all the weaponsyou have available to you to trade, I strongly urge you to integrate options into yourtrading arsenal. I believe that options allow you to be much more creative and to placethe odds in your favor. But before trading options, you have to make sure that you understand all the risks and rewards associated with options trading.
Rule 6: Manage the StrategyOnce you have placed a trade, you have to manage it effectively. If you buy a stock,when are you going to sell it? If you buy an option, do you want to exercise it or sellit? If you have a profit objective, when will you take it? If you have a trade on,when do you want to adjust it? These are just a few of the questions you need to answer. Sometimes the management of a trade is more difficult than just placing atrade. You should always know what your next reaction will be and what promptsyou to take it. Planning ahead is a very important part of the game and will definitely contribute to your success.
HOW TO PICK A STOCK WINNERTo be successful you need to know the rules of the game. Then you need to knowwhere to apply these rules. Every trading day, I wake up trying to figure out how topick a winner. I have a few guidelines that help me to make the right decisions thatI will now share with you.
Watch What MovesAll kinds of media bring us the news of the day and since news moves the markets,I have become a media hound. What follows is a brief synopsis of the main news arteries and how I take advantage of them.TelevisionFirst, I watch TV and lots of it. No, I don’t spend my time watching Barney or WhoWants to Be a Millionaire. I am busy watching the business channels: CNBC and
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CNNfn. I basically live and breathe watching CNBC. I have grown up with it as atrader and I get a great deal of useful information listening to it as a constant backdrop to my trading day. After all, if they are talking about it on TV, then the stock isusually moving. They are paid to talk about stocks that move, so I watch what theywatch. I like to play the momentum stocks and when they are talked about on TV,they usually have some reason to move. If you can’t watch CNBC all day long because you have a day job, then turn it on when you get home so you can catch up onwhatever you missed.When I am unable to watch CNBC then I watch CNNfn (CNN Financial). I haveappeared several times on this show and it seems to be almost everywhere includingthe airports. Watching it will help you to keep an eye on stocks that are in the news.If you are hearing about a stock on CNBC or CNN, so are millions of other tradersand investors.Web Site SurfingThroughout this book, I have constantly referred you to a host of web sites. Someweb sites have become so popular that they are carving their own special niche of influence on market sentiment. Sites like TheStreet.com, Zacks Investment Research,and Yahoo! Finance have taken the bulls by the horns more than once. So bookmarkthe biggies and surf the Net to find out what other sites can help you maneuver themarket obstacle course as best you can. There’s a great deal of information out there,so take another look at my recommendations in each of the “Roadmaps” to streamline your surfing and save time.I have to admit I am very prejudiced about my favorite web site: Optionetics.com.My team of traders and support staff work endless hours to make Optionetics.comthe ultimate site for traders. In addition to serving as the primary resource for tradinginformation for our students, we have thousands of people visiting it every day, andwe recently received a “Best of the Web” award from Forbes magazine. We striveeach and every day to provide high-quality information geared to helping you findpromising trading ideas and make informed trading decisions.Newspapers and MagazinesWhat would a trading and investing career be without the Wall Street Journal and Investor’s Business Daily? These two newspapers should be read daily to help you get afeel for what is happening in the markets. Both have good web sites as well. I also liketo read Red Herring, which has some great articles and information on one of my favorite markets: the technology sector. Make sure to check out its web site (www.redherring.com). Of course, Barron’s is another must-read and offers a host of informationyou can’t find anywhere else. These are just a few of the magazines and newspapersyou should read; but they should be the ones at the top of any trader’s reading list.
REVIEW OF FUNDAMENTAL ANALYSIS AND HOW IT WORKSIn this section, I just want to review and highlight some elements of fundamentalanalysis to try to simplify your analysis process. Remember that fundamental analysis
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scrutinizes a stock based upon information, which will likely drive the price of thestock. Let’s take a look at the events, which will most likely affect the price of a stock.It is important for you as a trader to understand each and every element that can drivethe price of your stocks up or down, or keep the stock in a trading range.
Earnings (Announced and Preannounced)Earnings are one of the main reasons stocks go up or down—sometimes with a vicious move that can ruin any trader’s day. Companies in the United States reportearnings every three months. These are referred to as quarterly reports. It is the jobof the company to accurately and fairly disclose its financial condition to the public.It does this in two ways: the actual announcement and a “preannouncement.” A preannouncement is when the company announces to the public that it will not meet, orit will exceed, earnings expectations. When this happens the stock will usuallymove quickly if the number is way out of line of what analysts and traders expected.Once a company preannounces, this is a good time to jump in since it is often agreat driver of price action.
Analyst Upgrades/DowngradesStock prices are very much a function of what the analysts say about a stock. WallStreet is driven by research from many brokerage firms on many stocks. The analystsfrom these firms stay in touch with the management of the company. It is their job totry to forecast the future growth of the company as well as stock prices for theirclients. They are not always right; no one is. But with their ear close to management’svoice, they can hopefully put together a smart future plan for their clients. Now, theproblem arises when the management has guided the analysts incorrectly and surprises the Wall Street analyst community with information that was unexpected. Onmany occasions, this can mean a stock price getting chopped in half. How would youlike to lose 50% on a stock just because the management was not guiding analystscorrectly? If management was guiding for a profit and a loss comes in, watch out. Payattention to what the analysts say; they can drive a stock in either direction quickly.
New Product AnnouncementsLet’s say you wake up one day and you hear about a company that has developed acure for cancer. What would happen to the stock price? It skyrockets, right? One company made this exact announcement and the stock went from $11 a share to roughly$85 a share overnight! Although it was exciting to see this kind of price action, youcan’t believe everything you hear. This same company later stated on CNBC thatmore tests were needed. Well, the stock fell $30 on that news and continued to fall.This is what a new product announcement can mean: a swift move in either direction.This is especially evident in the areas of human genomics. Watching these stocksmove swiftly in either direction can seem incredible. See what happens in the race to
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build the fastest computer chip between Intel (INTC) and Advanced Micro Devices(AMD), and watch Rambus (RMBS), also. These stocks move and they move big. Itis exciting to track stocks after they have announced new products, but you may wantto use nondirectional option strategies to take advantage of them.
Management ChangesIf a well-known company is sluggish or moving down, management changes maybe imminent. When a new CEO comes in, watch to see how the market reacts. Youcan make a great deal of money by following these companies when they make abig change. The big investors, the institutions, will drive the stock up if they like itand down if they don’t. Just look at what happened when IBM brought in Lou Gerstner, or when Hewlett Packard or AT&T made changes at the top of the management chain. These stocks all made robust moves to the upside. Keeping an ear outfor changes in management can earn you a great deal of money.
Stock SplitsIf there is a system that helps a trader make money (at least in the past few years), itcomes from focusing on stocks that have already announced a stock split or are projected to announce a split. Many momentum traders love jumping into these stocks.A company will announce a stock split usually when the stock has made a big runup in price. The board of directors votes on a split to make the shares more affordable to more investors (at least this is the theory) as well as to promote anotherstock run-up (this is not supposed to be the main objective). Splits are usually announced right around the same time as earnings reports. How do you find thesestocks? Just look for companies that have exhibited this pattern before. For example, if you look at a stock like Yahoo! (YHOO), you will see a distinct pattern. Also,companies should have enough shares authorized to make the split possible. Thereare some great stock split services on the Internet (check out www.splitmaster.com,www.stocksplits.net, and www.tradingday.com). As a trader, this can be a very lucrative way to look for opportunity. A word of caution: Stocks typically run up inthe anticipation of the split and the announcement. They may sell off in the shortrun after the split; but they are usually good companies, ready to go up again.
Accounting IrregularitiesWhat is an accounting irregularity? Well, another way to put it is a potential thatthe company has “cooked the books.” Some would call this fraud. What if a company has overstated sales or overstated earnings, and then its overstatements aresubsequently discovered? Well, it has to report this to the investment community.The investment community then gets a chance to react to the information. In mostcases, the stock will quickly fall in price. I have seen stocks decline as much as90% in price when information hits announcing that the previous information
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provided was false. This kills investor confidence, and everyone bails out asquickly as possible. Sometimes the accounting irregularity is not a big problemand the company will rebound. Most of the time, it is real and the stock price willplummet like Niagara Falls. In some cases, the irregularity is so severe the company has to file for bankruptcy, as it will have to restate earnings, may have defaulted on bank loans, and may be besieged by investor lawsuits. It is hard tocome back from all this adversity. Just do some research on Bre-X Minerals andyou will see what I mean. Even the hint of an accounting irregularity creates a badsituation for any company.
TakeoversTakeovers are another area that can really drive price action. There are two kindsof takeovers: friendly and unfriendly. You don’t make much money with friendlytakeovers. This is a kiss-and-hug situation when everyone agrees to the transaction. I like the unfriendly takeover, as this is where money can be made. If a company wants to buy another company without the target company’s blessing, thenthe first company must make a hostile bid. This means that it tries to accumulateenough shares to make its presence known. Then it starts a proxy fight to buy acontrolling share of the stocks of the target company in order to have control of theboard of directors. If the target company does not want to be acquired, it may putinto place defense tactics, or demand that the price be increased to expand shareholder value. In many cases, the price will be bid up not only by the first companythat made the offer, but also by other companies now interested in the target company. This is a very interesting process. Just watch the movie Barbarians at theGate and you will find a very humorous view of the RJR Nabisco bidding war. It iswell worth the time.
No NewsWhen you see a stock make a big move up or down and there is no news to befound, it usually means that some news has leaked and it will be evident in the shortterm. Keep an eye on these stocks. I can’t tell you how many times I have seen thestocks that I am watching make a major move only to find out that information (thatwas supposed to be made available to everyone at a later date) somehow alreadyleaked out. This happens in many cases when a big brokerage firm’s analysts mayhave received information that they are able to provide to their clients first. This isnot what the rules say should happen, but it has happened in the past. In fact, the Securities and Exchange Commission has just issued new guidelines for the release ofinformation making it wrong to have “selective disclosure.” Now companies haveto make information available to everyone, including the public trader, at the sametime. With the proliferation of the Internet, you now can listen to company conference calls that provide access to the same information the large institutional investors get.
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UNDERSTANDING TECHNICAL ANALYSIS AND HOW IT WORKSOne of the problems I had when I first started my trading career was that I readevery book on trading I could find and then focused on learning each and everytechnical analysis tool. In many cases, I would try to combine too many tools andeach would give me a different opinion. A multitude of technical analysis tools havebeen developed over the years. In this section, I will review my two favorite toolsthat I work with daily due to their simplicity and trading validity. For more information, please review the information in Chapter 9.
VolumeFirst, I like to look at the volume trading on a stock. How do you do this? Easy, just puta stock chart together using a daily bar graph and put a volume indicator on it. Almostall software programs which do charts will give you volume. I like volume because it’susually a great indicator for discerning the beginning or the reversal of a stock pricemove. This is especially evident when a stock has moved up or down quickly in a shortperiod of time—referred to as a volume spike. This means that the volume of sharestraded on the stock have spiked up from previous periods. You can even get an averagetrading volume each day; and if you see volume at least double, then this may be a precondition to a move or reversal. Remember that for every buyer there will be a seller.So if someone is giving up on a stock or taking profits, someone else is initiating a position. If you buy good companies when they get hit hard on a fast move down and thevolume spikes, this may be a great time to place a long strategy on the stock.
Moving AveragesI like to look at two very simple moving averages to give me an idea as to where thestock price will be: the 50-day moving average and the 200-day moving average.Remember that a moving average is an average of the closing price of the stockover the period of time you choose as the analysis period. So if you wanted to lookat a 50-day moving average of IBM you would take the closing price for the last 50days, add them up, and divide by 50. This would be the average price close for thelast 50 days. You would calculate the 200-day moving average (MA) the same way.Luckily, these days all programs have an ability to put moving average lines onyour charts, including multiple moving averages. How do you use this information?Well, a good company will usually have its stock price trading above both its 200and 50-day moving averages. Usually when the stock price falls below its 50-daymoving average you need to see if it will fall further to the 200-day MA. It shouldbounce from the 200-day MA. If it does not bounce and breaks below the 200-dayMA, then the stock will likely fall more. Just practice by looking at a large numberof charts with a 50-day and 200-day MA. You will eventually build a good feel as tohow to trade using this method.
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Don’t Overanalyze—Avoid Analysis ParalysisAs stated earlier, the problem with technical analysis is that an individual trader whenfirst introduced to the concepts will try to use too many tools at the same time. Thismay cause analysis paralysis, as novice traders have a tendency to overanalyze. I don’tknow anyone who overanalyzes who makes a great living as a trader or investor. Youneed to take action to make money in the markets. Without action, there will be noprofits. In the beginning you have to learn as much as you can about technical analysis.But as you progress, concentrate on the tools you like and understand best. Make sureto test them first by using any of a number of computer programs that allow you toback-test a system. Don’t waste a great deal of time on any system that doesn’t workfor you. There is no holy grail. More than likely, you will find out that you will makemore money using the same principle I use: the KISS principle (keep it simple, stupid).
PUTTING IT TOGETHER: HOW TO FIND A GREAT TRADENow that you have lots of great knowledge, how do you find that great trade? Well,I like to look at stocks that move—the bigger they move the more they excite me. Ilike to trade technology stocks because that is where the action has been. Somedaythe excitement (and movement) will be in another sector and I will change my focusto that sector. As a market player, you have to be able to adjust quickly to the marketconditions. Start by getting to know one sector very well. Get to know the topstocks in it very well. If you live in Texas, maybe the oil sector is best. If you live inSilicon Valley, then you are in the capital of the technology world. If you feel competent in one sector, go ahead and move into another and then another until youamass as much information as you can. But take the time to do your homework ineach sector before you start trading the stocks in it.
Step 1: Analyze Your PersonalityWhat kind of stocks do you like? How much risk can you afford to take? How muchare you willing to risk on one trade? How much time do you have to manage thetrade? It is absolutely vital to assess how a stock fits your personal trading approachand lifestyle.
Step 2: Pick a StockIntegrate the techniques explained in this book to find a promising opportunity. Makesure that any stock you choose is one that you want to follow. Look at the fundamental news to analyze the stock and then use technical analysis to analyze the timing ofthe trade. If you don’t know where to start, just pick a great company with great earnings prospects. Talk to other investors and watch CNBC. If you still don’t know
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where to start, look at Sun Microsystems (SUNW), Cisco (CSCO), and Intel (INTC).These have been favorites of many individual traders and institutions over the years.
Step 3: Analyze a Trade StrategyWhat kind of trade do you want to place? Is it an options or a stock trade? Whatkind of time frame does it require: short-term or long-term? What is the trade’s riskto-reward profile? What happens if you’re right? What will you do if you arewrong? These may seem like simple questions, but you’d be amazed at how manypeople never ask these kinds of questions before placing a trade. Cover your basesas best you can, and you’ll be prepared for whatever the future brings.
Step 4: Place the TradeBefore placing the trade with your stockbroker, write it down on paper so that youdon’t make a mistake placing it. All orders called in by phone are recorded, and it’svery easy to get nervous and place the wrong order (which can be disastrous). If youare using an online brokerage, make sure you are absolutely comfortable with theprocess. If you have any questions, call and ask a live broker to help you. There isno shame in asking for help, and it’s their job to help you make money—not lose it.If you still don’t feel confident placing a trade, paper trade it. Just track your positions on paper until you find you feel comfortable with the process. There’s alwaysanother good trade just around the corner, so don’t worry about missed opportunities. The key is to be comfortable with the ordering process. If you can’t find a goodtrade, or you feel uncomfortable with the trade, go back to Step 1 and keep tryinguntil you get it right. Perseverance is vital to your success.
Step 5: Manage the TradeManaging the trade is what makes or breaks a trader. If you’re right, what actionswill you take to capitalize on the situation? If you’re wrong, when will you get out?If it’s a long stock position, have you placed a stop loss? Do you know how to adjust your trade? Did you get out as the stock did not do as well as you thought itwould? These are all great questions to ask. Set your profit and loss objectives inadvance and follow your own rules to the letter.
Step 6: Monitor Your ProgressIt is important to monitor your progress as a trader or investor to learn from yourmistakes and your triumphs. What portfolio management system do you use? Haveyou been achieving the results you expected? If not, do you need more education orexperience? Are you habitually making the same mistake? What can you do to improve yourself as a trader or investor? Be bold in your efforts at self-assessment.
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Keep your head out of the sand. Accept your losses gracefully by using them as opportunities for personal growth. Remember that financial security is often the product of small but consistent gains coupled with huge once-in-a-while profits.
GIVE YOURSELF THE WINNER’S EDGEThis book is my attempt to help people take their first step on the path to success inthe stock market. I only wish I had been given this kind of a foundation when Istarted out. It would have saved me many years of hardships and many lost dollars.By reading this book, you should now have a clear understanding of what it takes topursue what I believe is the ultimate profession and lifestyle. The techniques in thisbook are many of the same principles of risk management used by professional brokers. Before you make any decisions with respect to a particular stock, ask yourselfnot only “What if I’m right?” but also “What if I’m wrong?” Only by being keenlyaware of market volatility, taking steps to mitigate risk, and filtering out unimportant information does it become possible for investors to avoid the school of hardknocks, sleep well at night, and enjoy trading for what it ought to be—fun.Although it may seem difficult at times, try to enjoy yourself while you take thisjourney. Undoubtedly the urge to quit may bear down upon you when times get tough.But winners don’t quit; they just keep persisting until they get it right. If you don’t enter, you can’t win—it’s as simple as that. It takes knowledge and experience to masterthe markets. By reading this book, you now have the basics of stock trading; it’s up toyou to gain the experience in slow increments that add up to a successful journey.I truly hope this book empowers you to become a successful trader or investor. Ifyou find enjoyment and success in the markets, then we have completed our originalgoal: to help people who simply didn’t know where to start find their way into the heartof the stock market. I wish you all the luck in the world. Welcome to the stock market!
Appendixes
A. Financial Profile TemplatesB. Stock Analysis TemplateC. Market Time LineD. Basic Strategy Reviews and Risk GraphsE. Option Expiration Month CodesF. Strike Price CodesG. Variable Option DeltasH. Intermarket RelationshipsI. Lists and TablesJ. Types of OrdersK. Exchanges and SECL. Media Sources and Web Sites GuideM. Online Brokerage DirectoryN. Formulas
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APPENDIXES
APPENDIX A. FINANCIAL PROFILE TEMPLATESAssetsFinances• Cash• Checking account• Savings account• Trading account• Mutual funds• 401(k)• IRAsSUBTOTALSLong-Term Assets• House (mortgage)• Vehicles• Fixtures• Recreation• Equipment• MiscellaneousSUBTOTALSNET TOTALSASSETS – LIABILITIES =
PERSONAL BALANCE SHEETAmountLiabilitiesShort-Term Debt__________• Credit card debt__________• Medical/dental debt__________• Vehicles debt__________• Short-term loans__________• Miscellaneous debt____________________
____________________________________________________________
Long-Term Debts• Mortgage• Tuition loans• Long-term loans
Amount__________________________________________________
______________________________
MONTHLY INCOME STATEMENTAmountMonthly ExpensesAmountBasic Living Expenses__________• Rent/mortgage____________________• Food____________________• Utilities____________________• Phone/ISP bill____________________• Heating____________________• Transportation__________• Clothes__________• Entertainment__________• Miscellaneous__________Insurance Payments• House/renter’sinsurance__________• Health insurance__________• Dental insurance__________• Car insurance__________• Life insurance__________• Long-term care insurance __________TotalsDebt PaymentsIncome Total – Exprenses Total =• Credit card (minimumpayment )__________• Alimony__________• Child support__________• Tuition loan__________• Miscellaneous loans__________Monthly IncomeCash Received• Wages after taxes• Alimony income• Child support• Rental income• Business income• Additional income
APPENDIX A. FINANCIAL PROFILE TEMPLATES
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RISK TOLERANCE AND INVESTMENT GOALSRisk ToleranceInvestment GoalsMonthly Income__________Investment Goal ÷__________– Monthly Expenses__________Years until Retirement__________Net Profit/Loss__________Annual Return Goal__________Total Assets__________Financial Potential– Total Liabilities__________• Tax bracket__________Net Worth__________• Utilities__________• Phone/ISP bill__________3 × monthly expenses• Heating__________(aggressive)__________• Transportation__________• Clothes__________6 × monthly expenses__________• Entertainment__________(moderately aggressive)• Miscellaneous__________Insurance Payments9 × monthly expenses__________• House/renter’s(conservative)insurance__________• Health insurance__________• Dental insurance__________• Car insurance__________• Life insurance__________• Long-term care insurance __________Debt Payments• Credit card (minimumpayment)__________• Alimony__________• Child support__________• Tuition loan__________• Miscellaneous loans__________TotalsIncome Total – Expenses Total =
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APPENDIX B. STOCK ANALYSIS TEMPLATECompany:
Entry Date:
Industry Sector:
Capitalization:
Present Price:
52-Week High:
Target Exit Price:
52-Week Low:Quarterly Figures
Quarter
Earnings per Share
Sales
Latest QuarterPrevious Year Quarter% Change(Latest Quarter—Previous Year Quarter)
Five-Year Price-Earnings FiguresYear
Price52-Week High52-Week Low
Earningsper Share
High
P/E RatioEPSLow
EPS
TotalAverageIs the current 52-Week High or Lowhigher or lower than the average?
Is the current P/E ratio higher orlower than the average P/E ratio?
Growth RateCurrentEPS
Next Year’sProjected EPS
Growth Rate =Projected EPSCurrent EPS
CurrentEPS
Projected EPSTwo Years fromNow
Growth Rate =Projected EPSCurrent EPS
Five-Year Sales/Expenses PerformanceYear
Annual Sales
Annual Exprenses
Net Profit
% Change(Last Year—two years ago)
Price to Sales Ratio
(Every $1 of sales = “X” amount of investing value)
Year
Market Capitalization
(# Outstanding Shares × Price per Share)
% Change(Last Year—two years ago)
AnnualSales
Price to Sales Ratio(Capitalization—Sales)
APPENDIX C. MARKET TIME LINE
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APPENDIX C. MARKET TIME LINEYEAR1273
HISTORICAL FACTKublai Khan issued the first paper notes made out of mulberry bark andfixed with his seal.
1368
The first official paper money—the Kwan—was created by the Ming dynasty of China.
1531
The first official stock exchange opened its doors in Belgium (althoughthe Romans are credited with the earliest history of traded securities).
1602
Amsterdam opened the second securities market.
1661
Sweden took credit for issuing the first European paper money.
1688
London hosted its first trading of securities.
1690
British Empire first used promissory notes to finance their siege ofQuebec.
1773
The first official London exchange opened its doors.
1790
Trading of securities emerged in the United States when the federal government issued $80 million in bonds to refinance all federal and stateRevolutionary War debt. The bonds were the first shares of public securities to be traded at the first American stock exchange established inPhiladelphia.
1792
New York City’s prominent merchants and brokers signed the Buttonwood Agreement formalizing the trading of securities at a regular commission basis and marking the unofficial birth of the New York StockExchange (NYSE). The NYSE began by trading five securities—threegovernment bonds and two bank stocks.
1830
The first railroad stock was listed. From that point on, railroad stocksconsistently dominated the markets for the rest of the century.
1842
The second exchange, the American Stock Exchange (AMEX), emergedand is still referred to as the “curb market” because originally trading actually took place on the street.
1871
The NYSE switched to a system of continuous trading which replacedthe trading of certain stocks at specific times. This major revision, in turn,created precise fixed locations to trade each particular stock eventuallyknown as trading pits.
1921
The AMEX finally moved indoors.
1929
Stock market crashed ushering in a decade of severe depression.
1971
Designed by the Securities and Exchange Commission (SEC), the Nasdaq, the world’s first electronic exchange, hits the airwaves.
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APPENDIX D. BASIC STRATEGY REVIEWS AND RISK GRAPHSLong StockStrategy = Buy shares of stock.Market Opportunity = Look for a bullish market where a rise in theprice of the stock is anticipated.Maximum Risk = Limited to the price of the stock as it approaches zero.Maximum Profit = Unlimited as the price of the stock rises.Breakeven = Price of the stock at initiation.Margin = Required. Usually 50% of the total cost of the shares.
Short StockStrategy = Sell shares of stock.Market Opportunity = Look for a bearish market where a fall in theprice of the stock is anticipated.Maximum Risk = Unlimited to the upside.Maximum Profit = Limited to the full price of the stock shares as they fallto zero.Breakeven = Price of the stock at initiation.Margin = Required. Usually 150% of the total cost of the shares.
Long CallStrategy = Buy a call option.Market Opportunity = Look for a bullish market where a rise above thebreakeven is anticipated.Maximum Risk = Limited to the amount paid for the call.Maximum Profit = Unlimited as the price of the underlying instrumentrises above the breakeven.Breakeven = Call strike price + call option premium.Margin = None.
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Short