are willing to tolerate tremendous drawdowns.

Its a whole new way of thinking for some, but most successful traders think in terms of risk/reward, which, of course, gives them an edge out there in the markets. Learning to trade and invest in this way will keep you in the game longer and enable you to run with your profits and cut your losses short. And what could be better than that?

About Van Tharp: Trading coach, and author Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors.

Click the "Risk and R-Multiples" header link above to learn more about Dr. Van Tharp and his trader training programs.

Good day and good trading.

Monday, May 29, 2006

Stop-Loss for Options

Sometimes you give your spouse or your kid your credit card and they spend hundreds or even thousands more than you expected! Wow, there's nothing you can do about it. The good news is, you can put stop losses and limits on your option positions. This way, your calls and puts do not run away with all of your money. The use of limit orders also sometimes allows you to get a better price than a market order instantly. For example, suppose the bid / ask spread is 3.30/ 3.50. You put in a limit order at 3.40 and it gets filled immediately and you save yourself 10 dollars per contract. It does not happen often, but it does sometimes depending on whether or not the market maker is willing to sell at 3.40. To sum up though, the use of stops and limits can have lots of benefits and there are drawbacks as well. Getting educated, however, only has benefits.

Stops and Limits Defined

A stop order is an order to buy or sell a stock at the market price once the price reaches or passes through a specified point, called the stop price. This type of order is generally used by traders who own a stock and want to make sure they sell out if the stock price starts to drop. The stop price placed on a sell stop order must be below the current bid price of the security. Stop orders in volatile issues will not guarantee an execution at or near the stop price. Once triggered, they are competing with other incoming market orders. Stop orders can be placed for buy orders as well. The stop price specified for a buy order must be above the current asking price. One last note on sell stops. If you use a sell stop for an option, the price that is used is the last trade price. In other words, the actual value of an option can go down significantly without there actually being at trade for the day for this particular option. In this way, a stop loss for an option has its drawbacks because it may offer less protection than it does for a stock that trades millions of shares per day.

A limit order lets you place a price restriction on your transaction. You indicate that you are only willing to buy or sell a stock at a certain price or better. Your order is not filled unless the stock trades at that level. Placing a limit order, however, is not a guarantee that your trade will be executed. It does, however, eliminate the risk that your order will be filled at a price worse than you expected. For example, if you want to buy ABC stock at $50 a share once again, and the market price is 50 bid and 50.20 offer, your order cannot be filled immediately. If somebody comes to sell the stock at $50, then your order will be filled if it is next in line for execution. If more buyers enter the pit and drive up the stock price, your order will not be filled.

Recommendations

We recommend the use of what we call a closing stop. A closing stop is just like other stops but it is not automated and it is based on the bid price as opposed to the last executed price. Let's say we buy an option at 3.00 and we want to set our closing stop at 2.00. We do not execute this order before closing time. Closing time is between 3:45 and 4:00PM Eastern Time. That is why we call this a closing stop- because we only execute it around the time of close. The reason for this is that when you are dealing with options, as in the above example, you might see the bid price as low as 2.50 during the day and then a pop back up to 3.20 for a swing of almost 30%. Intraday volatility is extremely high.

If you use normal stops, the chance of getting shaken out (exited) from a trade is very high. We do not want to get shaken out too often because we do not want to trade options excessively because of the wide bid/ask spread. The difference between a market order and a closing stop is that when a trader uses a closing stop, he has already committed that he will sell once the ask price goes under a certain level. This objectivity is critical in trading because it protects traders from making subjective, and emotional trades.

Next, lets talk about how we use limit orders. Most of the time it makes good sense to enter with a limit order. This guarantees that if we get execution, we will get it at the price we want. Now sell orders on the other hand should be treated differently. Traders have a tendency to hold onto losing trades too long. For this reason, market orders should be used to sell most of the time.

Here is an example: suppose you plan to sell your option at $2.00 and you put in a limit order at $2.00 and the current bid price is $1.90. You do not get filled. The market closes and the next morning the stock gaps down and the option is worth $1.00. You decide to hold on for the rest of the day, and the stock goes down another 4% and option at close is worth $.40! If you had just sold using a market order yesterday, you would have gotten out at 1.90 and saved yourself some significant money.

Most of time, depending on technical conditions and liquidity, traders should use market orders to close out their losing positions. On the other hand, the use of limit orders on winning trades is the better way to trade. This way, you prevent yourself from selling your winners too quickly, another common mistake of traders. So to sum it up, use closing stops with options trades to avoid excessive trading and to protect yourself from daily market noise. When possible, use limit orders to enter and market orders to exit. Be disciplined - and trade well.

Sunday, May 28, 2006

Weekly Stock Market Outlook


Nasdaq Outlook

After a rough start, the NASDAQ Composite finally came to life and put up some positive numbers for the week. The close at 2210.37 was a 16.49 point (+0.75%) improvement over the previous Fridays close, and put the index back above the 10 day moving average. However, that's still far from being evidence of a full-blown recovery. In fact, the NASDAQ could go even higher and still be in a bigger downtrend. As it was last week, things are going to be tricky to navigate in the coming week.

Fridays 12.13 point gain left the composite right above the 10 day moving average. That's the first half of a two-part buy signal; the second half is a second and higher close above the 10 day line. So in that light, we have to at least acknowledge that there may be some new upward momentum developing. However, any of that bullishness is tainted now that the index has been damaged so badly. For instance, the NASDAQ is still under the 200 day line, as well as the 20 and 50 day lines. Plus, when you are as stochastically oversold as the composite was last week, you are bound to bounce a little. That - so far - is all we see.

We will also point out that, even though the NASDAQ was rising over the last three days of the week, the volume behind those gains was shrinking (after that initial accumulation day on Wednesday).

So, we remain trapped between a rock and a hard place. Only a couple of closes above 2240 would get us thinking like bulls again. On the flipside, we would need to see a close under the year-to-date low of 2135.81(hit last week) to add new bearish trades.

On a side note, the NASDAQ Volatility Index (VXN) pulled back sharply after a rocket-ride to 23.55. Now, at 18.58, its in the middle of its Bollinger Bands, and pointed lower. That's technically bullish, but do not assume the VXN will have to get all the way back to the lower band (12.36) before bearish pressure sets in. Be sure to keep an eye on the VXN, taking note of any upside reversal bars. That may signal a downside move for the NASDAQ before it actually starts.

Nasdaq Weekly Chart

Nasdaq Weekly Chart

S&P 500 Outlook

The S&P 500 outperformed the NASDAQ last week by gaining 1.03%. The 13.10 point net gain over the last five sessions left the large-cap index at 1280.15 on Friday, which was just above the 10 day moving average. But like the NASDAQ, its still not clear if this was just the inevitable bounce following a 3.9% plunge, or if things really are getting bullish. More than that, we may not get an answer to that question right away.

Although the S&P 500 took a big hit too, it never really fell under the 200 day line in a significant way. In fact, the 200 day moving average was support, spurring the index higher in the latter half of next week. In fact, the push was strong enough to get the index back above its 10 day line too. Thats the first half of a buy signal, but like the NASDAQ, we are still a little skeptical of any buy signals for the SPX. The fact of the matter is that the index was stochastically oversold, and the Volatility Index (VIX) was pushing its upper limits.

However, its still under its 20 and 100 day line. So as with the NASDAQ, we need to see some more gains before we are convinced theres more upside fuel left. The resistance line to break is 1289, or the 100 day line. Support is the 200 day line, at 1258.65. We are neutral until one of those lines is broken, so be patient here.

S&P500 Weekly Chart

S&P500 Weekly Chart

Dow Jones Industrial Average Outlook

Although we were surprised to see stocks do as well as they did last week, we were not surprised to see the Dow do better than the rest of the indices. Its 1.21% gain for the last five trading days leaves this blue-chip index in its current role as the leading anchor for the bulls. It closed at 11,279 on Friday, 135 points better than the previous Fridays closing level.

The Dows relative strength has kept it in the best position to break above all of its key moving averages. In fact, it closed right at its combined 20 and 50 day lines on Friday, and well above its 10 and 100 day lines. So in that light, the Dow is still showing us general bullish momentum.

The downside potential is highlighted by the fact that Wednesdays low of 10,980 was the first lower low we've seen since October. Plus, an important support line was breached with the recent downward move. So even though things looked a whole lot better this past week, we do not want to jump the gun. Sit tight here - we will have a more definitive idea for the Dow by next week.

Dow Jones Weekly Chart

Dow Jones Weekly Chart

Thursday, May 25, 2006

Stop-Loss Price Targets

Do you use stops on all your trades? Trading without stops is the ego wanting to never be held accountable (to admit that a position was a mistake) if a certain level is breached or if a certain set of circumstances play out in an unexpected manner.

So whats the solution? Let the market take you out. This takes your ego out of the decision - the decision on what stop level to exit should be calculated before entering the trade. Again you want to prevent your mind playing tricks by rationalizing a new reason to hold on to a poor performer. I review my trading journal each day in order to remind myself of the #1 Entry Driver for the positions and key stop levels - if any of these are broken, I have lost the edge projected and should exit such busted trades immediately.

Most traders think of stops relating to their exit of a position, but I am finding these days that one of my most preferred entry techniques also involves a stop. A stop order to buy or buy stop becomes a market order when the market trades or is bid at or above the stop price. A stop order to sell or sell stop becomes a market order when the market trades or is offered at or below the stop price. The objective here is to only buy when the price takes out a significant prior high, or sell when the price breaks to a meaningful new low point. In this way I make the price prove to me that it wants to make the anticipated move. If it doesn't, I don't get into the trade. I have found this method far superior to the limit order technique of trying to buy below the current market price or sell above the current market price. What I generally have found is that limit orders hoping for a better price are merely another ego behavior to believe that we can tell the market what we want it to do. In turn when I missed out on getting filled due to a tight limit order, I was often left watching from the sidelines as the price mounted a continued trend. The stop entry has triggered me into some trends that I would have otherwise missed.

You should define an initial stop point for your trade, before you enter the trade. This determines the risk you are willing to take. The whole purpose of a stop in my opinion is to define the point at which the trend is invalidated. The potential reward should preferably be three or more times the risk you are willing to take. Next, you need to determine if a position is working for you, how will you protect your profits? This is known as a trailing stop. In a good uptrend, I prefer to use a close under the 10-day exponential moving average as my trailing stop.

At this point, let me explain my preferred stop method. I tend to use closing stops, meaning I do not want to place my stop order intraday to be gunned by the floor or taken out by day-trader noise. Many battles are fought during the trading day, but the war is won at the close. We want to wait to see who wins the war at the end of each session. If the price is going to close against my closing stop level, then I place a market order to close the position in the final minutes of trading. If the price happens to be within a few cents of this level and it is unclear, I will wait for the close, and if my level breaks, I will make sure to sell it at the market on the next trading day's opening price. This has kept me from getting whipped out of a number of good swing trades during the day, while still giving me the ability to exit when the stock has proved me wrong by days end. Some worry that a price may move too far against them by the close compared to an intraday stop, and occasionally a price will be filled well against our closing stop by the end of the day. But that risk is small compared to the bigger risk of getting whipped out of a position intraday, only to have it post a strong reversal in our favor and be off to the races. I call these Bend But Dont Break points. You want to wait for the end of that bars close. If the chart is a weekly chart, wait until the end of the weeks close to stay with the true trend while others will tend to get faked out.

The final exit issue I will deal with here is how to take profits. Should we use a fixed target, or should we only use trailing stops on winning positions until the trend breaks? The answer depends on your risk tolerance, as well as the market environment. For conservative traders, I recommend sticking with price targets compared to defined risk levels, as you can lock in profits more safely that way. In addition, in more choppy markets the target profit approach is advisable, as noise can work to your advantage in taking profits at targets. But in trending markets, we want to be able to keep at least a partial position on, and then use a trailing stop like the 10-day exponential moving average to stay with the best trending situations.

Happy Memorial Day Weekend America!

Ego Trading

If there's one word that costs traders the most money, I would have to say it is ego, when what we believe prevents us from seeing and acting on what the market is really telling us. Read on below for details on how to not let ego take over in your trading.

1. Master The Internal Ego

The idea is a simple one. You must precisely recognize what is keeping you from taking your trading success to the next level. The vast majority of the time, its your ego getting in the way. This is not the arrogant or over-confident type of ego. Instead, its more along the lines of a defensive, protective ego. The problem is, that kind of self-shielding ego is what prevents real learning. Lets take a closer look.

We are all human, and being human, we do not want to admit that we are wrong on a trade. The ego wants to uphold an ideal version of self that allows for only successes and not failures. Many traders lose millions of dollars trying to protect the egos version of reality. Your goal should be to trade without ego, without personal judgment of your self worth. Trading is a business, and the businessmen who do the best are the ones who treat as such. Its not a reflection of them personally. In fact its usually just a reflection of a mostly-mechanized trading system. In order to make money trading, your goal is to keep losses small while letting winners run. Your ego is not equipped to do that naturally, but a trading system is.

But are not you up against traders with a ton of experience and great trading systems? Absolutely. But remember, everyone follows the same learning curve, and nothing is free. You will have to spend time and effort to get good at this. How do you do that? Learn! The reality is that you chose to enter each and every trade. Examine why the losing trades failed, and why the winners were successful. This can be painful, at least initially, since the ego is built to deflect blame yet accept praise, this is why we said the ego can create problems. Thats a trap. If you find yourself saying that was a good trade entry but... then stop yourself immediately. Either everything before but or after but is inaccurate. If you rationalize or justify poor trades, then you will never learn from them. This is an important reality. The ego can prevent real learning. If you can learn to accept some failure without being emotionally devastated, then you will be a good trader. In fact its been said that the worlds top traders are not necessarily geniuses. They are survivors. They lasted longer because they could handle their ego, and in so doing learned a great deal just by being able to stay in the game longer.

2. Defend The External Ego

So what can you do today to start managing your ego? There's not enough space here to even really begin. However, there is one characteristic that seems to separate the great traders from the average ones. The great ones realize what kind of problems that a lack of confidence can present, so they do not even risk a shattered ego. How? They keep their trading activities to themselves. While the amateur trader will often tell friends, neighbors, and total strangers about trades he may have entered, it is all too often a setup for disaster.

Call it Murphys Law if you want, but one of the sure-fire trades you just entered and told your neighbor about will turn against you soon. And like clockwork, the neighbor will ask how it panned out. You have one of two options at that point. Tell the truth, or lie. You could lie to the neighbor and say the trade went fine. However, even though the neighbor may not know any better, the damage to our own ego is still a reality. Instead of acknowledging a losing position, we are forced to conceal the trade, which hurts your internal self-image.

On the other hand, you could tell the truth and own up to a bad trade, but that would negatively impact your confidence. You see, our perception of how others see us has a far greater impact, for better and worse, than our perception of ourselves. It may not be fair or logical, but its a fact nonetheless. And when we fail publicly, even at our own hands, we start to internalize and misinterpret external data, whether or not its accurate. In other words, our damaged ego affects our judgment.

For instance, the neighbor may ask How much did you lose?, while the trader may hear Why didn't you use tighter stops?

The neighbor may ask Why did you buy it in the first place?, while the trader may hear Can't you do adequate research?

The neighbor may say Better luck next time., while the trader may hear You have no business being in the market.

You get the idea. Enough of those innocent questions, and the trader is no longer trading. Or worse, the trader has changed his or her trading patterns in an effort to salvage some confidence. And all because he opened the door to his ego.

The only real defense against such an attack is to simply not share the details of your trading with others. There's nothing wrong with telling others you trade, but in no way will detailing your trading activity enhance your return. In fact, it may potentially do the opposite. If you profess a trade position to someone else, you have made a subconscious commitment to it. Maybe one you should not have. If you know someone may ask you about that position later, you are more apt to hold it, even if its a loser you would normally get rid of.

By not sharing your trades with friends and colleagues, you allow yourself to make mistakes free of criticism. You allow yourself to fail. You allow yourself to focus on finding better trades rather than proving someone else wrong. When you do not have to worry about protecting your psyche, you can shift the focus from defense to offense. A necessary trait for all traders. Good day and good trading.

Tuesday, May 23, 2006

Earnings Surprises

Yesterday, Lowes announced that first-quarter earnings were 44% higher than last year's. Yet as of this writing, Lowes is down 4% on high volume. Now how could a companies announcement of profit going up over 40% cause the stock to drop? The answer is expectations.

Today, I will discuss expectations and surprises. I will even look into data proceeding positive and negative surprises. Many novice investors assume that negative announcements cause stock prices to drop and that positive announcements cause prices to fall. But there is more to it than meets the eye. Not long ago, GM announced another loss for the current quarter yet the companies stock rose on the news. But why? Its because most analysts and market participants were expecting the announcement of a losing quarter but it turns out the loss was not as bad as expected and soon afterwards, GM received an analyst upgrade. So the point is that bad news or good news is not the bottom line when it comes to surprise stock movement. Traders who speculate on news releases must consider what current expectations are. If a news release is not surprising, then the stock price is likely to stagnate. Therefore expectations set up a virtual hurdle that must be surpassed in order for the stock price to increase. This is what we have seen in Google stock since the IPO. Time after time, the expectations were high for Google earnings, yet the company has surpassed these high hurdles like a pole vaulter. One analyst I know specializes in placing speculative trades prior to earnings announcements. His data suggests that the best earnings trades are proceded by a long-term rise in the stock price followed by choppy, sideways action a week before earnings on moderate volume. This analyst also takes into account surges in implied volatility. Another interesting website, www.buybackletter.com aims to profit from stock buybacks only. Now, onto specific data below.



Let's look at some real data on positive and negative surprises for stocks. This data above is based on a study by the University of North Texas. The study looked at price movement in stocks 1-3 years after different types of news items. As you can see, the data suggests that these various news items affect stocks in various ways. This data also suggests that this information is tradable and useable. If you are interested in surprise information, consider doing further research on the subject and if you feel strongly enough about it, then trade accordingly. No matter what you decide, be disciplined- and trade well.

Conventional Trading Wisdom


Dr. Van Tharp - International Institute of Trading Mastery

I think Dr. Van Tharp best stated it best with his trading teaching methods. Learn who you are as a trader first, as you can control yourself, but you cannot control the markets. Van Tharp starts with a trader survey to analyze what a traders beliefs are to then eliminate the incorrect beliefs and to instill and improve the correct beliefs of each of his students. On the topic of conventional trading wisdom, Van Tharp teaches people to develop and trade within themselves to be a success in the markets.

The human mind can rationalize a lot of things. Unfortunately, being human, it can also rationalize incorrectly. For example, if you toss a coin ten times, and landed on heads all ten times in a row, what is the likelihood it would land on heads on the eleventh toss? Most conventional thinkers would say that eleven heads in a row would be nearly impossible. But unconventional thinkers realize that the chance of getting heads on that eleventh toss is exactly 50/50.

Inaccurate conventional wisdom is common in trading. Two of these most common incorrect rationalizations are:

1) What goes up must come down.

2) What goes down must go up.

These axioms seem accurate on paper, do they not? But the reality is that these two statements are false as often as they are true.

What goes up may eventually come down, but if a stock is going up, it is going up for a reason. It may not be a good reason, but there is a reason nonetheless. That is why we typically recommend trading with the trend, rather than against it. That is also why we value technical analysis as highly as fundamental analysis. While a company may have outstanding fundamentals, the stock price is not set by a companies fundamentals - it is set by other investors. As a shareholder, you only make money if share prices increase. So, a good company is no guarantee of a good return on your investment. Conversely, shares that cannot go any higher can and often do go higher, even if the company is losing money. Conventional wisdom says buy good companies, but that is the wisdom that has been drilled into our heads since the day we started investing. Perhaps we should adopt a new conventional wisdom - buy stocks that are increasing in value.

The point is, you have to realize if your trading logic is flawed or not. Conventional wisdom is largely a collection of assumptions. The problem is, these assumptions may have stuck around for years after the events and information that led to those assumptions had changed. Are you basing your logic on what you think to be true, or what you know to be true? Successful investing speculating and trading starts with knowledge, setting goals, creating trading plans, and taking action on it all. Good day and good trading.

Sunday, May 21, 2006

Options Trading


Volatility is a Part of Life - Deal With It!

A little violence is ones life can be very exciting, and profitable. No, I'm not suggesting you go rob your neighborhood liquor store. I am talking about your trading life. The violence I am referring to is the up and down fluctuations in the stock market. How severe these fluctuations are is measured by what is called volatility.

Obviously, when there are dramatic spikes, the volatility can be very high. Conversely, when the stock is moving sideways, and not moving up and down, the volatility is reduced. Remember, in earlier posts I discussed the components of an option price based on the Black Scholes pricing formula. Volatility is one of the ingredients. Basically, increased volatility means there will be a higher premium. Reduced volatility translates into lower premium.

Volatility - Good or Bad?

How do we determine if the price of an option is good or bad? Well, it depends on what we're trying to do. If we're buying a put or call option, and we are hoping for a directional move, we do not want to overpay for the option. So, we look for options that are undervalued instead of options that are overvalued. We are essentially looking for a bargain.

When we buy an option, a portion of the price is time value. We discussed that quite thoroughly in previous posts. This time value will deteriorate during the life of the option. When picking a direction, we are hoping the underlying stock will move in the appropriate direction before all the time value disappears from the value of the option.

Note: Over 80% of options expire worthless. That should tell you a little about your probability of success from straight option buying. We will go into that later, in depth, and learn how to improve your chances of becoming profitable.

On the opposite side, if we are selling options, we want there to be as much premium available as possible. Why? Because it goes right into our pocket. In this case, we would want the option to expire worthless - because the other person owns it. When we sold them the option, we made a contract to perform. If we do not have to perform, we keep all the premium collected from the sale of the option.

How do we know if an option is a bargain? Or are we paying top dollar? There has to be a way to measure the price of an option - to determine if it is fairly priced, under priced, or over priced. In the Black-Scholes post, I looked at the theoretical value of an option. Those figures are available on the software of any quality broker.

Note: There are dozens of brokers out there - all claiming to be excellent option brokers. There is a huge difference between brokers - in price, efficiency, quotes, charts, etc. Be patient. Do not rush out and open a brokerage account for trading options just yet. We will be covering the topic of brokers in a few weeks. If you open your account too soon, you may not be able to resist the temptation to trade and guess what? You are not ready to trade yet.

Two Kinds Of Volatility

Lets confuse the issue a little more. There are actually two kinds of volatility - historical and implied. In its simplest terms, historical volatility is a measurement that averages out the volatility figures over an extended period of time - perhaps years.

Then, implied volatility is a calculation based on what has been happening to the underlying asset recently, and what is projected for the near term. This is another calculation that is normally provided on the site of a good broker.

Let's look at the official definitions of these terms.

Historical Volatility -- A statistical measure of the amount of fluctuation in a stock's price within a period of time. A stock with high volatility would have rapid up and down movements in its stock price. A stock with very little movement in its price would constitute low volatility.

Implied Volatility -- The volatility of a futures contract, security, or other instrument as implied by the prices of an option on that instrument, calculated using an options pricing model.

A few years back, especially during the internet bubble, volatility was ridiculously high. But, times have changed. For a long time, we have been in a low volatility environment. Options purchasers pay only a fraction for options now, a bargain compared to what they paid for a similar option back in the days of irrational exuberance.

There is a volatility index called the VIX. It is a calculation of the implied volatility of the 100 stocks in the S&P 100 index. The symbol for that measurement is $VIX. It's a good way to, at a glance, see what the market, in general, is doing.

Volatility Skew Charts

Charts can compare the historical volatility with the implied volatility. These are charts in which the chart of historical volatility is overlaid on the chart of implied volatility, enabling you to visually compare them. This is another standard feature available on good broker sites.

If the implied volatility is currently higher than the historical volatility, the option is overpriced. If the implied volatility is currently below the historical volatility, the option may be a bargain.

This bit of violence (or non-violence) can have a significant effect on an options price. This is an important concept, but does not come into play in all strategies. Its good to know, but its only one part of many in the decision making process of trading options.

Winning Trader Traits


Trade To Win

Ever wonder how some athletes get to be great, while others with much talent remain only good? While some talent is in-born, I believe the great ones cultivate a work ethic that is superior to those in the good camp. As the saying goes, the harder I work, the luckier I get.

Think about your preparation process as a chance to open you up to new opportunities. Do you prepare by rolling into the office soon before the market opens and glancing through the headlines to see which hot stock you're going to trade today? If so, I submit your preparation process is lacking, and as a result you are becoming too reactive as a trader.

Instead, do your preparation after the markets close the prior day, which allows you to get out of the heat of the moment and develop a plan to trade stocks based on your indicator setups. Then you can look for confirmation the following day as necessary. This allows you to be in a more proactive mindset, which makes you feel more in control of your trading destiny. Self-confidence is directly correlated with the trader's perception of his level of preparation coming into the trading day, which leads to his ability to perform successfully. Good preparation also influences the skill level that a trader believes he possesses. You need defined time to prepare for the next trading day to build up your trading feel and confidence.

After the close, I run my computer systems for new entries and exits, open positions first, then look at my plan and trading rules. The next morning I like to get in earlier than most, when things are quiet and peaceful. I find this leads to a more serene and calm effect on my trading for the rest of the day, versus getting in late and feeling like I am rushing. Its like the common metaphor of believing in abundance versus believing in scarcity. By getting in earlier without the rush into work, I pre-program to execute trade with visualization techniques, do my self-analysis described above to make sure I am ready to trade, then I take action. After the close I then review that day's trades, asking did I follow my rules? Then I run my computer systems and the cycle begins again.

One of the keys as a trader is that you must spend the time necessary to make trading skills automatic and create winning trading habits. If wishing to be immersed in total focus, you cannot be thinking about technique or strategy. As a beginning golfer I used to think a variety of swing thoughts Keep your head down, Left arm straight, etc. and then hit a rigid, weak shot because so much thinking was occurring that I could not unleash my fluid swing's true inner power. Preparation and practice make for proper skill development. By making these actions automatic, the mind can be more purely focused on trading actions necessary to generate profits or reduce losses.

One final thought. Let's say the average trader prepares for an hour each day. If you prepared for an extra 30 minutes each day (90 minutes per day total), in a week you would have prepared an extra 2-1/2 hours, in a month 10.5 hours extra and in a year 126 hours or an extra 19 trading days worth of preparation. This extra focus on your trading goal will create new opportunities for you that you never before seemed to find in a timely way. Extra practice and preparation can give you a serious edge if you are willing to commit the time. Most aren't willing to do this, and that is what separates the great ones in their commitment to superior performance.

Friday, May 19, 2006

Investment Diversification


Diversification is an important concept in managing your portfolio. Remember that this goes not only for your long-term investments portfolio but also for your trading portfolio. Diversification means that you attempt to limit the risk to your overall portfolio by spreading your capital over a variety of investments and assets with different levels of risk. Doing this properly should maintain a smooth level of growth.

There are a variety of different types of investments with different levels of risk that are available. Many people hold a small amount of their portfolio in cash. Having some cash on hand is always important for if some unanticipated need arises and to limit volatility in your account. It is the lowest risk position you are going to have but, of course, also the one with the lowest potential returns.

So now you can establish your base. Put most of your portfolio into low to medium risk positions. For the investor, this might include bonds, a little gold, mutual funds and/or exchange traded funds, depending on what you feel most comfortable with. Consider weighting your investments using Sector Rotation techniques (which we will discuss more in a future article). Basically, sector rotation is the concept of weighting your investments according to the cycles of the economy. For the trader, you will want to use a good system that generates picks for the ETFs or large-cap stocks or perhaps credit spreads, something with less volatility and risk.

Then you can get into your higher risk/reward plays. For investors, this is a small amount of your portfolio that you reserve as speculative money. Do you have some small Biotech stock in mind that you think might be a big winner in the next few months? Put 5% of your portfolio into that and take a chance. A couple speculative positions could add some nice profits to your portfolio. For traders, this is where you get into your swing trades or high-risk options trades that could provide some very nice returns for your portfolio.

Remember to not put all your eggs in one basket. Diversify your investments and you will provide yourself with steady gains in all market conditions. You will be able to sleep at night knowing that your money is safely protected across a range of different assets.

Thursday, May 18, 2006

Traders Coach Dr. Van Tharp


System Development by Dr. Van Tharp of International Institute of Trading Mastery

When I first entered the business of coaching traders most people thought that a trading system was an indicator.

People who trade and invest tend to fall into similar traps, becoming obsessed with

1) Finding the right stock that will make them a fortune and they think there is some magic way to do that.

2) Working on developing a trading system to the point of perfectionism, and never getting around to actually trading.

3) Finding the ideal system.

4) Just looking for someone to tell them what to do.

Do you relate to any of these scenarios?

Every trader needs a strategy or system to form a framework for their trading. Without a repeatable way to identify and execute trades, one can never be a consistent performer. Basically your system is a roadmap that guides your trading and keeps you from making decisions when you are least able to do so. Trading can be stressful. Its easy to get distracted. Life goes on regardless of what the market is doing. If you hear news about the market changing or you are running late for your next appointment, you are not likely to make good decisions about your trades.

However, many people believe that a trading system is something that is bought in a box, something that other people have created with specific technical skills or secret knowledge of the markets that they just don’t have. Well it is not.

There are hundreds, if not thousands, of trading systems that work. But most people, after purchasing a system, will not follow the system or trade it exactly as it was intended. Why not? Because the system doesn’t fit their personality or their style of trading.

One of the biggest secrets of successful trading is finding a trading system that fits you. Developing your own system allows compatibility with your own beliefs, objectives, personality, and edges.

Why develop my own system? Is it easier to just go buy a system with proven results?

When someone else develops a system for you, you do not know what biases they might have. Most system development software is designed because people want to know the perfect answer to the markets. They want to be able to predict the markets perfectly. As a result, you can buy software now for a few hundred dollars that will allow you to overlay numerous studies over past market data.

Within a few minutes, you can begin to think that the markets are perfectly predictable. And that belief will stay with you until you attempt to trade the real market instead of the historically optimized market. Many trading accounts have plummeted from this very thinking. One sure-thing trade placed without proper position sizing can wipe some traders completely out of the game.

And what if the person peddling the system is just a great marketer who makes their money from selling systems – not from actual trading? How would you know?

In Van Tharps experience very few people have really good systems and one of his jobs is to teach traders what it takes to develop a complete system for themselves. It is not rocket science. It just takes commitment and the right knowledge.

You may be thinking, But I don’t have the computer or math skills to create a system myself.

This is one of the biggest misconceptions out there.

If computers, math or anything mechanical terrifies you, that does not mean that you cannot determine how and what you want to trade, which is the basis behind developing your own system. In fact, you are the only person that really knows what will work for you.

The key thing to remember about system development is that the trading strategy is though up by you because it fits your beliefs, wants, desires and needs. You can hire someone else to computerize your strategy if you want to do that and cannot do it yourself. There are plenty of programmers that will do this for you.

However, not all trading systems have to be computerized! In fact, people have designed and tested successful trading systems for years by hand. Of course computers make things quicker, faster and more efficient, but they are not necessary at all unless you need to use computers to feel comfortable about your trading.

If you disagree with this, then you probably do need computer testing to feel comfortable or maybe you believe that when a computer generates numbers, it is more accurate.

If you truly understand what a trading system really is, then this will all make sense. It is not complex, unless you choose to make it so!

So What Is a Trading System?

What most people think of as a trading system, Van would call a trading strategy that consists of seven parts:

Set up conditions.
An entry signal.
A worst case stop loss.
Re-entry when appropriate.
Profit-taking exits.
A position sizing algorithm.
Multiple systems for different market conditions (if needed).
The set up conditions amount to your screening criteria.2 For example, if you trade stocks, there are 7,000+ stocks that you might decide to invest in at any time. As a result, most people employ a series of screening criteria to reduce that number down to 50 stocks or less. For example, you might want to find stocks that are great value or stocks that are making new all time highs or stocks that pay high dividends.

The entry signal would be a unique signal you would use that meets your initial screen to determine when you might enter a position—either long or short. There are all sorts of signals one might use for entry, but it typically involves some sort of move in your direction that occurs after a particular set-up occurs.

The protective stop is the worst-case loss you would want to experience. Your stop might be some value that will keep you in the trade for a long time (i.e., a 25% drop in the price of the stock) or something that will get you out quickly if the market turns against you. Protective stops are absolutely essential. Markets do not go up forever and they do not go down forever. You need stops to protect yourself.

A re-entry strategy. Quite often when you get stopped out of a position, the stock will turn around in the direction that favors your old position. When this happens, you might have a perfect chance for profits that was not covered by your original set-up and entry conditions. As a result, you will need to think about re-entry criteria. When might you want to get back into a closed out position.

The exit strategy could be very simple. It is one factor in your trading of which you have total control. It is your exits that control whether or not you make money in the market or have small losses. You should spend a great deal of time and thought on your exit strategies. This is an important shift in thinking that you will benefit from right now. You don't make money when you enter the market you make your money upon your exit of the market. Far too many people focus only on market entry, or what to buy, rather than when to sell.

Position sizing is that part of your system that controls how much you trade. It determines how many shares of stock you should buy or how much you should invest in any given trade. It is through position sizing that you will meet your objectives.

Finally, depending upon how robust your trading system is, you might need multiple trading systems for each type of market. At minimum, you might need one system for trending markets and another system for flat markets. Many professional traders have multiple systems that operate in multiple time frames over many markets to help offset the enormous portfolio dependence of a single trend following system.

Your system should reflect your beliefs (i.e., who you are as a trader and as a person). Many people are just looking for any system that works, but if your trading system does not match your beliefs about the markets, you will eventually find a way to sabotage your trading.

In addition, most people have never really taken the time to think through what they truly want from their trading. They do not have specific objectives in mind. They think they do, but they really don’t. They just have a vague concept in their heads of I want to make a lot of money. Yet, objectives are 50% of designing a system that fits you.

Examples of possible objectives:

1. I want to become a full time trader making 30% per year for my clients with potential losses no bigger than half of that.

2. I want to spend less than three hours a week on trading and get the maximum yield out of my system. While I would like to minimize my downside, I am willing to risk whatever it takes to get maximum returns, including losing it all.

3. I want to limit my draw downs to no more than 20% at all cost. With that in mind, I would like to make whatever I can, but minimizing the draw downs is my primary objective.

No system is a money making machine that you turn on and have it print cash forever. Systems must be evaluated and revised to adapt to changing market conditions. And while there are ways to measure the quality of the system, you will never trade a system properly that you do not feel comfortable trading. In the same way, you might have trouble following the advice of newsletters because you do not feel comfortable taking certain trades that they recommend.

Improving your trading performance will not come from some indicator that better predicts the market. It comes from learning the art of trading and understanding how to create a trading system that fits your wants, needs, desires and lifestyle.

So ask yourself, How much time and money am I willing to lose trying to trade other people’s systems?

A great trader asked me once what I wanted my system to do. I responded vaguely about outperforming the market…. He pushed me for the performance statistics I was after. I told him the general statistics I was after, but said that I needed to see what the system would do. He basically told me that I had it backwards. He said very specifically to start with the performance I was expecting in mind, and design a system to that specification.

About Van Tharp: Trading coach, and author Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. Click the header link "Traders Coach Dr. Van Tharp" above to learn more about Dr. Van Tharp and his traders training courses available.

Wednesday, May 17, 2006

Analysis Paralysis


How do you avoid being trapped with overanalysis, regrets over losses and other things that preoccupy when you are trading?

Its true that I can get emotional when trading. I get happy when returns are good which is dangerous and I get upset sometimes when trades are going badly. I think the best way to deal with those emotions is to think of myself as more of an observer than a trader. My job is to observe what happens, draw conclusions and make decisions that will improve the quality of my systems. That is my job in a nutshell- observe, improve, and act. My job is not to get happy, to think of myself great when trading is going well, or to get upset when losses happen (which is inevitable). Kaizen is what I need to concern myself with mainly. I get over losses by judging my actions instead of short term results. Its similar to a poker system. Sticking to the system and improving the system constantly is the name of the game. Short term fluctuations mean nothing. I trade based on long term profitability, logic and proven techniques that work in the long term. If I start setting bigger return numbers as targets, then I will mostly likely have to increase my risk expectations. The increased account fluctuations should be expected. Being in the zone or trading the best possible way means you can tolerate pain better. The author thinks that pain tolerance is the most important aspect of trading or perhaps one of the most important aspects.

As a trader, what more do I need to know?

Who the best traders in the world are.
What the best books in trading are.
What the best indicator is long and medium term.
Are there more ways to add fundamental analysis to trading short term?
Are low PE stocks that I trade performing better than the high-PE stocks?
Which securites offer the best returns?
How can I talk to more people who trade for a living and how can I get additional advice from them?

When you don't have a specific return target, then you will randomly choose one based on emotion and it may spin you out of control. Return targets are very important.

What can I do to change my self limiting habits and attitudes that often lead to repeated failures or limited success?

One habit I can change is this psychological need to be right. This can actually make things very bad and unprofitable for me. Of course I want to be right, but its not that important. But the truth is, the only thing I need to concern myself with is how to improve my trading. My concern over being right can often be couter-productive. Also this habit of starting a system and not continually honing it can be a problem. I should be working on it all of the time and each week I may want to schedule half an hour to improving my current system. This week, I can do that very thing by optimizing very thoroughly in several environments. I just need to remain calm and take the necessary steps to succeed. The word of the day is action!

What new approaches can I adopt that can transform my trading and make me much better returns with reasonable risk?

2 hours of reading a week is the most crucial thing I can do. Just what I got philosphically from Mortimer Adler is humungous. I should consider reading more of his stuff regarding philosophy because the logic helps me in trading.

How do I deal with ambivalence, uncertainty and indecision?

First of all, I believe that some decisions are worth waiting on. I cannot make quick decisions in every matter. That is, I cannot make a decision in one day on every matter. Sometimes it requires research to make a confident decision because decisions, especially when it comes to trading, have to be founded on historical probability or super-strong logic. That takes research. That being said though, I must also avoid sitting on my hands and doing nothing because that's not the name of the game either.

So there you have it. This is the kind of work I put myself through to improve my abilities on a consistent basis. One of the keys is to eliminate the EGO and focus on progress instead. Warren Buffet says that when he is evaluating the management of a company, one necessary characteristic of management is the ability to be upfront about good and bad decisions, because mistakes are made occassionally and they must be dealt with. As a trader, you must know your strengths and your weaknesses. Trading is driven by our psychology, ego, and emotions. You must constantly improve yourself through study and self-evaluation. Be disciplined and trade well!

Tuesday, May 16, 2006

The Buddy System


As analysts and traders its nice to have a buddy system in which each analyst has a partner with whom he joins with for purposes of accountability, discipline, and fresh ideas. This system is highly effective. We believe this system increases profit and prevents many serious errors in judgment and discipline. I recommend you do the same with someone you know who trades, or perhaps someone who does not trade at all. The first step in this system is to explain to your buddy what your buy and sell discipline is. This first step is very illuminating. Many traders find that their original strategy becomes more well defined, while other traders realize that they never had a clear plan to begin with. Remember, that the ego typically desires to be free and to have more discretion when it comes to trades. But, the objective of trading is not to massage ones ego. The objective is profit. If the system is most effective without discretion, then so be it. We use the format below to describe our strategy and discipline to each other.

Specific Criteria Necessary to Open a Long Position

Specific Criteria Necessary to Open a Short Position

Once a Stocklist is Formed w/ the Proper Criteria, Here is wow I Choose the Stock

Specific Criteria To Exit a Long Position

Specific Criteria to Exit a Short Position

Any Stop Strategies (For Example, Entering, Lowering, and Raising Stops)

What Must Happen for me to Change My Strategy

How I want Feedback and How Often

What Dates and Times I Want To Meet Regularly Regular Reviews

The next step in the buddy system is to have regular reviews. But what do you talk about during your reviews? Use the following template to review your buddies trades and to have your trades reviewed as well:

Did the analyst follow his rules for entry? If not, how so?

Did the analyst follow his rules for exit? If not, how so?

Did the analyst follow his rules for stops? If not, how so?

Did the analyst change his strategy? How so?

Any new ideas to share with the analyst?

Use this buddy system and have a review at least once a month if not more often. Sometimes it helps to have a partner when it comes to discipline.

Be disciplined, and trade well!

Monday, May 15, 2006

Risk & Reward


Think you know about risk and reward?

Most traders use the target price and the stop price as their model of risk and reward, and leave it at that. However, they may be missing an important risk/reward concept. Read on to add a new weapon to your trading arsenal.

The concept of a risk/reward ratio is pretty straight-forward. For any given trade, you are targeting a certain amount of gain, while setting a stop-loss limit if the trade goes the other direction instead. This is a critical concept for any trader to grasp, as the idea is to establish the potential loss to see if it justifies the potential gain. Of course in all cases, you want your reward to be at least a little better than your risk, so you set your targets and stops accordingly. A good rule of thumb is to seek a return of three times as much as the amount risked, making the reward/risk ratio 3 to 1. But its equally common to see reward/ratios of anywhere between 2 to 1 and 4 to 1. Let's go through a real example.

Say we're buying XYZ shares at $36.00. We think XYZ will move to $46.80 for a 30% gain, and we are willing to risk a 10% loss in the attempt to get that 30% gain. A 10% loss on $36.00 (initial investment) means shares would fall to $32.40 before we threw in the towel and closed out the position. Our potential reward is 30%, but we are risking a 10% loss. What is the reward to risk ratio? Well, 30% divided by 10% equals a 3 to 1 reward/risk ratio.

So as long as your rewards are bigger than your risks, over time (and enough trades) you will make money, right? Wrong. Unfortunately, too many traders automatically set up a 3 to 1 ratio when setting price targets and stop losses on any of their trades. But they are forgetting something very important. Just because your profit target is three times as big as your risk does not mean you will ever actually hit that target. You also have to factor in the likelihood of a successful trade. Lets take a look at why.

Lets stick with the assumption that our optimal reward/risk ratio is 3 to 1. Lets also assume you have developed a trading system (or you are able to pick stocks) that produces one winning trade in every four trades. So, your win/loss ratio is 1 in 4 (25%), while your reward/risk ratio is 3 to 1. Do you think you will make money with that system? Nope - for every trade that gains 30%, you have three more trades that lose 10%. The rewards were three times as big as the risk, but it did not create any real profit! The best you could hope for is to break even.

So how does one measure the real reward-to-risk ratio? You have to factor in the odds of a winning trade into the potential gains or losses. Again, we will illustrate it with an example. Say you have found a stock you think will move 20% higher, and you are willing to risk 10% to enter that trade. Your target is 20% above your entry price, and your stop loss is 10% under your entry price. With a reward/risk ratio of 2 to 1, this trade does not necessarily seem all that great. But, what if the trading system had a success rate of three winners for every four trades? You'd have a 75% chance of making 20%, while only a 25% chance of losing 10%. With that particular trade, your real reward-to-risk ratio would be about 6 to 1.

The point is, do not fall into the trap of setting targets and stops based on a predetermined risk/reward ratio. Big rewards and small losses are pointless if the system is a net loser. Rather, focus on the actual risks and rewards of a total methodology. This will also force you to determine just how successful your trading system or stock picking really is, which is something you should know anyway.

Market Volatility


LAST WEEK IN THE MARKETS

What started off as great news this week with the Dow near all time highs turned rather sour after the Fed made their move with ambiguous language (see below for more). Commodities were the place to be with gold hitting multi-year highs, while oil reached for $75. Transports lifted higher early in the week before giving back gains. Nasdaq has been clearly weak for several sessions, dropping sharply this week. Technology leaders (of the past) have lagged the market throughout the last few months. Markets are heading into a seasonally weak period which can last for several months into the fall.

WHAT THE FED STATEMENT MEANS TO MARKET VOLATILITY

As you may have heard, the Federal Reserve this week raised the Fed Funds rate to 5%. This was the sixteenth consecutive meeting where the commitee boosted the overnight rate since June 2004. This was hardly unexpected as the language from the last meeting gave hints to continued policy tightening.

What I found interesting this time around was the posture of the Fed portrayed in their recent statement, and the importance on forthcoming data. It seems pretty clear to me that the Fed is in a watch and view mode, and will likely take its cue from future economic numbers. This tells me the Fed is comfortable with this current rate and will probably pause at the next meeting, looking for signs of inflation cooling off, but will monitor new information if they decide to change their minds.

In striking fashion, commodities such as gold, oil, and metals continue to reach for multi-year (new alltime) highs. These rises generally signal inflationary trends, as witnessed three decades ago. So, if the Fed is going to wait and look at data before acting, how does the market take that change in posture? Are the expert economists on the same page? Hardly so, it's likely volatility will rise because of this uncertainty.

Remember, markets hate uncertainty. Even more than Fed rate hikes (it is showing this angst with a vicious selloff on May 11) Why is this so? Uncertainty creates jolts and surprises, so volatility should rise. The market has pretty much known rate hikes were coming, and the adjustment can be made, hence, the low VIX levels for recent years. The Fed has been transparent in their expected actions. This time around, less is known as to how the Fed will act.

Look for a rise in market volatility risk over the coming months. As an aside, the meeting minutes have been scrutinized more than ever, to see what they are really thinking. Look for the May 10 meeting minutes to be release around the end of the month.

Saturday, May 13, 2006

Weekly Stock Market Outlook


NASDAQ Outlook

In the MidWeek Update we cautioned that things looked more like a setup for the bears than any beginning of a monster rally, primarily because the NASDAQ was lagging (badly). On Thursday and Friday, that's pretty much how it panned out. For the week, the NASDAQ Composite fell 98.79 points (-4.22%) to close at 2243.78. Thats the second lowest close all year long, and certainly should be a concern for the bulls. Yet, there may be a small glimmer of hope if you did not get to make exits before the destruction in the latter part of last week. Could that short-term bullishness turn into longer-term bullishness? Anythings possible, but we would have to say the odds are against it.

OK, the coming few days are going to be tricky to navigate. Not only are we in the wake of an extreme selloff (which encourages some buying from the bottom feeders), but we're also entering an option expiration week, which wreaks its own special brand of havoc. There is no guarantee, but here's what we see in store.

Basically, the sellers went a little overboard. Yes, we were due for a dip, as we stated last week. However, a 4.2% selloff is a little much - too much, maybe. Going from the overbought extreme to the oversold extreme is now setting up an upside bounce, at least to a small degree. We saw a bearish gap between Thursday and Friday, which should be pressured to get filled in the coming week - possibly early in the coming week. You'll also see that the VXN is back at its upper Bollinger band (20 day), which is usually when the rebound starts. See the arrows on the VXN and NASDAQ charts? Take a look at the last three times the VXN bumped into its upper band - three bounces. The only caveat is that the VXN may end up making a series of higher closes, ALL above the upper band. If the VXN actually starts to trend higher rather than meet resistance at the upper band line, then forget about the bounce - the buyers aren't quite ready yet.

In either case, our bigger-picture outlook is generally bearish, whether we get that short upside move or not. The composite is under the 100 day line for the first time in months. Plus, we've seen that higher highs trend turn into lower lows since late April. The tone is definitely changing, and the NASDAQ is leading the way. If we get that bounce, we're going to expect resistance around the 100 day line (2299). If the composite starts to roll over around there, that would probably be a good entry point for new short/bearish trades.

NASDAQ WEEKLY CHART

Nasdaq Weekly Chart

S&P 500 Outlook

The S&P 500 closed at 1291.25 last week was 34.50 points lower (-2.6%) than the prior weeks close, with most of that loss being incurred on Thursday and Friday. While we generally try and take things at face value, here, we have to look at the bigger picture. Based on the pattern we've seen all year long, the selloff for the SPX might actually be close to an end. If its not, then this short-term breakdown is about to turn into a much bigger bearish move.

A few days ago we commented that the S&P 500 had been range-bound in a channel that was generally bullish, and that the pressures of being overbought were probably going to be just strong enough to drive the index to the lower edge of that range. Well, even after last weeks plunge, the SPX is just now at that lower support line. Check out the short-term channel lines (blue, dashed). Its definitely pushing its limits now, but technically, the support is intact. The same goes for the support provided by the 100 day moving average. Until it breaks, we want to give the benefit of the doubt to the bulls. Besides, the VIX is also at an extreme that suggest a short-term bottom. So, dont be shocked if we see some strong buying early in the coming week.

The question is, how much? Will the bigger uptrend resume, making this dip just one of many in a zig-zag motion? Maybe, but look at the long-term support line (red, dashed). It extends all the way back to October, so clearly the momentum is waning.

The ultimate test is the 100 day moving average line, currently at 1288. It's going to be tested as support real soon (Fridays low was 1290.40), much like it was tested in early April. If that line breaks - and it wouldnt have to be immediately - then we'll look for a trip possibly all the way back to the 200 day line at 1257. But we will repeat, it doesn't have to happen immediately. With as mush selling as we went through over the last two days, a bounce of some sort is very possible. The SPX could crawl all the way back to the 10 or 20 day average line (1313) before rolling over again and moving under 1288. Keep your eyes open in the coming week - its going to be interesting.

S&P500 WEEKLY CHART

S&P500 Weekly Chart

Dow Jones Industrial Average Outlook

Despite the fact that the Dow has been leading the bullish charge over the last few weeks, even its relative strength wasn't enough to keep it out of the red by the time Fridays closing bell rang. The blue-chip index closed at 11,381, losing 197 points (-1.7%) over the last five sessions. It was still the most resilient though, in that it lost the least - as we discussed a few weeks ago. Nevertheless, a loss is a loss, and there may be some more of them in store for this chart in the next few days.

Basically, the Dows incredible strength over the last month left it a little more vulnerable to a correction. So, the blue-chip index isn't quite as primed for a bounce as the other indices are. In fact, if anything, the Dow is still poised to fall a little further - to the long-term support line around 11,155.

Other than that, the bigger-picture scenario for the Dow is about the same as for the other two indices.

DOWN JONES INDUSTRIAL AVERAGE WEEKLY CHART

Dow Jones Weekly Chart

Friday, May 12, 2006

Trading Games


Trading Rules

Trading is a game just like any other game. When you are learning how to play a game you first need to become familiar with all the rules and only then can you start to practice what you have learned to start playing the game. Eventually with practice your skills will improve and you will start to win more. You must be careful to not mix up those steps though. Remember, practice makes permanent not perfect. You want to discipline yourself to practice the right way from the start so you have good trading habits.

Lets start with the rules. What are your rules for trading?

The rules are different for every trader. That is something you have to decide for yourself based on your goals and the amount of risk you are willing to take. It works best if you write these rules down on paper or on your computer, somewhere where you can see them easily and review them often. The first draft doesn't have to be perfect, but this will be your playbook for the game. Always keep yourself accountable to these rules. Here are some questions you will need to ask yourself to start to develop your rules for your system of trading:

When are you going to trade? Are you going to place all your orders after hours and let them execute during the day or are you going to watch the market during trading and place your orders? Types of orders are you going to use? Are you going to place market orders, limit orders, stop orders or a combination of different types depending on the situation? What are the advantages and disadvantages to each and how will you use them for money management? What is your hold time going to be? Day trading? Swing Trading? Short-term trading? Long-term trading? Different time periods have different potential opportunities and risks. What are you going to trade? Just stocks? Perhaps options as well or even futures and currencies. How does volume affect your trades? There are plenty more as well, but you get the idea.

Then you need to use your rules to develop your system. To do this you will need to learn about different indicators and oscillators, how they work and what assets they work best with. You will need software of some kind to test the results of your strategies.

Once you know the rules then you need to practice the game.

Then it is a good idea to do some paper trading with your newly developed system, that is using either one of the stock market trading simulators available on the internet or just keeping track on your own. Get used to applying your strategy to real life and get a feel for how to manage it for several weeks at least.

Once you've done all this, you will be ready to start playing for real.

You probably noticed that the majority of this article was dedicated to the rules section. That is how it is supposed to be. The actual trading is the easy and fun part. Just like most games, playing is the fun part, but many hours of work and dedication go into learning the skills before playing the game. So learn the rules, practice what you have learned and then you will be ready to win.

Thursday, May 11, 2006

Forex Signals


Forex Daily High Low Predictions & Trade Recommendations May 12 2006

Forex daily high low predictions and forecasts for the major currency pairs with trade recommendations. When taking a position in the fx market, know what the primary trend and secondary trends are. The primary trend is the main longer term trend, and the secondary trend is the shorter term counter trend within the primary trend. In general there is more risk trading the secondary counter trend than trading with the primary trend. Use strict money management by not over leveraging your account, and always use stop-loss exit points in case the position goes against you.

DAILY FOREX COMMENTARY
US retail sales rose 0.5% in April with a 0.7% underlying increase. US jobless claims fell slightly to 324,000 in the latest week. Euro-zone GDP rose 0.6% in the first quarter of 2006 with 2.0% year-on-year growth. UK industrial production rose 0.7% in March with a 0.7% manufacturing-sector increase.

DAILY FORCASTED FOREX HIGH LOW RANGES AND TRADE RECOMMENDATIONS

EURUSD
High 1.2895
Low 1.2781
Buy in the 1.2781 area. Target 1.2895. Stop-Loss 1.2755

USDJPY
High 110.86
Low 109.89
Sell in the 110.80 area. Target 109.89 possibly more. Stop-Loss 111.15

GBPUSD
High 1.8907
Low 1.8726
Buy in the 1.8726 area. Target 1.8890. Stop-Loss 1.8695

RISK WARNING

Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.

Valuable Information


Information or Dis-Information?

William Oneill says to buy high P/E stocks. Buffet and David Dreman say to buy low P/E stocks. Most major broker/dealers suggest that investors get a piece of each sector and then overweight and underweight certain sectors. Buffet suggests avoiding entire sectors (like technology) and would also suggest that it does not make sense to buy every sector. Information overload is a challenge in our industry as well as in all other industries. Who do you listen to? Today, I am going to show you how to absorb as much information as possible quickly and to how to avoid bad information. After all, as Michael Douglas says in the movie Wall Street - nothing is more valuable than information. Specifically, I am going to show you how to read effectively and how to avoid bad ideas and stick with strong ones.

Read Effectively

One of the first challenges to reading is how to fit it into your schedule. Ram Charam said ask yourself this: are you are at a higher level of performance and skill than you were 5 years ago? Think about it. Why did it take you five years? I realized the answer to that question quickly - my reading was the primary reason. In the past 5 years, my skill level in many of my areas of life have improved almost entirely because of reading and watching DVDs and listening to tapes/CDs. So that means I should read more right? Absolutely. New information is more than just information. It is a vehicle to a brighter, more profitable future immediately.

So how do I get the most out of it? First of all you have to realize that you can learn about anything, but you cant learn about everything. Theres not enough time. Do not kick yourself for not having a P.H.D. in statistics. It's not necessary to have one in order to make money. So here's your first technique.

Skimming - Your school teacher taught you to finish what you start. But that rule only makes sense with fiction books and as I said, there's not enough time to read all books. So when you go to the library or bookstore, look at the table of contents, introductions, and conclusions of books before you invest 4-8 hours of your life reading a book. I personally am focusing on books that provide statistical and historical data to back up trading strategies, so I toss most trading books aside when I read them. If I was interested in curing lung cancer, I might only read books that include verified/published research from accredited colleges. So skim books before you read them. You do not have to read entire books. Theres no reason to read filler material. It is of no use to you. "

Take notes - I recommend taking written notes in your word processing software. I have hundreds of pages of notes from books I have read. The key to note taking is this. You must paraphrase when taking notes. If you cannot express an idea in different words, that means you do not understand it. Repeating someones exact words does not mean that you get it. The reason reading changes people so much is that it creates new understanding. New understanding creates new action and new action creates new results. Paraphrasing is a way to almost guarantee new understanding.

Think Effectively

I spoke earlier about how hard it is to decide on who to listen to when reading. Here are some key points to remember when reading.

1. Understand - You need to know exactly what someone is saying before you can disagree with him. Once again, try paraphrasing.

2. Explain yourself - Agreeing with someone without knowing why is ridiculous. Disagreeing with someone without reason is equally preposterous. Interestingly enough, this insight will help you recognize when someone else has disagreed without a reason.

3. How to disagree - Here are several reasons to disagree with someones ideas. The first reason is logic, that is, the conclusion that someone has drawn is illogical. The second reason is that the person is misinformed. The third reason is that the persons analysis is incomplete. The fourth reason is that the author is uninformed about something. Its likely that if you disagree without one of these reasons, that you may be disagreeing out of spite, ego, or the conclusion is inconvenient to you (which means you disagree even though you have no logical reason to).

4. Know the difference - between a sales pitch and real information. Did you watch the last presidential election? Both candidates had access to the same economic information and one candidate wanted to show that the economy was doing well, while the other said the economy was in bad shape. If you omit the right data, you can get the data to suggest anything. Ask yourself what the author or speaker is trying to achieve. Filter out alterior motives.

Thats it for today. In conclusion, remember how important reading can be and do it well. In school, they never really taught us how to read, so throw those old rules out and adopt new ones. If you want to be profitable in trading, then you will need more than just your instincts. You'll need a constant flow of new information.

Wednesday, May 10, 2006

Forex Signals


Forex Daily High Low Predictions & Trade Recommendations May 11 2006

Forex daily high low predictions and forecasts for the major currency pairs with trade recommendations. When taking a position in the fx market, know what the primary trend and secondary trends are. The primary trend is the main longer term trend, and the secondary trend is the shorter term trend to the primary trend. In general there is more risk trading the secondary counter trend than trading with the primary trend. Use strict money management by not over leveraging your account, and always use stop-loss exit points in case the position goes against you.

DAILY FOREX COMMENTARY
The USA Fed has increased rates by 0.25% to 5.0%. The statement says further rises may yet be needed. The US Dollar has been seen bouncing back some now after this statement. With the Euro and Pound having had a big up move in the last month, the possibility of a selloff for these currencies is very possible. Keep stops tight.

DAILY FOREX HIGH LOW RANGE AND TRADE RECOMMENDATIONS

EURUSD
High 1.2816
Low 1.2691
Buy in the 1.2691 area. Target 1.2780. Stop-Loss 1.2658

USDJPY
High 111.69
Low 110.52
Sell in the 111.69 area. Target 110.52. Stop-Loss 112.00

GBPUSD
High 1.8688
Low 1.8532
Buy in the 1.8532 area. Target 1.8647. Stop-Loss 1.8500

RISK WARNING

Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.