<s>  
SECTION FIVE
OPTIONS 
CHAPTER 1 1
A FEW WORDS ABOUTUSING OPTIONS WITHSWING TRADES
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The setups and concepts described in this manual are designed to captureexplosive short-term moves in stocks. As such, they often lend themselveswell to option trading. Be warned, however, options are an extremely com-plex vehicle and you must use utmost caution when trading them. Makesure you fully understand the nuances and risks involved. There are entiretexts devoted strictly to option trading, pricing models and volatility. Istrongly urge you to learn as much as possible about options before at-tempting to trade them.
It has been estimated that as much as 90% of those who trade optionslose. Why? Because most who buy options do not have a strategy, amoney-management plan in place, and tend to buy extremely speculativeout-of-the-money options. The following guidelines, while by no meansexhaustive, will help improve your odds when using options to initiateswing trades.
Avoid Out-of-the-Money Options—One of the main reasons most peo-ple lose when trading options is that they buy mostly out-of-the-moneyoptions. Although cheaper in absolute dollars, these options are normally
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very expensive in terms of true value. And more often than not, they ex-pire worthless. Even if the underlying stock price rises sharply, these op-tions often do not increase enough in value to make trading themworthwhile.
In order to avoid the pitfalls associated with out-of-the-money options, agood rule of thumb is to buy options that are 1 to 2 strikes in the money.These options will tend to trade in tandem with the underlying stock.For instance, if the stock rises 1 point in value, an in-the-money call op-tion would also rise one point in value. In option lingo, this is known ashaving a delta of 100. This means the option trades in a similar mannerto 100 shares of outright stock.
Buy the Nearby—As a swing trader we are looking to position ourselvesfor the next two to seven days. We do not have to increase our risk bybuying longer-dated, higher premium options. Therefore, look to tradethe front-month options unless the expiration is less than seven tradingdays away. In these cases, go to the following month’s expiration.
Those familiar with options may argue that nearby options have worsetime-decay profiles than longer-term options. | understand this argu-ment, but believe that the potential of the patterns in this manual tomake an immediate move far outweigh these drawbacks.
No Tickie, No Tradie—As discussed in Chapter 2, Landry’s Rules andMoney Management for the Swing Trader, you should not buy or sellshort a stock unless it triggers a setup. The same holds true for buyingoptions. Only buy options if, and only if, a setup triggers in the underly-ing stock. Be warned, however, if the stock is in a fast move when it trig-gers the setup, the spreads on the option will likely widen. In these casesyou may have to be willing to forgo an options position.
Consider Options as a Stock Replacement on Profitable Stock Posi-tions—Once a swing trade entry is triggered, in most cases, it’s mucheasier to enter the underlying stock than it is to buy options. This is espe-cially true during fast markets that often occur when setups are trigger-ing. Therefore, you may want to consider options as stock replacementafter you have entered the underlying stock and only if the positionshows a reasonable profit.
For instance, if after entering a swing trade, you are fortunate enough tohave a large profit, rather than carry a large stock position overnight, youmight look to sell the position and buy options with a piece of your prof-its. This is, of course, provided the options are reasonably priced. This
 A Few Words About Using Options with Swing Trades
way, you have banked a profit and will still have the potential for awindfall profit on the option position with defined downside risk.
If You Hit a Double, Bank Half—Option prices often fluctuate wildly.Therefore, whenever you initiate an option position, you should immedi-ately place a limit order to sell half of the position at twice your originalcost. For instance, suppose you buy four options for $5 each, you wouldthen place a limit order to two options at $10 (or slightly higher to covercommissions). Should the option spike higher, you'll get filled on thislimit order and have covered the cost of the entire position. You shouldthen look to scale out of these remaining options by following manage-ment principles outlined in this manual.
O&A
Q. You mentioned buying calls to replace stock in order to help reducethe risks of holding overnight. Why not just buy puts to hedge the po-sition?
A. You could but often the premium on the puts is often quite high be-cause many with profits will be looking to hedge off risk. Also, if youbuy puts, you now have to manage a hedge along with your originalposition. In other words, you have two positions to deal with. For in-stance, what if the stock continues to rise? You now have to buyhigher strike puts in order to remained hedged. For me, it’s easier tothink and manage one position in one direction.
Q. You don’t mention option pricing models in your guidelines. Do youuse them?
A. As|Isaid earlier, there are entire texts devoted strictly to option pricingmodels and volatility. My goal with this manual was to provide acomplete manual for the stock trader. I do look at the implied volatil-ity on the options and compare it to the historical volatility. I use thisas a general guideline to gauge how expensive the option is. However,keep in mind that no option pricing model or technique can accuratelypredict future volatility. There are (albeit rare) times when optionsmay appear expensive on the surface but are actually a bargain in re-
ality.
Q. Can you give us an example of when this occurs?
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A.
Q,
Sure, in a blow-off market, no one knows how far and how long itwill go. For instance, in early 2000, call options were fairly priced butin reality, due to the extreme nature of the market, were actuallycheap. Many at-the-money options became 10, 20, 30 or more points inthe money in a matter of days. No option pricing model could haveaccurately predicted this.
Do you have a favorite pattern for trading options?
The best setups are those that occur during a low-volatility situation{see Chapter 9, Finding Explosive Moves: An Advanced Lesson inSwing Trading). In these cases, option premiums tend to fall right be-fore a large increase in volatility and stock price. This is the best ofboth worlds for the buyer of options.
What about covered calls, spreads and other option strategies?
As mentioned earlier, the focus of this manual is predicting theshort-term directional moves in stocks and not options trading. I pre-fer to keep it simple: J’ll occasionally use calls if I’m bullish or puts ifI’m bearish. 
SECTION SIX
PSYCHOLOGY 
CHAPTER 12
TRADER’S PSYCHOLOGY
The Speculator’s chief enemies arealways boring from within.
—Edwin LeFevre,Reminiscences of a Stock Operator
I'm afraid that some timesyou'll play lonely games, too.Games you can't win
‘cause you'll play against you.
—Dr. Seuss, Oh! The Places You'll Go!
Tn trading, there are many psychological barriers that you must overcome.The first step you must take is to realize that the trading world is much different than the “real world.” For instance, in the “real world,” as long asyou perform your job to the degree expected of you, you'll continue to re-ceive a paycheck on schedule. In trading, however, you can work hard, doeverything “correct” and occasionally still lose money. Even worse, the mar-kets will sometimes lull you into a false sense of security by rewarding “badbehavior” such as being careless and taking excessive risk.
In the real world if something goes awry on the job, it can be covered up,the blame can be shared and in some cases, insurance will cover the
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losses. In trading, however, there is no safety net and nowhere to hide.You must take responsibility for your actions. Your account balance does-n't lie.
In the real world, you are expected to stay busy. After all, they’re notpaying you to sit on your butt. In trading, however, sometimes the bestthing to do is just that—nothing. Trying to make something happen inthese environments can be detrimental to your account. The old saying,“Don’t confuse activity with accomplishment” applies here.
Obviously, operating in the unstructured environment of the tradingworld versus the real world can be difficult. You have to manage your-self and your emotions. Below we will look at ways to recognize andovercome the psychologicai pitfalls of trading.
Realize That Losses Are Part of the Game—You can’t take a loss person-ally. If you think about it, the guy on the other end of your trade has the
exact opposite opinion of you. You can’t both be right. Therefore, every
trade has the potential to be a loser.
Money Management, Money Management, Money Management—Proper money management will help solve many of the psychologicalpitfalls of trading. For instance, if you are only risking 1% to 2% pertrade, then any individual loss should be of little consequence.
Have Confidence—You -must be comfortable with your methodologies.You develop this comfort through historical research, real-time observa-tion and trading. This does not mean that you are confident to the pointthat you are infallible on any one trade. Rather, you know that through aconsistent approach, you will make money in the long run.
Remain Humble—This may seem like a contradiction to confidence buta good trader must also be humble. The best traders are confident abouttheir methods but humbled by the fact that market can do anything itwants in spite of their opinions.
Realize That You Have No Control Over the Markets—The market cando whatever it wants. It is made up of millions of individuals who youhave absolutely no control over. The best setup in the world won’t workif some hedge fund or large trader decides to dump his position (forwhatever reason) right after you enter the market. Also, you have nocontrol over outside influences. This doesn’t have to be something obvi-ous like a war or even an off-the-cuff remark from a world leader. It canbe something as simple as the actions of some lunatic. For example, Ionce was knocked out of a perfectly good and profitable S&P futuresTrader's Psychology
trade because some psychopath decided to start shooting people in ournation’s capital building.
Forget About Being Right—In swing trading as many as half of yourtrades will result in a loss. Yet through controlling those losses, the win-ning trades will more than make up for the other half. Your goal is not tobe right. Your goal is to make money, period.
Realize That No Methods Are Perfect—Be a student of the markets butrealize that there is no “Holy Grail’—an infallible system that will leadto riches without risk. Stick with simple conceptually correct methodssuch as those outlined in this manual. In the past, many have made bil-lions on simple systems such as those developed by Donchian. In hiswords: “In this field of technical study, it is probably safe to state that the be-ginning of wisdom comes when you stop chasing rainbows and admit that nomethod is perfect. When you find yourself willing to settle for any comparativelysimple method that, in tests over a long period, makes money on balance, thenstick to the method devotedly, at least until you are sure that you haven ‘'t discov-ered a better method.”
Be Consistent—You must be consistent in your approach to the markets.You will never be successful as long as you are jumping from method tomethod. Find something that works and stick to it.
Keep Emotions in Check—Those who become euphoric when things aregood are also those how tend to fall the hardest things turn bad. Strive tostay on an even keel in good times and bad.
In Times Of War Prepare For PeaceIn Times Of Peace, Prepare For War
—Sun Tzu
In good times, you must realize that you are just around the corner froma string of losses. Conversely, after a string of losses, better times oftenfollow.
Embrace Who You Are—We are all individuals with our own psycholog-ical makeup. Recognize and embrace what makes you different and useit to your favor when trading. For instance, J was raised with a strongwork ethic. Phrases such as “There's no free lunch” were common in myhousehold when I was growing up. However, as mentioned previously,sometimes in trading, the best thing to do is nothing. This goes com-pletely against my upbringing. At these times I would feel lazy and
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guilty for “not working.” I would then try to make something happen byestablishing positions even though I knew I shouldn't. I finally realizedthat during poor market conditions, I must channel my energy intosomething other than trading. I’ve discovered that if I used this time toconduct market research, I felt productive without having to expose myequity unnecessarily.
Treat Profits as Your Own. Money—Chances are, if you are a successfultrader, you have worked very hard to achieve this goal. Therefore, whenyou make money trading, you are being paid for that hard work. It’syour money and should be treated no differently than a paycheck. Donot become careless and violate your rules because it is the “market'smoney” or a “free” position. It’s ok to occasionaily press a little when youhave windfall profits, just make sure you keep the lion’s share.
Only Trade When You Are Of Sound Body And Mind—Do not tradearound major life events or when you are sick, distracted or simply notprepared.
Only Trade When You Have an Edge—The best times to trade are thetimes when the overall market and individual sector(s) are suggesting aclear direction. It is at these times you will find yourself having troublechoosing between all those wonderful setups. Other times, when its ex-tremely difficult to determine market and sector direction, it will benearly impossible to find decent setups. And when you do, you’ll oftenfind yourself quickly stopped out. At these times, you must be patientand wait for better times. —
Be Positive in Life But Skeptical in the Markets—In life, we are taughtto be positive. “Look on the bright side,” “Things normally work out”and “Have faith” are phrases we have all heard over and over. However,having faith and hope for a losing position is fruitless. The best tradersdon’t focus on what they will make on a trade but rather how much theycan lose and how to manage that risk. Successful traders are positive inlife and confident that their methodologies will work over the long haulbut remain skeptical on any given trade.
Don’t Expect Immediate Success—Some of the worst novice traders Iknow are medical doctors. Why? Because they are successful in whatthey do and automatically assume they can transfer their success to trad-ing. They forget that it took an intense study of 10 years before they wereallowed to cut on their first patient.ATrader's Psychology 171
My intent is not to pick on doctors, I also know incredibly successfullawyers, engineers and even a rocket scientist that think that they canquickly pick up trading because they have become masters in their ca-reers. What they fail to remember is that it took them more than a fewweeks to become successful in their professions.
Learn from Your Losses—A loss in the market is not a total loss as longas something is learned. For instance, after getting stopped out numeroustimes only to watch the trend resume, I discovered the Trend Knockout(TKO) (Chapter 6).
Work Hard and Love What You Do—You should be passionate abouttrading. It is not something you should do casually. Because money is theultimate motivator, I can assure you those on the other sides of yourtrades have dedicated the better part of their lives to trading. And, theyare all too happy to take money away from those less serious.
Keep a Journal—Other than finding a methodology that makes sense toyou and applying strict money-management principles, the best way tobecome a better trader is to monitor yourself and your own performance.I strongly urge to you keep a trading journal. Whenever you enter atrade you should write: What motivated it? What was the setup? What isthe overall market doing? What is the sector of the stock doing? If thetrade is a larger- (or smaller-) than-normal position size, why? Print andlabel any charts that support you claim. Once all the mechanics aredown, make sure you include a little about yourself. Are you feelingwell? Are their any stresses weighting you down? Have you experiencedany major life changes recently? Have you been making money lately?
Plot Your Equity—The value of your trading account does not lie. If youmade it this far in this manual then by now you should know what atrend is. Therefore, if your equity curve is trending steadily higher, thenyou are doing something right and/or market conditions are favorable.On the other hand, if your equity curve is trending lower, then you aredoing something wrong and/or market conditions are unfavorable. Stoptrading and reevaluate the situation with a clear head. The name of thegame is long-term survival. The markets will always be there.
I know several traders who know very little about market timing, yet arealways out of the markets when conditions are at their worse. How?They stop trading after a string of losses, wait for better times and thenslowly ease back in. 
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Reflect At the end of the day, take a few minutes to quietly reflect onyour trading. Mentally rehash the day’s events. What did you do right?What did you do wrong? What could you have done better? Did youkeep losses in check? Did you honor your stops? Did you take partialprofits if they were offered to you?
SUMMARY
The trading world is vastly different from the real world. There are manypsychological barriers that must be overcome. However, if you strive tobecome successful, I can assure you that it will be well worth the effort.With hard work and devotion, there is no limit to what you can achieve.Think about it. How many times at work have your accomplishmentsgone unnoticed and un-rewarded? How many times have others takencredit for your actions? This will never happen in the trading world. Youand only you control your own destiny. 
CHAPTER 1 3
LESSONS LEARNED
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Over the years, I have learned many lessons about trading through theschool of hard knocks. In more recent times, by being a public figure in thetrading world, I have been able to re-learn these and new lessons throughfellow traders. The following are some of my favorites.
START TRAINING ON MONDAY,COMPETE ON WEDNESDAY
My wife Marcy asked me if I would discuss trading with two of her cli-ents and their spouses. She explained to me that they are all going toplop down $3,000 dollars each on a weekend seminar that would teachthem “everything they needed to know to immediately start earning aliving trading.” Marcy knew that none of these individuals had everytraded and feared the seminar would be a waste of their money. Andworse, she was concerned that they would lose much more moneyshould they decide to jump into the markets. I agreed and we ali haddinner the following Sunday night.
After patiently listing to a regurgitation of the motivational speech thathad been given to them, I studied the materials that were to be covered.To my surprise, it involved technical analysis and didn’t involve any“magic” systems. However, much of the material was dated and wasn’tanything you couldn’t get from a good $50 primer on the subject. Fur-
 
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thermore, it certainly wasn’t enough for a novice to become a full-timetrader a few days later.
I tried to talk them out of the seminar in several different ways. I offeredto loan them books, suggested they get a free trial toTradingMarkets.com and even was willing to give them private lessonsfor free—provided of course they were serious about learning. I empha-sized that they should do this before plopping down money on a get-richseminar. All of this fell on deaf ears as they once again repeated the salespitch to me.
As I watched them drink their water and eat their bland chicken andvegetables, finally it hit me, I had to speak in their terms. The gentlemenwere body builders and their wives were fitness fanatics. All had the ut-most discipline and had been training for years. One of the men heldseveral regional bodybuilding titles and the other was preparing to com-pete in his first amateur competition. For dramatic effect, I put a wholejumbo shrimp into my mouth, took a big slurp of my 25-ounce beer andslammed it down on the table. Talking with my mouth full, I then said,“You know what? I’m going to finish this beer, my fried shrimp appe-tizer, my 14-ounce steak and fries and on Monday I’m going to starttraining and dieting (I was about 30 pounds overweight at the time).Then, on Wednesday, I’m going to compete in a bodybuilding contest.”
Follow-Up: Couple A heeded my advice and avoided the seminar. In-stead, they continued to focus on growing the business they owned. Infact, the business has grown so much that they have recently consideredfranchising.
Couple B attended the seminar, quit their jobs, and after a brief stint attrading, are now searching for the next get-rich-quick scheme.
The moral: Becoming a successful trader is possible, but it takes morethan a weekend.
ENJOY THE RIDE
Joe is a successful long-term trader who decided to try his hand at swingtrading. I began working with Joe and he became quite successful in ashort period of time. The fact that he started during the greatest bullmarket blow off in last 20 years didn’t hurt either.
One day we were discussing the markets and he said that he had alreadymade over $35,000 and it wasn’t even noon. He was bragging that thisa goLessons Learned 175
just about covered his tricked-out sport-utility vehicle that he had or-dered the day before. At this point, I told him, “As soon you hang up thephone, cash out, write a check and pay for your new truck.” Then, nomatter what happens to you in the markets, at least you have nice truckto ride around in. He took my advice and paid cash for his truck.
Follow-up: Ironically, Joe suffered a severe loss in the markets in the fol-lowing few weeks but is really enjoying his SUV.
The moral: Take something out.
NURSING POSITIONS
Longer term, Bill was a successful trader but had recently entered somebad trades. We were talking one day about all the setups there were. I as-sumed that he must be printing money as we were both looking at thesame stocks and they were all moving nicely. When I inquired about hisposition size, he replied that he did not take these new positions becausehe was too busy “nursing all his bad positions.”
The moral? Because he was focused on positions that were not working,he missed all the opportunity of the new stocks that were setting up. Toquote Livermore, “The chap who is compelled to lug a corpse a year ortwo always loses more than the original cost of the deceased; he is sureto find himself tied up with it when some reaily good things come his
”
way.
WHO MAKES A BETTER TRADER:
AN MBA OR A RECEPTIONIST?
Many years ago, I worked on a base where they used to test rocket en-gines. The base was so large that it had its own fitness facility. One day, Iwalked into the gym with a long face.
The receptionist: “What's wrong?”
Me: “I’m in a bunch of bad stocks.”
The receptionist: (with a perky little smile and a high-pitched bouncyvoice): “Well, sell them and buy a bunch of good stocks.”
Her statement infuriated me. After all, I had recently completed my MBAand had been studying the market for a few years. I thought, “What thehell does a receptionist know about trading?”(er
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Follow-Up: Evidently, she knew a lot more about trading than I did atthat time. Taking this simple advice would have saved me about$30,000—a lot of money for a kid fresh out of school!
The moral: Trading is not rocket science.
THE GENIUS
Mike, an accomplished long-term trader, has recently begun swing trad-ing. He calls me a few times a week. Almost always, it’s the same con-versation:
Mike: “I'm up 4 points on XYZ, what should I do? “
Me: “Sell half and move your stop on your remaining shares tobreakeven.”
"
Mike: “Man, that’s great advice. You're a genius
The moral: Simple money management is not rocket science.
NEVER-WRONG MAN
Never-Wrong Man never loses money trading. Even when he’s followinga mechanical system, he “forgets” to take the losing trades. There’s al-ways an excuse. “I got busy and forgot to check my signals.” Or “thebroker screwed my order up, so while I thought I was losing money, inreality the trade didn’t go through.” When he does take what would turnout to be a losing trade, there’s always another excuse. For instance, “youknow, I can’t explain it, but I just decided to sell the stock afterhours, fiveminutes before the bad news came out.”
I used to be intimidated by Never-Wrong Man. I would think, “Geez,what’s wrong with me? Why do I make mistakes? Take bad trades? Getstopped out? Why can’t I be more like Never-Wrong Man?” I later real-ized that no one is immune to losses in this game, not even Never WrongMan. You win some, you lose some and hopefully, by being consistentand controlling losses, you make money overall.
The moral: Big Foot, The Loch Ness Monster and Never-Wrong Man al-legedly exist, yet their existence has yet to be proved.
ANTHILL
Bob entered a swing trade and failed to place a protective stop. Withinhours, he was down over 20 points. The next day, he got an incredible
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Lessons Learned
break, the stock came all the way back plus some. Bob was smug abouthis trade as cashed out for a 2-point gain.
The moral: Mark Boucher refers to a strategy like Bob’s as an “Anthill”strategy: Ants can build a significant mound with tiny little bits andpieces but all it takes is one big footprint to smash it down.
METHOD MAN
Method Man is a setup junkie. He reads everything he can get his handson regarding trading. The problem is, he runs out and tries to apply con-cepts with his hard-earned money literally minutes after reading aboutthem. He doesn’t take the time to do the proper research, to prove thatthe setup has worked historically and through real-time observation.Method Man occasionally gets lucky but never has consistent longer-termperformance.
The moral: Find something that works and stick to it.
SHOW-AND-PULL
I once checked out a chat room full of daytraders just to see what it wasall about. There were a few smaller “wannabes” in the room, but for themost part, it was made up of larger, well-capitalized traders. One of thenewer traders entered a small position in a thinly traded stock. The stocklooked impressive and fit all the criteria for a good setup. After mention-ing the stock to the group and the fact he was long 100 shares, one of thelarger traders in the group decided to have a little fun. He said, “Hey, ev-eryone, pull up XYZ on your Level II quote screens...now watch this...”He then put out a 10,000-share offer on the stock. He laughed as thesmaller began to squirm and beg him to take it down. A few secondslater, he removed the offer.
Now here’s a guy that was screwing around just to get a few laughs.However, this could have had a material impact on the stock. What ifother traders would have been scared out of their position based on thisbogus offer? A chain reaction could have knocked the small trader out ofa perfectly good position.
The moral: All it takes is one jerk to screw up a perfectly good trade.
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GET YOURSELF A PUNCHING BAG
Steve, a daytrader, always had a chip on his shoulder. He was constantlymad at the market makers for “screwing him.” In fact, on some days,Steve would send me numerous emails complaining about the above. Hewould even go through the painstaking process of providing time andsales information and other information to support his claims. He be-came so obsessed he began watching stocks that he had no intention oftrading just so he could prove his point. I couldn't image where an activedaytrader was finding so much time intraday. I knew he had to be miss-ing numerous opportunities while expending all that negative energy.Finally, after getting tired of reading all his emails, I decided to take ac-tion. I explained to him that he was wasting far too much energy onthings he couldn’t control. Further, I admitted that I, too, occasionally gotmad at brokers, market makers and the market in general but instead ofobsessing over it, I go to the back of my office and beat on my punchingbag. After a few minutes of this, I return to my screens focused and re-freshed. Next!
The moral: Get yourself a punching bag.
RETIRE ON A SAILBOAT
John, a friend of mine, became incredibly bullish on a certain stock.Starting with $5,000, he began buying options on the stock. Turns out,John’s analysis was right. The options soon became worth many thou-sands of dollars. As the options neared expiration, he sold them and par-layed the money into more further out-of-the-money options. He beganto repeat this process over and over. This strategy was so successful thathe quit his day job. As he approached the million-dollar mark, I sug-gested that he lock in his profits and place them into a secure fixed-in-come investment. He explained to me that when he reached four millionhe was going to buy a sailboat and retire.
Follow-Up: Unfortunately, the stock began to implode soon after hereached a million dollars. His entire account was wiped out over the nextfew weeks.
The moral: Don’t expect the market to fulfill your dreams. To quoteLivermore: “There isn’t a man on Wall Street who has not lost money try-ing to make the market pay for an automobile or a bracelet or a motorboat or a painting.”
 rrLessons Learned 179
THE BEAR HAS EYES
In the late ‘90s during one of the greatest bull markets in history, BearMan, one of the best daytraders in the world, was constantly faxing,emailing and calling me to talk about how the bull market was comingto an end. He’d support his claims with articles and newsletters alongwith market statistics and historical comparisons. His research was oftenthorough and quite convincing
The conversations were almost always the same. After about 10 minutesof listening to his bearish arguments:
Me: “Okay, I know you are bearish. So what are you trading?”
BM: “I'm long, ABC, CDE and EFG.”
Me: “Why no shorts?”
BM: “Because the market is going up.”
The moral: Bear Man never confuses being right with making money.This is why he is one of the greatest traders in the