are a few guidelines that will enhance your ability to identify profit-making opportunities. A desirable investment has the following characteristics: • Involves low risk. • Has a favorable risk profile. • Offers high potential return. • Meets your time requirements. • Meets your risk tolerance level. • Can be understood by you, the trader. • Meets your investment criteria. • Meets your investment capital constraints. Involves Low Risk First and foremost, a good investment must have low risk. What does low risk really mean? The term’s significance may vary with each person. You may be able to accept a risk level of $5,000 per trade based on the capital you have available. However, an elderly person on a fixed income may find $100 to be too much to risk. Acceptable risk is based on your avail- able investment capital as well as your tolerance for uncertainty. You should trade only with money you can afford to lose, as there is risk of loss in all forms of trading. Has a Favorable Risk Profile Every time you contemplate placing a trade, you need to create a corre- sponding risk profile. Whether you trade shares or commodities, invest in real estate, or put your money in the bank, every investment has a certain potential risk/reward profile. Some are more favorable than oth- ers. Studying a risk profile can show you the potential increasing or de- creasing profit and loss of a trade relative to the underlying asset’s price over a specific period of time. As the variables change, the risk curve changes accordingly. In order to find the best investment, you have to look for trades that offer optimal risk-to-reward ratios. For example, which of the following investment choices has the better risk-to-reward ratio? • Trade A: potential risk of $1,000; potential reward of $1,000. • Trade B: potential risk of $1,000; potential reward of $5,000. Anyone would rather make $5,000 than $1,000. However, to actually make a good decision, you must also have enough knowledge to discern which trade has the greater probability of working out. Another key 404 THE OPTIONS COURSE ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 404 ingredient is time frame—the time it takes to make the money. If trade A can make me $1,000 in one month with a 75 percent chance of winning, and trade B takes a year to make $5,000 with a 75 percent chance of win- ning, I would rather go with trade A. In one year, I could potentially make $9,000 [(12 × 1,000) × .75] repeating trade A, and only $3,750 ($5,000 × .75) using trade B. This is referred to as an expected value calculation. The risk/reward profile of any investment must take into account the following elements: • Potential risk. • Potential reward. • Probability of success. • How long the investment takes to make a return. Offers High Potential Return Risk comes hand-in-hand with reward. A trader cannot be expected to take a risk unless reward is also in the equation. Believe it or not, I have seen countless investors make foolish investments where the risk out- weighs the reward many times over. Why would they do such a thing? Usually because they simply haven’t taken the time to verify the potential risk and reward of the trade or they are taking advice from someone who doesn’t know any better. The best investments have an opportunity for high reward with ac- ceptable risk. In addition, the good trades have a high probability of win- ning on a consistent basis. I consider 75 percent an acceptable winning percentage. This means I win three out of four times I place a trade. A baseball player who could do this would have a .750 batting average— which is unprecedented in baseball history. Meets Your Time Requirements The process of locating and monitoring your investments must meet your time constraints if you are to be successful. In other words, if you do not have the time to sit in front of a computer day in and day out, then your best investments will not be day trades (entering and exiting a position in the same day). If you don’t even have the time or inclination to look at your investments over a one-week period, then you have to take this into consideration. The time you have available for making investment deci- sions and monitoring those investments will affect the types of invest- ments you should make. If you don’t have enough time to pay attention to a trade that needs to be closely monitored, chances are you’ll lose money on it. The best investments will match your time availability. Mastering the Market 405 ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 405 Meets Your Risk Tolerance Level Your risk tolerance level is directly proportional to your available investment capital. Risking more than you can afford to lose creates stress that impairs your ability to make clear decisions. Some people have the ability to handle uncertainty better than others. It is important to accurately assess your own risk tolerance levels and stay within those boundaries as you progress up your own trading learning curve. As experience in the markets naturally develops your confidence level, your risk tolerance level will increase. Can Be Understood by You, the Trader One of my most basic investment rules is as follows: If you don’t know how hot the fire is, don’t stick your hand into it. This rule is broken on a consistent basis by many beginning and intermediate traders. In addi- tion, many seasoned traders singe their fingers as well. Basically, if you don’t understand the exact characteristics of a trade, it is better to walk away from it. It is imperative that you familiarize yourself with the trades you place. Each trade has a unique personality. Your personality and your trade’s personality have to match for you to be successful over the long run. Meets Your Investment Criteria Your personal investment criteria can come in many shapes and sizes. Each individual has personal goals, expectations, and objectives when making investments. When I ask my students what they want out of their investments, the typical response is to make money. However, there are a number of related issues that also must be evaluated, including: 1. Capital gains (stocks—medium- to high-risk securities). What are the tax implications of your investing and trading practices? 2. Interest income (fixed income securities—medium-risk bonds and lowest-risk U.S. government securities). Is your objective to earn interest income? 3. Security (government securities—lowest-risk securities). Do you want to invest in only low-interest, low-return investments such as U.S. government securities (e.g., Treasury bonds)? Meets Your Investment Capital Constraints Do the investment requirements match your capital available for invest- ment? Just as your investment strategy must meet your personality and 406 THE OPTIONS COURSE ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 406 time constraints, the capital you have available will have a major impact on what you invest in, how often you invest, and the number of contracts you can afford to trade. For example, if you have a small account (less than $10,000), you will invest very differently from someone with $1 mil- lion. In addition, if you’re trading commodities with a small account, you should trade in markets that have low margin requirements and good re- turn potential. You should stay away from the high-margin markets such as the S&P 500 stock index futures. No matter how much money you have to invest, start small. I have taught a variety of people over the years with a very wide range of capital available for investment. I advise them all to start by trading small until they figure out what they’re doing. Whether you have $1,000 or $1 million, you have to learn to walk before you can run. In the beginning, I recom- mend risking only 5 percent of your account on any one trade. In this way, you can afford to learn from your mistakes as a novice trader. Often, having too much money as a beginner can be detrimental. The more money you have, the greater the chance of overinvesting and making costly mistakes. I find that the best long-term investors are very cautious early on. However, they systematically increase the size of their trades based on the steady increase in capital in their accounts. For ex- ample, you may begin with $5,000 and choose to invest 100 shares at a time, then not increase to 200 shares until such time as your account has doubled to $10,000. IMPORTANCE OF TARGETED EXIT POINTS One of the most important decisions a trader must make when entering a position is determining when to sell or close out the trade. It is imperative to set a target exit point for each trade. A target exit point is an option price that would result in a substantial, yet attainable, profit. By setting your profit objectives in advance and determining your target exit point before you trade or at the time you make your option purchase, you avoid the consequences of one of the major stumbling blocks to achieving trading profits: greed. It is very hard for most in- vestors to set reasonable profit goals once an option has jumped sub- stantially in price. That extra point becomes a moving target with each advance in the option’s price. Therefore, it is not surprising that a reason- able profit is not achieved when the investor is forced to bail out because of tumbling prices. Although setting profit goals in advance may be simplistic and not the most flexible approach to option trading, the target exit point approach to Mastering the Market 407 ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 407 taking profits is a necessary compromise. This is especially true for the options trader who has neither the savvy nor the emotional control to know when to hold and when to fold in the heat of battle, and who is also unable to stay tuned to the markets throughout the trading day. Note also that the profit objective should be substantial, meaning at least 100 percent, or double your initial investment, so you will not be walking away with small profits by using this approach. With this ap- proach, you will miss out on those 1,000 percent gains that are the options equivalent of hitting the jackpot; but much more important, you will mini- mize the instances of solid profits becoming painful losses and you will regularly be taking respectable gains off the table. Once you have entered the heat of battle, the tendency will be to base your decisions upon emotion, and therefore your decisions will tend to be incorrect. To avoid this pitfall, set a closeout date based on the amount of time you expect the option needs to reach its target exit point. If that profit level has not been reached by the closeout date, exit the position on that date. Closeout dates should be set so that there is still enough time until expiration to salvage some time value from the option if the underly- ing stock has failed to move. Resist the temptation to sell at a small loss prior to your closeout date. You will be yielding to fear, robbing yourself of some potential gains. Also, resist the temptation to raise your profit objective as the price of the option nears your target exit point. You will then be yielding to greed, and your profits will slip away. Another important question that needs to be addressed is when should you not sell? You should not sell a position the instant it moves against you. There is never a need to engage in panic selling if it is as- sumed that your original conditions for opening the position still hold true (e.g., your market outlook and your outlook for the stock on which you own options have not changed); also, that you are not committing an ex- cess amount of trading capital and you are still operating within your own risk tolerance. As option traders we create option positions for their huge profit po- tential, which can be fully realized only by allowing positions to remain open for a reasonable period of time. Setting predefined exit points goes a long way to facilitate this task. TIPS FOR SPOTTING AN EMERGING BULL MARKET Although no two bulls or bears are exactly alike, and sometimes their sig- nals may be a bit obscure, eventually the indicators will pile up and a 408 THE OPTIONS COURSE ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 408 trend will become evident. As you analyze the stock market for signs of shifting trends, be cautious. Each market is different from its previous cousins, so not all the warning signs will be present each time. If you no- tice only one or two of the telltale clues, some fleeting business or eco- nomic event temporarily may be tilting the market. However, if you detect four, five, or more of these signs appearing all at once, you’ve probably discovered a major new market phase. Before the bull begins to charge ahead, you will find six major signs that the bear has retreated into hibernation. Most of these signs apply to stocks, but often they readily relate to other investment markets as well. One of the signs is that the market has undergone a mature decline. Naturally, if you want to determine whether a new market is on its way up, one of the first things you’ll do is determine what activity has come before. If the market has undergone a mature decline then a bull may not be far off. Second, look for a market that is dull and boring. Historically, bear markets generally storm onto the market scene, but they depart extremely quietly. This kind of lackluster activity is one of the most common signs that a bear market is losing strength. Such sluggishness may go on for weeks or even months, but stock prices do not necessarily tumble along with trading volumes. When this scenario occurs, professional investors might say the market has been seized by a complacent attitude. The next possible sign is when the market resists bad news. Gener- ally, financial and even some sociopolitical news has a marked effect on the markets. When the markets refuse to budge, despite significant devel- opments, you definitely should take notice. Another sign is when the gloom is so deep that even the top-quality investments are sold. As a severe bear market grinds on for what seems like forever, stock investors, for example, often sell their blue-chip secu- rities in one last brief selling period. These probably are the last stocks to go, as investors will have unloaded their lower-quality holdings at the start of the bear. When the market has fallen to an uncomfortable degree, and investors believe hope for a quick recovery is gone, blue chips hit the market with a sudden decline. Not surprisingly, that tends to reinforce the bleak market mood, as investors begin to think that if even the best stocks are acting this way, then something really must be wrong with the market. Next, as a bear market begins to fade, stocks that once sold at price- earnings ratios of, say, 18 to 20 times earnings often are selling at unusu- ally low P/Es, perhaps less than half their former figures. When those stocks once regarded as must-have securities lose all their appeal, the change from the normal situation should cause investors to take notice. Those who have a chance to purchase bargain stocks before the next bull market should swing into gear. Mastering the Market 409 ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 409 Finally, high dividend yields offer a key signal. Like low price-earnings ratios, the often high-dividend yields to be found at the tail end of a bear market represent a market reversal in market psychology. Although yields in a bear market typically are higher than those for the same stock at the peak of a bull market, you can look for this phenomenon to alert you that a bear market has run its course. What does it mean when you can identify several of these indicators? Obviously, the bear market has begun to fade and the bull market slowly is taking shape. More and more trading occurs daily, and the number of advances, the upward movements in the prices of the individual invest- ments, outpace the declines. The volume of trading and the number of advances and declines indicates the market breadth. To summarize, be aware of the following key signals that a bear mar- ket is approaching a bottom. First, market prices have been declining for more than 12 months. Second, the volume of trading declines and you start to observe a very boring market. Third, bad news makes no impres- sion on the markets. Fourth, investors start unloading top-quality invest- ments by heavily selling many of the blue chips. Fifth, investments that once were stars are now on the skids, selling at undervalued prices. With stocks, price-earnings ratios are unusually low. And finally, sixth, stock dividend yields rise abruptly. The bottom line is if you observe most or all of these signs, the bear market is probably coming to an end and a new bull may not be far behind. TAKE A LOOK BEHIND THE ANALYST CURTAIN How many times have you placed a trade that you thought was perfectly set up only to have an unforeseen or unexpected event cause the trade to go bad? The technicals all looked good; maybe even the fundamentals were all in place. To all intents and purposes, the trade looked like a win- ner. Then all of a sudden out of nowhere comes a comment from one of the “guru goons” (my term for analysts), the company announces an ac- quisition that the Street doesn’t like, or maybe even a bizarre incident like an earthquake in Taiwan! The underlying then reverses and the trade moves against you. Let’s look behind the scenes of how analysts and insti- tutions really work. It’s amazing how many individual investors and traders still live and die by analysts’ recommendations. Many people actually still think that analysts make recommendations for the good of investors. Think about it, who do the analysts work for? They work for the institutions. Why do analysts con- tinue to rate a stock a “strong buy” while the underlying is bleeding a slow 410 THE OPTIONS COURSE ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 410 death? Why do the same analysts raise a stock’s rating that has clearly been in an extended uptrend? Institutions build inventories in stocks that they then allocate to their brokers to sell to investors. In some cases, it is nothing more than a quota that the broker is expected to sell. The analyst from the institution will then focus on some piece of positive data regarding the stock and raise the ratings on the same. This causes a short-term buying in- terest in the stock by retail investors and usually a bump up in the price as well. Who are the retail investors buying from? Their institution! The institu- tion has been accumulating inventory in a stock, so then it manufactures a buying spurt and depletes its inventory at a higher price. Many times this oc- curs as the stock is showing signs of topping out. The institution makes money, and who is left holding the “bag” or stock? Institutions are in the business to make money, and that consists of more than just broker commissions. If the investors make money, then that’s okay, too, but it’s not the priority. In fact, in some cases your own in- stitution will actually take a position against your trade! It goes even deeper. If an institution is dumping an inventory and you have purchased the stock and later decide that you want to sell, the institution won’t buy your stock back! It will execute your trade only after it finds some other patsy to take it off your hands. Have you ever wondered why analysts always seem to be a step be- hind? When a company announces something negative, if it’s a stock that the institutions are interested in, the analysts all jump on the bandwagon with downgrades. As retail investors are dumping the stock based on the downgrades, the institutions are sitting back and waiting for the down- draft to subside and then they begin to start accumulating again. The whole process starts all over again. How about raising a stock to a “strong buy” once it appears ready to break out of a long-term consolidation or basing pattern? Wouldn’t that be a novel idea? That would mean that ana- lysts were really employed to help investors, however. Then there are all of the amazing abuses of investors by analysts re- garding initial public offerings (IPOs). How many investors own Internet stocks that were priced at ridiculous price multiples due to continued up- grades by analysts as the stock prices went into the stratosphere? How many investors still own those stocks today under $10 a share? Do you think the institutions feel bad that they sold investors those stocks at ridiculous multiples? Believe me, they will only feel bad until they look at their bottom lines. Some of these longtime abuses are finally beginning to surface in the media, both on the television networks as well as in the print media. Some investors have even sued the analysts. Okay, so what’s my point in all this? We are on our own out here and have only ourselves to hold accountable when investing our hard-earned money. Optionetics exists because no Mastering the Market 411 ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 411 matter how much research we do, no matter how good a trade looks when we place it, things happen that are out of our control and can cause trades to go against us. Hedging all trades is crucial. When an unforeseen event does happen, we can employ a creative options strategy to take advantage of it. Even in our worst-case scenarios, our losses are minimal and we live to fight another day. Option strategies are designed not only to aid your re- search, but also to help hedge the trades you make, regardless of existing market conditions or directional bias. COMPUTERIZED TRADING SYSTEMS Trading systems facilitate trader discipline. Computerized systems offer additional advantages. The speed and efficiency with which a computer identifies patterns and generates signals is one obvious advantage. Com- puters can quickly achieve the number crunching necessary to recognize trading signals. However, it is possible for a trader to calculate these sig- nals manually (in the time required), and the trader’s ability to evaluate a complete rule-based system is limited as well. Computer systems offer di- rection and suggestions about what to do in a given market and help limit the range of choices. This makes the trader’s task less overwhelming, be- cause the possibilities and opportunities become more clearly defined. Trading systems approach the market consistently and objectively. Programs are designed logically. Rules are uniformly applied to defined market conditions. Trading systems are effective since rules are not the victims of trader judgment. The whimsical nature of a trader is diminished by a system. The emotional aspect of trading can be significantly reduced as well since systems are void of emotion and judgment. Unfortunately, the emo- tional tendency of a trader is to outguess the system, even when it’s pro- ducing profitable trades. If a trader can discipline himself or herself to follow a system with rigor, emotions will not rule the decision-making process. Trading systems are designed to think, not to feel. Another posi- tive feature of trading systems is that they generally include money man- agement rules that help to facilitate trading discipline. One of the more common arguments against trading systems is that they can become popular enough to influence the underlying price. This concern has been voiced both by the market federal regulatory agencies and by individual traders. The concern is that the similarity of computer- based systems used to manage large positions may cause large traders to respond in the same way at the same time, thereby causing distortion in the markets. 412 THE OPTIONS COURSE ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 412 While it is not guaranteed that past price patterns guarantee future price patterns, it is also not true that markets are random. Another argu- ment against the use of trading systems is they define market behavior in limited ways when the market can, in fact, behave in an infinite number of ways. It is believed that because systems are mathematically or mechani- cally defined, this reduces relationships of events to percentage odds of what could happen next. While the criticism is valid in that systems do capture a very limited number of possibilities, this characteristic is also what makes systems useful. The ability to reduce information to observ- able patterns gives the trader some semblance of order and direction. Without this, many traders feel overwhelmed and directionless. One of the more controversial techniques to develop from computer- ized trading is the concept of optimization. Optimization is a process by which data is repeatedly tested to find the best results. The best moving average size, point and figure method, or other parameters are made to fit the raw data. It is important to understand the methods of optimization and to provide proper precautions regarding optimized trading systems. Performed properly, extensive testing can reveal a great deal. However, excessive optimizing can be misleading, deceptive, and costly. Trading systems give the trader a way to interpret, quantify, and clas- sify market behavior. Since trading systems define potential opportunity and provide specific trading signals, following these signals can facilitate the development of profit-making trading skills as well as strong exit and entrance discipline. Computerized trading systems have vastly expanded the scope of in- formation available to today’s traders. Systems can now be thoroughly back-tested and perfected using the computer to test many if-then sce- narios. Trading systems offer a way to define and categorize market be- havior by reducing information to patterns that generate trading signals. While systems are without emotion, traders are not and often try to out- guess a system. Misuse and lack of discipline are major causes of losses in trading systems. CONCLUSION The investment elements mentioned in this chapter are designed to guide you on the road to trading success. Trading can be a humbling experience. It can also be highly profitable. Perhaps it is human nature to get a little overconfident and cocky when the money starts rolling in. But that’s the time when you need to fight against your own bravado. Remember, it takes only one big mistake to send you back to ground zero. Start small Mastering the Market 413 ccc_fontanills_ch16_403-414.qxd 12/17/04 4:28 PM Page 413 [...]... typically includes two variables 422 THE OPTIONS COURSE (more can be used) For example, we may look at the price of gold trading right now and how that price compares to the average over the past 10 days and the average price over the past 30 days When the 10-day average goes below the 30-day average, you sell; and, conversely, when the 10-day average goes above the 30-day average, you buy Technicians... on the weather (oil, soybeans, wheat, etc.) See how they are reacting to seasonal factors The tougher the winter, the higher the price of heating oil The longer the drought, the higher the price of soybeans All of this information can be used to find highly profitable trades Walk around Retail Stores You can even make money while you are spending it Just open your eyes and ears when you are shopping and. .. trades on the Chicago Board Options Exchange, the index ratio considers only index trading For example, February 12, 2004, 5 08, 743 put options and 916,360 calls traded on the CBOE So the put-to-call ratio was 56 (or 5 08, 743/916,360) The same analysis is repeated for the CBOE index putto-call ratio, but the equation considers only index options The ratios are available daily at the CBOE web site Put/call... bullish, below 0.7 are bearish Market P/E ratio Breadth Contrary Price-earnings ratios of 5 and 25 are approximate lower and upper trend boundaries DJIA dividend yield Breadth Contrary DJIA yield gets as low as 3 percent at market tops and as high as 18 percent at bottoms use timing and technical indicators to secure the best moment of entry and exit They take advantage of the market’s swings rather than... letting volatility take advantage of them That’s why it is so important to learn how to use timing indicators—to put the odds in your favor and dollars in your trading account OPTIONS AND THEIR BUILT-IN SENTIMENT INDICATORS The utilization of sentiment indicators has been common in the stock, futures, and options market for a long time However, the difference for the options market is that it inherently... pray that they will be right Even when their initial position goes against them, they just stay in the bad trade praying the market will come back They continue to pray until they can’t take the loss anymore or they lose all their money Nick Leeson, the trader who allegedly lost $1 billion for Barings Bank—a loss that brought down the 200-year-old institution—got himself into a bad position and kept... spans and averages to use When you find the right time frames, the moving average is probably the simplest and most effective technical tool Moving averages and crossovers can be very useful tools To keep their strengths and benefits in perspective follow these five suggestions regarding their use: 1 If you get a buy or sell signal and you take on a position, keep that 2 3 4 5 position until the 18- day... Opportunities 421 there has been a management change Maybe the weather is killing the orange juice crop It’s up to you to learn how to apply this information to making money in the markets Typically, I don’t listen to others, because too often they are wrong On the other hand, I love to find opportunities to do the opposite of everyone else This is known as the contrarian approach—when all the information... using an option valuation model In the case of VIX, the options are on the S&P 500, or SPX index, which is an index of 500 large companies with stocks trading on the U.S exchanges Therefore, VIX represents the market consensus view regarding the future volatility of 500 of the largest and most actively traded stocks So, as VIX measures the implied volatility of SPX options, it will begin to rise when... from 1999 to early 2004 During the fifth year, beginning in March 2003, the market performed well and stocks moved broadly higher During that time, the CBOE Volatility Index edged lower In fact, VIX fell to seven-year lows of 14.3 percent in early 2004 There was no fear reflected in the market’s “fear gauge.” Another interesting aspect of the chart is the periodic spikes in the volatility index This happens . indicators? Obviously, the bear market has begun to fade and the bull market slowly is taking shape. More and more trading occurs daily, and the number of advances, the upward movements in the prices of the individual. look at the price of gold trading right now and how that price compares to the average over the past 10 days and the average price over the past 30 days. When the 10-day average goes below the 30-day. on the bandwagon with downgrades. As retail investors are dumping the stock based on the downgrades, the institutions are sitting back and waiting for the down- draft to subside and then they