a return.
A. Limiting the risk.
B. The reward/risk ratio.
C. The delta neutrality.
D. All of the above.
3. 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______________ over a speciﬁc period of time.
A. Volatility.
B. Volume.
C. Price.
D. Change in direction.
4. The best investments will have an opportunity for ______________with acceptable risk and a high probability of winning on a consis-tent basis.
A. High reward.
B. High volatility.
C. High liquidity.
D. Major market movement.
5. True or False: If you do not have the time to sit in front of a computer
day in, day out, then your best investments will be day trades.
6. Your  risk  tolerance 
level 
is  directly  proportional  to  your
______________.
A. Knowledge of the markets.
B. Computer availability.
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C. Time requirements.
D. Available investment capital.
7. Name a few investment objectives.
____________________________________________________________
____________________________________________________________
MEDIA ASSIGNMENT
This chapter discusses risk tolerance and how to take emotion out of trad-ing. Having a set plan in advance for entering a trade is an important keyto lowering the part emotions play in our trading success. If traders takerisks that do not ﬁt their risk tolerance, this will increase the emotions feltwhile  trading.  For  this  media  assignment,  take  the  time  to  write  downyour  risk  tolerance  and  goals.  This  includes  writing  down  the  time  youhave available to trade, the amount of capital that will be used to trade,and the proﬁt goals you have set for your trading account. From the ﬁrsttrade, keep a trading journal that tracks not only the details of each trade,but the emotions and feelings you had as the trade progressed. You’ll beamazed at how much knowledge can be gleaned from reading the infor-mation found in a trading journal.
VOCABULARY LIST
Bear market
Bull market
Capital
SOLUTIONS
Capital gains
Interest income
Price/earnings (P/E) ratio
1. Name as many elements of a good investment as you can.
Answer: A good investment has low risk, a favorable risk proﬁle, andhigh  potential  return.  It  meets  your  time  constraints,  risk  tolerance
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level,  and  investment  criteria.  It  also  meets  your  investment  capitalconstraints and can be easily understood.Discussion: This might seem like a lot to remember, but it all makessense. However, it is amazing how often new traders enter trades thathave  horrible  risk  proﬁles  or  that  don’t  meet  their  time  constraints.Initially, a new trader might need to go through each of these criteriato make sure a trade makes sense. After a while, this type of analysiswill become second nature, allowing a trader to make healthy proﬁts,even while limiting risk.
2. ______________ of any investment must take into account the fol-lowing elements: potential risk, potential reward, the probability ofsuccess, and how long the investment takes to make a return.Answer: B—The reward/risk ratio.Discussion: All traders want to make as much proﬁt as possible withthe capital used in their trades. By looking at a risk graph, many of theproblems with a trade can be uncovered. The reward/risk ratio can helpyou to determine the validity of a trade. However, you also need to un-derstand the probability of success and how long the reward will take toaccumulate, in addition to the basic risks and rewards possible.
3. 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______________ over a speciﬁc period of time.Answer: C—Price.Discussion: A  risk  graph  helps  a  trader  view  how  the  trade  willchange  in  value  given  a  move  in  the  underlying  security’s  price.  Ofcourse,  there  are  other  variables  that  can  impact  an  option’s  value,but the main component is the price of the underlying. It is easy tocreate a risk graph for simple strategies like long calls and long puts,but more complicated strategies might require the use of a computerprogram to view a correct risk graph.
4. The best investments will have an opportunity for ______________ withacceptable risk and a high probability of winning on a consistent basis.Answer: A—High reward.Discussion: It wouldn’t make sense for a trader to enter a trade thathas  a  loss  potential  of  $5,000  when  the  maximum  reward  is  just$1,000—that is, unless the probability of success is very high. This is thevery  reason  why  we  do  not  suggest  naked  option  strategies,  as  thesetrades are extremely high risk and offer only a small reward. Though
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they  have  a  high  probability  of  success  in  most  cases,  the  one  timewhen the trade goes against you can ruin your entire trading account.
5. True  or  False:  If  you  do  not  have  the  time  to  sit  in  front  of  a computer  day  in,  day  out,  then  your  best  investments  will  be  daytrades.Answer: False.Discussion: Day trading requires the attention of a trader on a minute-by-minute basis. This obviously wouldn’t be appropriate for a profes-sional who trades only occasionally. Before entering a trade, a tradershould look at the time needed to manage the trade. If this time com-mitment can’t be made, move on to a trade that can be handled in thetime you have available.
6. Your  risk  tolerance 
level 
is  directly  proportional  to  your
______________.Answer: D – Available investment capital.Discussion: Though there are traders with large accounts who havevery low risk tolerances, normally the amount of capital available isthe largest determinant for a trader’s risk tolerance. When trading op-tions and individual stocks and futures, we should never use moneywe can’t afford to lose. Though we don’t plan on losing the money, ifwe can’t afford to lose it our emotions will take control of our trading.
7. Name a few investment objectives.
Answer: Interest  income,  tax-free  government  securities,  capitalgains.Discussion: Most traders view their main investing objective as mak-ing money. However, this has many meanings depending on the traderand his or her situation in life. Older individuals who are in retirementmight  be  concentrating  mainly  on  income.  Others  might  have  taxproblems that require a large amount of money to be placed in govern-ment securities. Even traders looking for capital gains should have anunderstanding of how their trades will be impacted by taxes.
MEDIA ASSIGNMENT
Setting  up  a  trading  journal  will  be  a  real  eye-opener.  By  reading  backthrough your thoughts and feelings during a trade, you’ll learn a lot aboutyour state of mind and how controlled you may be by emotion. Not only
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should you keep track of the details of a trade, but write down these feel-ings and review them consistently. By looking back on past trades, you cangain a better understanding of what you did right and what went wrong.
VOCABULARY DEFINITIONS
Bear market: A declining stock market over a prolonged period, usuallylasting at least six months and normally not more than 18 months. Usuallycaused by a conviction that a weak economy will produce depressed cor-porate proﬁts. Also, a market in which prices of a certain group of securi-ties are falling or are expected to fall.Bull market: A rising stock market over a prolonged period, usually last-ing  at  least  six  months  and  normally  not  more  than  18  months.  Usuallycaused by a conviction that a strong economy will produce increased cor-porate proﬁts. Also, a market in which prices of a certain group of securi-ties are rising or are expected to rise.Capital: The  amount  of  money  you  have  invested.  When  your  investingobjective  is  capital  preservation,  your  priority  is  to  try  not  to  lose  anymoney.  When  your  objective  is  capital  growth,  your  priority  is  to  try  tomake your initial investment grow in value. Capital also refers to accumu-lated money or goods available for use in producing more money or goods.Capital gains: The proﬁt realized when a capital asset is sold for a higherprice  than  the  purchase  price.  Your  costs  (when  you  buy)  include  thecommission  you  paid  your  broker  and  are  deducted  from  the  proceedswhen you sell.Interest income: A type of income generated from interest-bearing secu-rities. The closer to retirement a person gets, the more important interestincome  usually  becomes.  Government  bonds  and  high-dividend-payingstocks provide this type of income.Price-earnings (P/E) ratio: A tool for comparing the prices of differentcommon stocks by assessing how much the market is willing to pay fora  share  of  each  corporation’s  earnings.  It  is  calculated  by  dividing  thecurrent market price of a stock by the earnings per share.
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CHAPTER 17
How to SpotExplosiveOpportunities
SUMMARY
No two traders are exactly alike. Some, like stock investors, spend a lotof  time  studying  individual  companies,  earnings  reports,  or  ﬁnancialstatements. Others, like currency traders, are more focused on economictrends,  interest  rates,  and  geopolitical  events.  Still  others,  such  as  fu-tures traders, are often more focused on charts and graphs. One methodis  not  better  than  any  other,  but  you  will  ﬁnd  that  many  successfultraders specialize in one approach and become experts in that particularﬁeld of study.
In  this  chapter,  the  reader  is  introduced  to  a  wide  variety  of  meth-ods—including fundamental, technical, and sentiment analysis—that canbe  used  to  help  locate  proﬁtable  trading  opportunities.  Readers  are  alsoencouraged to use various media sources, including The Wall Street Jour-nal,  Investor’s  Business  Daily,  and  CNBC.  In  addition,  a  few  informaltechniques—from  using  the  contrarian  approach  to  critiquing  productsyou own, as well as some effective stock indicators—are explored.
QUESTIONS AND EXERCISES
1. What are the two general forms of market analysis?
1. _________________________________________________________
2. _________________________________________________________
194
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2. ______________ analysis is primarily concerned with the underlying
factors of supply and demand regarding a stock or commodity.
A. Fundamental.
B. Technical.
C. Sentiment.
3. Name some factors of fundamental analysis.
____________________________________________________________
____________________________________________________________
4. ______________ analysis is primarily concerned with statistics gener-
ated by market activity and the resulting patterns and trends.
A. Fundamental.
B. Technical.
C. Sentiment.
5. Name two common tools of technical analysis.
1. _________________________________________________________
2. _________________________________________________________
6. ______________, probably the simplest and most widely used techni-cal  tool,  calculate  price  action  over  a  speciﬁed  period  of  time  as  amean or average.
A. Technical charts.
B. Moving averages.
C. Momentum indicators.
D. Contrarian approaches.
7. A ______________ utilizes price and volume statistics for predictingthe strength or weakness of a current market and any overbought oroversold conditions.
A. Technical chart.
B. Moving average.
C. Momentum indicator.
D. Contrarian approach.
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8.
______________ analysis is primarily concerned with the nature andimpact of crowd psychology on ﬁnancial markets.
A. Fundamental.
B. Technical.
C. Sentiment.
9. Name some tools of sentiment analysis.
____________________________________________________________
____________________________________________________________
10.
If you use  ______________, you will be trading against the majorityview of the marketplace.
A. Charting techniques.
B. Moving averages.
C. Momentum indicators.
D. The contrarian approach.
11. True  or  False:  Fundamental  and  technical  analysis  are  mutually 
exclusive—traders should learn to use one or the other.
12. By studying the daily reactions of speciﬁc markets to  ______________,you  can  begin  to  forecast  which  strategy  can  be  used  to  make  thelargest potential proﬁt.
A.
Interest rates.
B. Seasonal changes.
C. Government reports.
D. All of the above.
13. Name  three  ways  you  can  spot  potentially  proﬁtable  investments
when shopping in a retail store.
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
14. Name four ways to spot potential investments in your everyday life.
1. _________________________________________________________
2. _________________________________________________________
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3. _________________________________________________________
4. _________________________________________________________
15. Data service providers can relay information in which three ways?
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
16. True  or  False:  If  you  are  going  to  sit  in  front  of  a  computer  all  day
long, then you don’t really need real-time feeds.
17. ______________ was born from the Financial News Network (FNN),
which was watched widely by the investment community.
A. CNN Business.
B. CNBC.
C. CBS.
D. FOX.
18. The  best  investments  have  ______________,  which  should  be  moni-
tored over both a short and a long period of time.
A. Cheap options.
B. Low margin.
C. Momentum.
D. Low volatility.
19. An  increase  in  a  stock’s  ______________  signals  movement  and  a
good opportunity for investment.
A. Price.
B. Volume.
C. Perceived risk.
D. All of the above.
20. The  best  investments  have  a  reasonable  ______________  relative  to
the industry average.
A. Settle.
B. Yield and percent.
C. P/E.
D. Open interest.
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21. Name six ways to spot potential proﬁt-making stock opportunities.
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
4. _________________________________________________________
5. _________________________________________________________
6. _________________________________________________________
22. A low-priced market trades for less than ______________.
A. $10.
B. $20.
C. $30.
D. $50.
23. Why is it easier to make money on low-priced markets?
A. You can make a high return much faster.
B. You have less invested to lose.
C. You can play more stocks with less money.
D. All of the above.
24. The theory behind ______________, the basis of a mutual fund, is thata larger group of stocks will even out the chances of winning in thelong run.
A. Diversiﬁcation.
B. A broad portfolio.
C. Both A and B.
D. None of the above.
25. Momentum  investors  are  much  more  ______________  oriented  than
mutual fund investors or money managers.
A. Short-term.
B. Long-term.
C. Volatility.
D. Proﬁt.
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26. A long-term indicator of momentum can be measured by looking for a
change in price of a stock over the previous ______________.
A. 15 days.
B. 30 days.
C. 60 days.
D. 90 days.
E. Both A and B.
F. Both C and D.
27.
If  a  stock  has  increased  or  decreased  in  price  more  than______________  since  yesterday,  this  can  be  used  to  indicate  a momentum investment.
A. 5 percent.
B. 10 percent.
C. 15 percent.
D. 20 percent.
28.
If a stock trades less than ______________ shares daily, try to avoid itin short-term trading.
A. 100,000.
B. 300,000.
C. 500,000.
D. 1,000,000.
29. To apply the contrarian approach, look at the ______________ list toﬁnd stocks that have made major moves down (50 percent or greater)and then look for a rebound.
A. Price Percentage Gainers.
B. Price Percentage Losers.
C. Volume Percentage Leaders.
D. Lifetime High and Low.
30. The blow-off bottom may have occurred when a stock is coming off a
new ______________.
A. High price with high volume.
B. High price with low volume.
C. Low price with high volume.
D. Low price with low volume.
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MEDIA ASSIGNMENT
The  purpose  of  this  media  assignment  is  to  ﬁnd  a  reliable  source  forstock  charts  and  indicators.  There  are  a  number  of  ways  to  do  so.  Anumber  of  web  sites  offer  stock  charting  capabilities—including  the Interactive  Wall  Street  Journal,  Bloomberg.com,  Stockcharts.com,BigCharts.com,  Optionetics.com,  and  a  host  of  others.  If  you  have  abrokerage  account,  your  ﬁrm  might  also  offer  real-time  charts.  Sub-scriptions  to  more  advanced  charting  programs  such  as  TradeStation,eSignal,  and  ProﬁtSource  sometimes  make  sense  for  more  activetraders who are looking for more sophisticated charting tools.
Whether using free trading capabilities online or using a more sophis-ticated software package, readers will want to begin reviewing charts on aregular basis. The ﬁrst step is to select a small number of stocks that areactively  traded.  Look  at  the  graphs  over  different  time  frames—daily,weekly, monthly. Understand that a trend can easily go from an uptrend toa downtrend depending on the time frame used in a chart. For example,what appears to be an uptrend on a daily chart could well be a downtrendon the monthly chart.
Next,  apply  indicators.  Some  important  indicators  have  been  dis-cussed  throughout  the  chapter.  Moving  average  convergence/divergence(MACD), Bollinger bands, and Elliott Wave analysis are examples of com-mon  indicators  that  can  be  applied  to  charts  using  almost  any  softwareprogram  or  web-based  charting  tools.  Look  at  a  number  of  differentstocks  and  consider  how  various  indicators  can  help  identify  turningpoints in different situations. In conclusion, readers should begin chartingstocks and applying indicators. Doing so provides a quick and easy way tosee the price action and technical trends of a stock or index.
VOCABULARY LIST
Bar chart
Blow-off bottom
Blow-off top
Capitulation
Contrarian
Data feed
Diversiﬁcation
Fund manager
Fundamental analysis
Momentum
Moving average
Moving averageconvergence/divergence (MACD)
Mutual fund
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On balance volume (OBV)
Sentiment analysis
Price-to-earnings ratio (P/E)
Technical analysis
Real-time data
Seasonal patterns
SOLUTIONS
Volume
1. What are the two general forms of market analysis?
Answer: Fundamental analysis and technical analysis.Discussion: Technical analysts rely heavily on charts, volume infor-mation, and trends. Fundamental analysts are more concerned withthe company or the industry. So, instead of looking at charts, the fun-damental analysts will spend more time with news releases, earningsreports, and other ﬁnancial statements.
2. ______________ analysis is primarily concerned with the underlying
factors of supply and demand regarding a stock or commodity.Answer: B—Technical.Discussion: Technical analysts will look at a chart along with volumeinformation to study the balance of supply and demand with respect toa speciﬁc stock or commodity. Technical analysis is based on the theorythat market prices display repetitive patterns that can be tracked andused to forecast future price movement.
3. Name some factors of fundamental analysis.
Answer: Products,  customers,  consumption,  proﬁt  outlook, management strength, supply and demand with regard to outputs,and economic data.Discussion: Fundamental analysts are concerned with the proﬁtabil-ity  of  a  company  or  industry.  Often,  the  focus  will  be  on  hard  factssuch as earnings, market share, and growth rates. The ultimate objec-tive is to determine whether the market price of the stock or commod-ity reﬂects its true value. If the market price is too high, then it wouldmake sense to sell short the investment. If the price in the market istoo low relative to the true value of the company or investment, the in-vestor may want to buy the asset or place a bullish options strategy.
4. ______________ analysis is primarily concerned with statistics gener-
ated by market activity and the resulting patterns and trends.Answer: B—Technical.
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Discussion: Technical analysts want to determine if the buying pres-sure or selling pressure is increasing relative to a speciﬁc stock or in-vestment. When buyers are gaining greater control, prices are likelyto rise. When sellers seize control, prices will fall. Statistics based onmarket  activity  along  with  patterns  or  trends  can  help  determinerelative levels of buying and selling pressure.
5. Name two common tools of technical analysis.
Answer: Moving average and momentum indicator.Discussion: Moving  averages  and  momentum  indicators  areamong the more commonly used technical indicators, but there aremany more.
6. ______________, probably the simplest and most widely used techni-cal  tool,  calculate  price  action  over  a  speciﬁed  period  of  time  as  amean or average.Answer: B—Moving averages.Discussion: A moving average is the average of a given amount ofdata  plotted  on  a  stock  chart  using  different  time  frames.  For  ex-ample,  a  14-day  average  of  closing  prices  is  calculated  by  addingthe last 14 closes and dividing that number by 14. This simple toolis an easy way to see long-term trends and identify areas of supportor resistance.
7. A ______________ utilizes price and volume statistics for predictingthe strength or weakness of a current market and any overbought oroversold conditions.Answer: C—Momentum indicator.Discussion: Momentum trading is the practice of buying or selling aninvestment based on its price trend. For instance, if a stock has beenmoving higher on heavy volume for a considerable period of time, itis said to have strong upward momentum. Momentum traders will at-tempt to proﬁt from this inertia by purchasing that stock during theupward move.
8. ______________ analysis is primarily concerned with the nature and
impact of crowd psychology on ﬁnancial markets.Answer: C—Sentiment.Discussion: Sentiment  analysis  gauges  investor  sentiment  by  ana-lyzing  the  group  consciousness  of  the  marketplace,  using  various
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market criteria that deﬁne the market’s “state of mind.” The goal is todetermine if investors, or “the crowd,” are bullish or bearish towardthe  market.  When  studying  market  sentiment,  the  technical  analystgenerally  takes  a  contrarian  approach.  That  is,  if  investors  are  pre-dominantly bullish, the analyst will be bearish (sell stocks). If, on theother  hand,  the  crowd  is  bearish,  the  analyst  will  turn  bullish  (buystocks).  Examples  of  indicators  used  in  sentiment  analysis  includethe  following:  survey  of  newsletter  writers,  amount  of  margin  debt,and mutual fund cash levels. The interpretation of these criteria, how-ever,  is  subjective.  Luckily,  market  analysts  do  agree  that  certainmeasurements  strongly  suggest  a  predominantly  bullish  or  bearishtone to the market, but sentiment analysis requires the combinationand interpretation of several measurements to reach a conclusion.
9. Name some tools of sentiment analysis.
Answer: Volatility Index (VIX), VXN, put/call ratios, advisor sentiment,conﬁdence index, odd-lot short sales, mutual fund liquid assets ratio,short  interest  ratio,  over-the-counter  (OTC)  relative  volume,  marketP/E ratio, and the Dow Jones Industrial Average dividend yield.Discussion: A  wide  variety  of  sentiment  indicators  exists  fortraders  to  explore.  Two  of  the  most  popular  include  the  VolatilityIndex  (VIX)  and  put/call  ratios.  VIX  reﬂects  the  implied  volatilityand premium paid for SPX options and can rise dramatically duringperiods  of  uncertainty  as  investors  scramble  to  hedge  portfolioswith SPX puts. VIX tends to stay within a range for long periods ofmonths or years. When the VIX either exceeds or drops below thisrange, a mood of either pessimism (a high VIX) or optimism (a lowVIX) prevails.
Put/call  ratios  are  used  as  a  contrary  indicator.  Since  calls  makemoney when shares or indexes rise, they often represent bullish betson  the  part  of  investors.  Conversely,  puts  increase  in  value  when  astock  or  index  moves  lower  and,  therefore,  reﬂect  bearish  bets.Again,  studying  put/call  ratios  is  an  exercise  in  contrary  thinking.Speciﬁcally, if most market participants (the crowd) are buying puts,it  is  a  sign  of  negative  sentiment  and  reason  to  turn  bullish.  Con-versely, a low put/call ratio is interpreted as a market negative sincethe crowd is excessively bullish, but probably wrong.
10.
If  you  use  ______________,  you  will  be  trading  against  the  majorityview of the marketplace.Answer: D—The contrarian approach.
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Discussion: Contrarians bet against the crowd. The idea is that themajority of investors can’t be correct all of the time. When the major-ity view becomes too one-sided, it pays to bet against that view. Thus,the contrarian investor does the opposite of what the general consen-sus may be. Even though this may sound suicidal, time has repeatedlyproven this strategy’s wisdom.
11. True  or  False:  Fundamental  and  technical  analysis  are  mutually 
exclusive—traders should learn to use one or the other.Answer: False.Discussion: Many successful traders use a combination of technicaland fundamental analysis. In general terms, fundamental analysis isthe  study  of  the  company  and  technical  analysis  is  the  study  of  thestock price. As a trader, use what works for you.
12.