%Fin
 
OPTION T -*Tickr® volatility $ -*Same" volatilityPRICING: M ~ Trade "Match" volatility 12.5% (or any other volac.}
 
 
 
 Maximizing Profits in Short-Term Market Declines
FIGURE 26.2a NASDAQ 100 Index—Historicat Volatility
209
 
|
 
FIGURE 26.2b NASDAQ 100 Index—lImplied Volatility
     
 
 
 
NDX Index OHTFor specific month: OHT 5 for May, OHT 6 for June, ...16:56 DISPLAY: ¢ C-chg/tchg, D-delta/volatMon 4/1Aarne onion OPTION HORIZON ANALYSIS“ive ie APR OPTIONS ON NASDAQ 100 STOCK INDXNDX MARKET IS CLOSEDTODAY “oF DAYS LATEROpTioN 261899 “612.99 unchPRICING: — Tickr Tickr Volat =Saite Volat =SameCALLS PUTS CALLS PUTSSTRIKE Pr¢_ De] I.Vol Pre _Cha_$Chy= tak +29°-26.91 Zi 2's 9 A De 348166 27.88 % +33 26.09 20's -Pa -14E Sy R308+62 24,22 aa «39° 27.22 Y54q ~3 -16¥ B= 2"y 268+56_24,87 242 24.17 ig 3 Be 27 ag =«5123.41 S4aMy 649 25.43 9 Xe -27e-23% 1D, 25-288+45 25,92 & +56 23.12 BAe -Ban -27E By. Es TAS+38 22.21 +60 25.53 Bie 2a 39% 1M, Dw DEm8 31_21,02 } §5 25.55 ag 2a = ty 2 2 98Mon 24/°3796 (29days Expr) YSS16%Fin 6/96 ( E2days Expr) 5.16%Fin
 
DG28 Index OH T
 
*Tickr" price
M - Trade "Match* volatility 12.5%
 
PRICING:
T*Same* volatility
{or any other volat.)
 
 
 210 Chapter 26
FIGURE 26.3a Insurance Index—Historical Volatility
 
 
—
 
HISTORICAL VOLATILITY
= 100 doy100 day100 day
13.4% Last13.4% Lost13.4% Last15.4% Last
  
Mon @/s2/96 (F39days
OPTIONPRICING:
 
 
 
   
T -*Tickr" volatilityM - Trade “Match* volacility
 
FIGURE 26.3b Insurance Index—Implied Volatility
 
 
  
IUX Index O#T DG28 Index OKTScreen printed.11:31 DISPLAY: © C-chg/tchg, D-delta/volatMon 4/1Anmame Anus OPTION HORIZON ANALYEBISssw he, APR OPTIONS ON S&P INSURANCE INDEXrex WORKSHEETTODAY PAK DAYSB98aT97 .- we Volat=BaikeCALLS PUTS CALLSPro__-Chg $Chg Pre __Cha_ ChgBY 21 18.31 why 743%—— # ds 233 18.1) Pg ae =3-17.89 aa fy. 4717.80 @, -P 22% Fe -1-208+38 17.66 ¢nfa n/a 2%, -1'n -32% Ate tha 46%+24 16.62 n/a nfa NA AGE eat 4 Eaf hy tty 42%
“ppr) GSaeeFin [Mon (8778798 GAadays Expr). 517¥Pin
@ -"Same” volatility12.5% (or any other volat.)
 
 ASAMaximizing Profits in Short-Term Market Declines 211
Strategy #2—-Sell OEX Calls
Though you will not hit a home run if the market crashes, you will makemoney with this strategy. More importantly, you may profit even if themarket rises. How is this possible? When the market rises, the impliedvolatility in the options tends to drop, thereby offsetting a portion of themarket's increase in price. Remember, they are overvalued derivativeswith time decay in your favor (see Figure 26.4). Finally, as with all strate-gies, stops must be used to protect yourself in case you were wrong.
 
    
 
   
 
FIGURE 26.4OEX Index OHT 0628 Index OH TFor other months enter a month # such as “CVT 4" for calls in April.17:07 DISPLAY: ¢ C-chg/*chg, D-delta/volatMon 4/1Assume toads OPTION HORIZON ANALYSIS$V vive Div, APR OPTIONS ON S&P 100 INDEXoEX WORKSHEETTODAY -2 DAYS LATEROPTION Soe30c 80 633.00 + 2.20Ke Tickx Volat=14.71 Volat=15.85PUTS CALLS PUTSPro_Del_I.Vol Bro Chg *Chg = Pre Chg _ 4ay 27° 19.29 2076 tn 2% 2-33° 18.51 16% 7m BEB39° 17,72 1B, ta 2B4716.85 10° + 64-2 -23%55 15.77 Te tte 63% Hy 18 y -15%15.71 St, 4p 410% 12 -13%14.74 BY. 4 422% 15". 29%—850 Fas 20 13.41 M2aha 73 19.03 | __2’., _4*y +328 _19 5. -3 11796 T9days Expr) {Sl16%Fin |Wed -4/°3/96(A7days Expr) 5.16%FinOPTION T -"Tickr" volatility $ ~"Same" volatilityPRICING: M - Trade "Match" volatility 12.5% (or any other volat.)
 
 
1. When the OEX is at 630.80 and the implied volatility is at 15.71, theat-the-money option is priced at 10 1/8.
2. Two days later, even though prices are higher, the drop in impliedvolatility combined with the time decay, leaves option prices withlittle gain.
  
212
Chapter 26
Strategy #3 (Equities)—Stocks to Sell Short
No reason to get cute. Short the stocks of brokerage houses and thestocks of the mutual fund companies. As I mentioned earlier, no industrygets hurt more than the brokerage houses in a bear market. The indus-try’s profits are highly correlated and dependent upon higher stock andbond prices. These are the first stocks to decline in any sell-off.
As I mentioned earlier, if interest rates are rising, also look to short theinsurance stocks and possibly the major banks and mortgage companies.
A final note: if you are unable to get an uptick before the market closes toshort these stocks, buy deep in the money puts on these companies (tomake sure the premium is small).
Strategy #4 (Futures)—Short the S&P 500 Futures
Obviously, the strategy with the largest profit potential is to sell the S&Pon the futures market. What concerns me here is the risk and the volatil-ity. Unlike buying the index options, your risk is unlimited if you arewrong. With that said, let’s look at a way to minimize the risk.
* Sell the futures “market on close.” This will allow you to avoid amarket snap-back which may happen in the last few minutes oftrading (short covering). Research has shown that sharp afternoonsell-offs have a higher likelihood of follow-through into the nextmorning.
« Protect yourself on Globex. Should the market rally in the evening,there is less likelihood of a down opening the following morning.Though you may lose some sleep during these occasions, it’s betterthan losing money.
« Finally, one of the surest phenomena I have observed is that Fridayafternoon weakness begets Sunday evening weakness. This is a sce-nario that all futures traders should be aware of.
Strategy #5—-Spiders (SPY)
Spiders (Standard & Poor’s Depository Receipts) are the safest, most effi-cient and most liquid vehicle to trade to capitalize on market moves.These American Stock Exchange securities are simply a basket of theStandard & Poor’s 500 index divided by 10. For example, if the Standard& Poor’s cash index is at 935.00, the spiders will be trading at approxi-
 Maximizing Profits it Short-Termt Market Declines
mately 93 1/2 (935 = 10). Also, a terrific feature of this derivative is youdo not need an uptick to go short, therefore, giving you an instant fill ona market order.
The specialist of the security usually maintains a market of 100,000 shareson each side which means that there is always liquidity. Also, the spread(difference between the bid and ask) tends to rest between 1/16 and 1/8,which is as low as you will see on a listed security. (The daily volume isapproximately one-half million shares per day.)
One final thought: Spiders are an inexpensive method to hedge a netlong portfolio when you do not have the time, nor the inclination, toliquidate your stocks.
SUMMARY
The profits from declining markets come fast and large. I cannot stressenough the importance of being prepared for these sell-offs. At times theycome so quickly that unless you are fully ready, you will miss the move.As I am writing this, we are still in a major uptrend, but the recent in-crease in volatility may signal more opportunities for traders to profitfrom market declines. With the strategies in this chapter, you will be bet-ter prepared than the average trader who will attempt to participate inthese declines by “shooting from the hip.”
213 
CHAPTER 2 7
LARGE-RANGE DAYS
Ce ay
Tn this chapter we will look at the times markets make large one daymoves. I will show you why it is usually wrong to enter these marketsimmediately following these moves and I will show you why it is aneven bigger mistake to buy options immediately following such a move.
Conventional wisdom states that large one day moves immediately con-tinue in the direction of the move. My research indicates otherwise. Mar-kets that have big one day moves attract attention. For example, whenthe Dow has a large move (100+ points) most news channels carry thestory, most newspapers make it the lead business story and every marketanalyst and guru tells how the move will certainly continue. In looking atthese large one-day moves, the reality is that the majority of time thesemarkets do not follow through—they move sideways!
In studying this phenomenon, I looked at a market which closed twostandard deviations (see box for calculation) from its previous days close(this occurs approximately once out of every twenty trading days). Themajority of the time, the market didn’t follow through over the next fewdays. In fact, from a directional viewpoint, you could flip a coin as towhether the move would be up or down the next day. Just as impor-tantly, the market many times closed near the closing price of the largemove day, three to four days later.
215 
216 Chapter 27
 
Here is how to calculate a two standard deviation move in bonds. We will assumebonds are trading at 110 and its 100 day historical volatility is at 10 percent.
10% H.V. / Square Root of 265 trading days = .6250%
-6250% x 110.00 (bond price) = .6875 or 22/32 (one standard deviation)22/32 x 2 (standard deviations) = 1.375 or 1 12/32
110.00 + 1 12/32 = 111 12/32
110 - 1 12/32 = 108 20/32
pose ee
 
Now, let’s apply this to the real world. The strong urge (human nature) isto allow ourselves to get caught up in the hype and trade in the directionof the move. Worse, the urge among traders is to do this via options.These options will be overpriced. This is because the implied volatilityincreases due to the excitement among traders caused by the move. Notonly is there a high likelihood that the move won’t continue (causingtime erosion in the options) but worse, you are buying overvalued op-tions! You have the worst of all worlds. In fact, the smarter strategy is tosell the overpriced options via a naked combination. You can sell the callsthat are one standard deviation from the large day move’s high and theputs that are one standard deviation from the big move’s low. If the mar-ket moves sideways the premiums on both sides will collapse.
When markets move two standard deviations from their normal volatil-ity, the reversion to the mean principle will kick in and more than likely,the market will take a few days to rest.
A word of warning—in strongly trending markets (ADX greater than 25), thisprinciple does not hold true. Our research has found it works best in non-trend-ing markets.
As an example, the following dates in the bond market had a two stand-ard deviation move from the previous day’s close. When you look atthese moves, notice how many times the market closed within the large-move day’s range three to four days later.
 Large-Range Days 217
 
Daily Two Standard Deviation Moves in Bonds Over the PastTwo Years—Reflects 100-Day Historical VolatilityDate Date Date
1/13/95 7/21/95 3/11/961/27/95 8/25/95 3/12/962/3/95 9/21/95 3/27/963/14/95 9/29/95 3/28/963/24/95 10/13/95 4/5/965/4/95 12/4/98" * 4/12/965/5/95 12/18/95 5/2/965/9/95 12/20/95 5/10/965/24/95 1/5/96 6/7/966/2/95 1/10/96 7151966/9/95 1/25/96 8/1/966/13/95 2/20/96 9/13/966/29/95 2/23/96 10/4/96716/95 3/1/96 10/29/96
 
 
7/19/95 3/8/96CHAPTER 28
TWO-FOR-ONE MONEYMANAGEMENT
 
Here is a specific money management methodology to use which helpsmaximize profits while keeping risks to a minimum. I believe the “Two-for-One Money Management” strategy gives you more confidence in tak-ing trades as it allows you to enter into potentially explosive setups whilereducing the risk inherent in these setups. Please note that this is not origi-nal research, Variations of this method can be found in other publications.To me it is one of the better money management methods a short-termtrader can rely on.
The Two-for-One Money Management strategy allows you to minimizetisk while maximizing gains. Many traders I’ve talked to say they do nothave the proper method to allow profits to run. This strategy partiallyoffsets those concems.
Here’s how the strategy works:1. We will use one “unit” as our position size. For our purposes in
this chapter, each unit will be worth 1,000 shares for equities andtwo contracts for futures.
The general idea is to take off half a unit at a profit target equal to theposition’s original stop loss. As you will see, by having cashed in half a
219220
Chapter 28
unit early, there is no loss if the trade turns against-you and takes out theoriginal stop. You've created a free trade (minus commissions).
You should note that while this is a “conservative” method of trading, itmany times leads to two profits. The first at the “free trade” profit. targetand the second on the profitable close of the second half of the unit.(You'll see this in example two in the bonds and in others).
2. — Let’s assume for equities we have a set-up pattern which triggers abuy signal at 53 and our initial protective stop is at 52 1/4 (risking3/4 of a point). If our sell stop is not triggered we will take profitson 1/2 of our position (500 shares) at a distance off our entry pricethat is equal to our original stop, (53 + 3/4 = 53 3/4) and leave thestop on the other half at 52 1/4.
We now have a free shot at being in a position that may continue to run.With strategies such as 1-2-3-4’s, historical volatility, etc. many times mar-kets explode from our entry point and with the “Two-for-One” methodyouhave a low-risk strategy to participate in thesé explosions. * * *
To help clarify this strategy let’s look at intraday Turtle Soups (from StreetSmarts) and daily 1-2-3-4's.Two-for-One Money Management 221
FIGURE 28.1 June S&P’s (10 Minutes)
 
 
 
10100 10-90 1100 HEe30 4210012190 1300013690 410014190 151001590 16-00mar 30
 
 
1. On May 30, 1996, the S&P’s make a 20-bar low and reverse trigger-ing a Turtle Soup buy signal at 666.05 for two contracts (one unit).Our stop is at 665.65, one tick under this bar’s low. Let’s assume theunthinkable and there is no slippage, so our risk is .40. We will sell1/2 our position (one contract) at 666.45 (666.05 + .40). On beingfilled we cancel selling two at 665.65 and replace it with selling oneat that price.
2. Our strategy gave us a free shot at picking the low for the day. Themarket rallies sharply and we have the option of locking into prof-its at higher levels or selling MOC.
In studying and trading this strategy, I have observed that the TurtleSoup setups on average tend to pick the top or bottom of the day ap-proximately one out of every eight days. That is, on one out of everyeight days the daily high or low is created via a Turtle Soup setup.Seen
222 Chapter 28
FIGURE 28.2 June Bonds (10 Minutes)
109-04
10°00 10:30 14001490 12-09 1219D_ 1300 1319D 410014130 15400bay 22
 
1. A Turtle Soup Plus One setup. We buy two contracts at 109-11 andour initial stop is a 109-06 risking five ticks.
2. After trading sideways for two hours, bonds explode to the upsideand we sell one contract at 109-16 and cancel and replace our two-lot stop with an order to sell one at 109-06.
3. The second half of our unit closes at 110-05. We make five ticks onone contract and 26 ticks on the second.A A SS SSS
Two-for-One Money Management 223
FIGURE 28.3 July Soybeans (10 Minutes}
 
 
 
 
 
1. A short Turtle Soup Plus One setup on July Beans on May 17. Sellat 829 1/4 and our protective stop is at 831 1/4 (risking two cents).
2. Take profits on half at 827 1/4 and reduce the sell stop size by half.
3. Beans close on their low with a good profit for those trading thismethodology MOC.
Please don’t think that picking tops and bottoms happens every day.However, setups like the Turtle Soup and Turtle Soup Plus One combinedwith “Two-for-One” money management do meld into a strategy whichallows you to maximize profits at intraday tops and bottoms.224 Chapter 28
FIGURE 28.4 Proxim Inc. (PROX)
 
 
COMPOSITE” TRADECast Sit on 0520/96on 0520/96 f--.Close?on 0424296
 
 
 
Here's “Two-for-One” money management in action on 1-2-3-4’s.A. A 1-2-3-4 buy setup (ADX is above 30)
B. On May 2, we buy one unit (1,000 shares) of Proxim at 28. Our sellstop is at 27 3/8, the low of the previous day and our risk is 5/8 ofa point. The market immediately trades higher and we sell 1/2 ourposition at 28 5/8 and reduce our sell stop to 500 shares.
C. As does happen from time to time with this strategy, the stock ex-plodes and moves more than 65 percent higher over the next threeweeks. (Note that we have again shown a profit on both halves ofthe unit).Two-for-One Money Management 225
 
 
 
 
 
 
 
 
1-2-3-4 setup. ADX @ 37.Buy one unit @ 48 7/8. Stop @ 47 7/8.Sell of 500 shares @ 49 7/8.
Six points higher in two weeks.
S90 FP
(1-for-1 reward/risk on 500 shares, 6-for-1 reward/risk on 500shares)
SUMMARY
As you can see from the examples, this exit strategy does a good job atallowing us to participate in potentially large moves with reduced expo-sure. 
CHAPTER 29
MORE THOUGHTS
J had a small handful of friends who trade read the galleys of this bookand they came back to me with a series of questions. I hope this sectionwill help answer many of your own questions.
Q:
Do you trade every strategy?
A: No, there are obviously too many. A good handful now make up the
Q:A:
Po
methodology we use in our money management firm.
Can these strategies be improved upon?
Yes, and I have evidence of this. I consider the subscribers to mynewsletter the Professional Traders Journal, to be among the smartestpeople who trade. Over the last two years I have received numer-ous suggestions of enhancements for many of the strategies.
: Why don’t you publish those enhancements?
: Unless someone gives me specific permission, 1 will never reveal
their improvements. As with many other traders, I have unfortu-nately been associated with a few individuals who have revealedmy research after I have asked them not to (I was dumb enough tolet one person do it to me twice!). Fortunately, these individuals are
227 
228
Chapter 29
Q:A
: Obviously, the first and most important thing to do is to implement
the exception, not the rule. Therefore, I will always keep private theresearch that others share with me.
What do you think is the best way to improve one’s trading?
very disciplined money management. A second way is to act inamanner opposite to human nature.
Let me dwell on this point a bit. I am as guilty as anyone of pounc-ing on a methodology after it has had two or three successfultrades. After these successful trades I immediately ask myself whydon’t I make my life simple and only trade this strategy? I thenload up on the next signal only to watch my net-worth get reduced.Every methodology has a “reversion to the mean” principle builtinto it. This means, that the best time to trade the methodology isafter it has had two or three consecutive losses, not winners! Hu-man nature is to trade a strategy only after it has worked a numberof times in a row. This success reinforces in your mind the pleasureof the strategy, not the pain. If a trader waited only for each of thesestrategies to have two or three consecutive losses and then traded it,his returns would be much higher. Unfortunately, we all do the op-posite.
This is further evidenced in the money management world. There isa high-profile hedge fund manager whose overall performance iswell above average. The problem is that many people lose moneywith him. This is because he has large swings in his quarterly andyearly performance. When he has a spectacular quarter (or year) themoney pours into him. Then the reversion to the mean principlekicks in and he has horrendous drawdowns and these same inves-tors, who originally believed they were investing with GOD, nowhate him and pull their money out, usually at the bottom. Hissmallest account accepted is one million dollars so we are not deal-ing with an uneducated group of people. These are successful pen-sion fund managers and businessmen—all affected by the samehuman nature.
If you can find the courage to trade a methodology only after con-secutive losses instead of gains, you will likely improve your per-formance.More Thoughts
Q: Why publish your research. Why not keep it only for yourself?
A: Obviously, it’s an extension of my business. More importantly, itserves no purpose to take the information to my grave. And mostimportantly, I have yet to see it have a negative effect, in terms ofslippage, on my trading.
Q: Why not trade just one strategy?A
: I have thought about that a lot and I have great deal of respect for‘ traders who do it. Unfortunately, I am not wired that way and Ineed diversity.
Q: What about mechanical exit strategies?A
: Even though I have presented mechanical exit strategies with somemethods, I can never use them myself. I am much too hands-on to‘sit’ ‘tight asa position is running one way or another. This does notmeaii this is the way you should trade. This is the way I need totrade. I know successful traders who exit mechanically and I knowsuccessful traders who exit with discretion. These people are suc-cessful not because of their exits, but because they have an edge,and they know what works for them.
Q: Can you recommend other researchers/traders whom you look upto?
A: There are too many to list, but I’ll name a few. I relate well to manythings written by Gerald Appel. I think most of Larry Williams re-search is very strong, I have business relationships with MarkBoucher and Jeff Cooper, and I’m biased toward their work. NelsonFreeburg’s research is solid, Welles Wilder’s techniques such asADX and RSI are brilliant, Shellie Natenberg’s work on option vola-tility is the best. The list can go on but if you study the concepts ofthe above group first, you won’t go wrong.
Q: Why not a chapter on money management?
A: First, because this is an advanced trading book, I assume everyoneunderstands the importance of stops. Without them you will even-tually get blown out. I have attempted to show you where to placeyour stops in many of the strategies.
229230
Chapter 29
Where you decide to place your stops and the position size youdecide to take is a personal decision in which many factors comeinto play. The most important factor is your risk tolerance. If pasthistory is any guide, thousands of traders will read this book. Everysingle one will have a different level of risk tolerance. [ will notimpose my risk tolerance levels upon you. You know what is best. Icannot tell you that your position risk should be 1 percent or 5 per-cent of your portfolio size. I cannot tell you that your account sizeshould be $50,000 or $250,000. I cannot tell you how many shares orcontracts to trade per $25,000. You, and only you, know the correctanswers.
Let me go one step further. Over the past decade or so, one of thebest performing groups of traders in the money management busi-ness have been the original Turtles Richard Dennis taught. Theyemploy a breakout method that has stood the test of time. Their
‘method has one major drawback though: it experiences large, and
_ sometimes very large, drawdowns of 20, 30, and 40 percent.
I am convinced the Turtle methodology works. Will I trade it?Never! Why not? I do. not have the stomach to live through thedrawdowns. Those Turtles who are the most successful havelearned to live with the risk levels associated with the drawdowns.Their money management risk tolerance is far different than mine.If I worked for them, I would think they were insane to take suchrisks. And if they worked for me, they would think I was insane forkeeping my stops so tight. Again, only you know what your risktolerance is and your stop placement, account size, and positionsize should be reflected upon it.
With that said, let me mention a few additional thoughts on the
» topic:
1. Every position must have a protective stop in place. This rulemust never be broken!
2. If you are selling options, you should have an offsetting longposition (creating a spread) to avoid a catastrophe (the bad tail).
3. You must be aware of markets that are related. If you are longbonds and long Euro dollars, you have basically doubled yourrisk as they move in a high correlation to each other.More Thoughts 231
4. Volatility changes! As mentioned in an earlier chapter, the Cana-dian dollar usually trades with a volatility of under 10 percent.If you normally trade 10 contract