mutual fund, is thata larger group of stocks will even out the chances of winning in thelong run.Answer: C—Both A and B (diversification and a broad portfolio).Discussion: A mutual fund is a large pool of money that invests indifferent types of securities. For example, a stock mutual fund holdsa portfolio of stocks. The benefits are that mutual funds allow investors to spread their investments across a broad range of securitiesand therefore offer diversification.25. Momentum investors are much more ______________ oriented thanmutual fund investors or money managers.Answer: A—Short-term.Discussion: Momentum investing is an aggressive short-term trading style that is much more active than mutual fund investing. Itinvolves much short-term buying and selling. In most cases, mutualfund investors buy shares and hold those shares over the longterm.26. A long-term indicator of momentum can be measured by looking for achange in price of a stock over the previous ______________.Answer: F—Both C and D (60 and 90 days).Discussion: Technical analysts look at indicators over different timeframes, but 60 and 90 days are common for longer-term momentumindicators.
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27. If a stock has increased or decreased in price more than______________ since yesterday, this can be used to indicate a momentum investment.Answer: D—20 percent.Discussion: A rule of thumb when looking at daily price moves in astock is 20 percent. A gain of 20 percent or more suggests strongupward momentum. A decline of 20 percent or greater is a sign ofpowerful downside momentum.28. If a stock trades less than ______________ shares daily, try to avoid itin short-term trading.Answer: B—300,000.Discussion: Illiquid and thinly traded stocks rarely make suitable investments for short-term trading. Traders generally want to focus onstocks that see volume of 300,000 shares or more each day. Thegreater the volume, the better the stock for trading purposes.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.Answer: B—Price Percentage Losers.Discussion: Use the Price Percentage Losers list to find stocks thathave fallen too far, too fast. If a stock is down 50 percent or more,there is a strong chance that it is due to rebound. This would be acontrarian approach because it is betting against the momentum ofthe stock.30. The blow-off bottom may have occurred when a stock is coming off anew ______________.Answer: C—Low price with high volume.Discussion: Blow-off bottoms occur when a stock falls sharplyand investors panic. High volume is a sign that a blow-off has occurred. At that time, the stock will come off a low price and beginto move higher.
MEDIA ASSIGNMENTThe purpose of the latest media assignment is to find a source of stockcharts and perform some simple analysis. Recall that charts are really
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windows for viewing the past price patterns of stocks, futures, and indexes. They can provide quick information and, although chart reading isgenerally considered the domain of technical analysts, almost all investors use charts in one form or another. In addition, with today’s onlinecharting capabilities, applying indicators like moving averages is free,quick and simple. In the end, the reader should be able to:• Access stock charts.• Create daily, weekly, and monthly charts for stocks like IBM, ExxonMobil, and General Electric.• Create similar charts for the Dow Jones Industrial Average and theS&P 500.• Apply moving averages and other indicators.• Draw trend lines as well as identify support and resistance areas.
VOCABULARY DEFINITIONSBar chart: Sometimes called the open-high-low-close (OHLC) chart, itgraphs the open, high, low, and settlement prices for a specific tradingsession over a given period of time.Blow-off bottom: A sharp and dramatic fall in price accompanied byheavy trading volume. This often occurs when sellers have thrown inthe towel and the investment is due to head higher. It is also known ascapitulation.Blow-off top: A steep and rapid increase in price followed by a steep andrapid drop in price. This is an indicator seen in charts and used in technical analysis of stock price and market trends.Capitulation: When investors en masse have completely given up hopeon an investment or market. Capitulation often occurs on heavy, panictype selling, and is followed by a major advance in the investment or market. It is also known as a blow-off bottom.Contrarian: An investor who continually bets against the crowd. Thecontrarian believes that the majority of investors are wrong about the direction of a market or investment at major turning points and that therefore it pays to invest in a manner contrary to popular opinion.Data feed: An electronic source of information that delivers quotes,news, and other research to a user’s computer. Traders rely on data feedsto deliver current prices, news, and charts.
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Diversification: Spreading one’s assets across a wide variety of investments within a portfolio to minimize the impact of any one security onoverall portfolio performance and to reduce the overall risk.Fund manager: An individual responsible for the day-to-day investmentdecisions of a mutual fund. Fund managers often receive a performancebased incentive fee for handling the fund.Fundamental analysis: A type of investment analysis that focuses oncompany-specific facts from financial statements like the balance sheetand annual reports. Earnings, sales, assets, management, products, andmarkets are also considered important. This type of analysis is used to determine whether a stock or group of stocks is overvalued or undervaluedrelative to the current market price.Momentum: The tendency for the underlying asset to move in trends,higher or lower. As inertia takes hold, sometimes the move can begin toaccelerate. When this happens, the asset has strong price momentum.Moving average: Added to stock charts, these indicators represent average price over time. By averaging prices, the indicator can smooth or eliminate the fluctuations in data and assist in identifying trends.Moving average convergence/divergence (MACD): Created by GeraldAppel, MACD is a technical chart indicator based on moving averages. It appears on charts as two lines. Crossovers of these two lines generate buy andsell trading signals. Alternatively, some traders plot MACD as a histogram.Mutual fund: A pooled investment that holds a portfolio of securities. Investors can buy into the pool by purchasing shares. Mutual funds specialize in different types of investments—growth stocks, conservative stocks,bonds, and so on.On balance volume (OBV): A tool for viewing trends with respect tovolume. Developed by Joseph Granville, the indicator measures thebuying and selling pressure by looking at daily volume during a stock ormarket’s advance or decline. The math behind the indicator is straightforward. If a stock finishes the day higher, the volume is added to the runningtotal; but if a stock finishes the day lower, the day’s volume is subtracted.Traders want to see OBV moving in the same direction (confirming the existing direction).Price-earnings (P/E) ratio: The price of a stock divided by its annualearnings. Price-to-earnings ratios are often used to determine if a stock isunder- or overvalued.Real-time data: A source of information that is updated live and changesinstantaneously as prices change in the marketplace. Real-time data isusually provided for a fee.
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Seasonal patterns: A consistent but short-lived rise or drop in marketactivity that occurs due to predictable changes in climate or calendar.Sentiment analysis: The study of market psychology. The goal is to determine whether traders and investors are predominantly bullish or bearish toward the stock market. In general, analysts consider excessiveamounts of bullish sentiment to indicate short-term market tops. Highlevels of bearish sentiment often occur near market bottoms.Technical analysis: A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value.Volume: The amount of trading activity associated with a given securityduring a period of time. Stock volume is measured in shares, and options volume is based on number of contracts. In addition, volume canbe computed over different time frames, such as hours, days, weeks,months, or years.
CHAPTER 18
Toolsof theTrade
SUMMARYThis chapter discusses some of the tools available for the stock and options trader, including charts, software programs, seminars, and tradingweb sites. Option traders need to develop a working knowledge of technical, fundamental, and sentiment analysis, as well as understand how options work. Although studying books can help traders become moreknowledgeable, it often takes time and practice to successfully learn themore subtle details of trading.Although a new trader does not need to learn how to use every toolavailable, certain tools help flatten the learning curve. For example, theOptionetics web site has a number of free tools, including articles, charts,and option information. Other tools, like Optionetics Platinum, ProfitSource, and Advanced GET from eSignal, might also provide much neededhelp as you integrate options into your trading approach.This chapter provides a brief example of how these tools can beused to find explosive trading opportunities. If you are new to theoption trading game, then choose a few strategies that you feel willwork best for you and learn them inside and out. Too many traders get“analysis paralysis” when they try to use too many tools or technicalindicators to find a trade.
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QUESTIONS AND EXERCISES1. True or False: A trader can never use too many tools to make tradingdecisions.2. Name some of the tools that are available for the options trader.________________________________________________________________________________________________________________________3. True or False: A new trader should learn and implement everystrategy available.4. Which of the following are chart types used by traders of stocks andoptions?A. Line.B. Bar.C. Candlestick.D. All of the above.5. Name some of the tools the Optionetics Platinum site can provide fora trader.________________________________________________________________________________________________________________________
MEDIA ASSIGNMENTTake a free tour of the Optionetics web site, as well as the Platinum site.Optionetics.com is free of charge and has an abundance of articles andtools that can be accessed. Although Platinum has a fee, check out the 14day free trial to access the potentials of this innovative site. By viewingthese two sites, a trader can start to work with data that can be systematically gathered and used time and time again to make profits. Many tradershave a daily ritual of visiting the Optionetics web site to garner information about the options game from its staff of writers.
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VOCABULARY LISTBar chart
Put/call ratio
Candlestick chart
Volume
Line chart
SOLUTIONS1. True or False: A trader can never use too many tools to make tradingdecisions.Answer: False.Discussion: Though it is important to have various tools at your disposal, using too many can create confusion. When a trader becomesoverwhelmed with analysis tools, he or she may find it hard to decidewhich factors to follow, and that makes decision making tough.2. Name some of the tools that are available for the options trader.Answer: Internet sites, seminars, software programs, brokers andCNBC.Discussion: Some tools are free and some have a cost. Though manytraders have become successful without paying for extra services andtools, using these tools can often cut the learning curve down substantially. A carpenter could probably build a house with a hammerand handsaw, but it’s a lot easier to use more efficient tools.3. True or False: A new trader should learn and implement everystrategy available.Answer: False.Discussion: Though a new trader should gain a basic understandingof the various strategies available, it is best to narrow trading choicesdown to a few strategies. This way a trader can gain specializedknowledge that will create consistent profits rather than trying to bea jack-of-all-trades.4. Which of the following are chart types used by traders of stocksand options?Answer: D—All of the above (line, bar, candlestick).Discussion: Traders tend to form their own opinions of what chartswork best for them. Though line charts aren’t as popular as they once
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were, there still are traders who choose to use this simple charting tool.Bar charts and candlestick charts are the most popular styles used today because they paint a broader picture of the action of the stock.5. Name some of the tools the Optionetics Platinum site can provide fora trader.Answer: Stock charts, implied volatility charts, historic option data,option search tools, stock search tools and risk graphs.Discussion: Though a trader does not need Platinum to become successful, it definitely helps speed up the process. Platinum offers toolsthat enable traders to search through millions of single option orcombination trades in just a matter of seconds. It also provides riskgraph analysis of your own personal trades, implied volatility rankings tailored to any option you choose, a trade selection matrix thatallows you to match trades with your market preferences, access toeasy paper trading through portfolio management with nightly e-mailof profit/loss performance, and historical back-testing capabilities onoptions going back more than two and a half years.
MEDIA ASSIGNMENTThere are many web sites and books available that will provide information about trading options and stocks. The Optionetics site is one ofthese and is free, including a discussion board where traders can shareideas and ask questions. By studying the information available on theOptionetics site, you’ll become familiar with a variety of tools for yourtrading arsenal.Though it requires a fee, the Platinum site is a tool that many optionstraders say they simply cannot live without. The Platinum web site providesoption traders with a variety of powerful tools including:• End-of-day options price, volume, and open interest data for indexes,stocks, and futures.• End-of-day options Greeks for all puts and calls.• Option trade portfolio tracking and profit/loss calculations.• Implied and historical volatility information and charts.• Stock ranking tools.• Option search tools.• Extensive option analysis tools.• Complete back-testing of all trades and Platinum functions.
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Option trades can be saved online and named along with a text description. Trades can have any combination of stock options and longand short positions. Saved trades can be edited, copied, and sorted. Inaddition, end-of-day trade performance can be e-mailed each evening tothe trader. Option Greeks can be computed for the entire trade as wellas each leg, and online trade data can be transferred to other productslike Excel.Platinum offers powerful visual features by allowing the graphical analysis of profit-and-loss risk caused by stock price changes, Greek delta variations, and sensitivity to implied volatility changes. The trade probability ofprofit and most likely expected profit are also computed on a daily basis.Some of the key volatility variables and options data that can be plottedinclude implied volatility (IV), statistical volatility (SV), stock price, volume,put/call ratio, option skew charts, and IV/SV charts for many different timeframe combinations.The stock ranking and option search tools offer the user a high degreeof flexibility. Stocks can be ranked using up to 35 different ranking criteria. Many of the rankings are precomputed daily and put online for easyaccess. These rankings can be saved online in 10 user lists and can be accessed in other Platinum tool sets. The option-searching feature cansearch a single stock’s option chain for option trades as well as traversemultiple stocks in lists simultaneously. Multiple option trading strategiescan also be searched using a variety of different search parameters.Risk graphics of any trade can be computed for different criteria. Forback-testing tasks, the web site can operate at any trading date in the pasttwo and a half years. This includes all charts, option tables of data,searches, and risk graphics. In addition, users can enter trades in the pastand see how they have evolved to the present. As they enter these tradesthey have the ability to save them and close them out on their close date.I encourage those of you new to Platinum to try out the free tour toget a deeper understanding of the software’s capabilities. If you are a newuser and there is a feature you are confused about, be sure to utilize thecontext help facility, which is available on virtually every screen in thesystem. The Platinum site makes it easy to integrate these powerful toolsinto your own trading.
VOCABULARY DEFINITIONSBar chart: A chart that graphs the high, low, and settlement prices for a specific trading session over a given period of time. Also called an OHLC chart.Candlestick chart: A type of charting that uses a body and shadow foreach trading period. Like a bar chart, the open, close, high, and low pricesare found in each candlestick.
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Line chart: A type of chart that uses only the close of each period. Thistakes out much of the noise found in the daily movement, but these detailsare often important to a technical trader.Put/call ratio: The amount of puts traded on a security compared to theamount of calls. This is a contrarian indicator that helps traders find possible tops and bottoms for a stock or index.Volume: The amount of shares bought and sold on a stock exchange.
CHAPTER 19
FinalSummary
SUMMARYTraders are constantly bombarded with a multitude of ways to trade stocksand options, leaving many traders unsure of where to start. Optioneticsteaches that a systematic approach, used with discipline, can create solidtrading profits. Though options traders can benefit from directional strategies, traders can also profit without the need to predict market directionusing delta neutral strategies.In the beginning, new traders need to focus on learning just a couple ofthe strategies and master them. As your experience increases, along withyour success rate, you then can add a wider variety of strategies. Tradersneed to use proper risk management and money management, allowing limited mistakes to be made. Make sure you use only money that you can affordto lose. In addition, you should not invest all your trading capital at one time.This chapter provides a trading matrix that can be used to narrowdown the appropriate strategies given the level of implied volatility and atrader’s view for the stock. Options provide a number of strategies that canbe implemented in any type of market environment. However, it is up tothe trader to decide what strategies fit the given market scenario.This chapter also discusses the investing philosophies of some of themost successful investors throughout investing history. Though these investors looked more long-term for their trades, we can learn from their disciplined approaches and viewpoints. Diversification was a common theme,as was having a thorough understanding of the investment. The key to success in trading stocks or options is to take emotion out of the equation.218
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This may be tough to do; however, by choosing profit and loss exits aheadof time, emotions can be pushed aside when this selling point is reached.
QUESTIONS AND EXERCISES1.
How much time should a new trader take paper trading a new strategy?A. None—just jump right in with real money.B. One trade.C. One week.D. At least three months.
2. Using ______________, traders have the opportunity to maximizeprofits and make consistent returns without the need to predictmarket direction.A. Vertical spreads.B. Delta neutral strategies.C. Covered writes.D. Ratio spreads.3.
Ultimately, only ______________ can take care of your money.A. Your broker.B. A financial guru.C. You.D. The IRS.
4. A directional trader has to be right about which of the followingassessments?A. Direction.B. Magnitude of the move.C. Time frame of the move.D. All of the above.5. True or False: Understanding volatility is one of the most importantcomponents of becoming a successful options trader.6. Which one of the following strategies would not fit a scenario of lowvolatility with a bearish bias?A. Buy put.B. Bear put spread.
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C. Buy ITM call.D. Bull put spread.7. ______________ is merely another way of expressing a driving needfor perfectionism.A. Fear.B. Lying to yourself.C. Greed.D. Poverty consciousness.8. Which of the following is/are key for a trader to become successfultrading options?A. A bargain-hunting instinct with the ability to identify undervaluedand overvalued options.B. A sound and well-designed game plan that provides consistentaction over time and that prospers in all market conditions.C. The discipline to follow the game plan.D. All of the above.9. What are the three questions every trader should ask before gettinginto a trade?1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________
MEDIA ASSIGNMENTBy now you should have a good understanding of what is needed to become a successful options trader. Take the time to write down thethings you have learned from this book and review these discoveriesfrom time to time. In addition, choose a few strategies that have caughtyour interest and start paper trading them. If you haven’t already doneso, start a trading journal to track the details of each trade, as well as todocument your thoughts along the way. Hopefully, this book has provided some tangible insights about how to trade options successfully.Now it’s up to you to take these ideas and integrate them into your trading plan.
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SOLUTIONS1. How much time should a new trader take paper trading a new strategy?Answer: D—At least three months.Discussion: Each trader will have his or her own time frame that isneeded to paper trade a new strategy. However, most traders shouldspend at least three months testing a new strategy. A longer amount oftime might be necessary if a strong understanding of the strategy is notachieved within three months. Nonetheless, eventually a trader needsto bite the bullet and test these strategies with real money. The key is tostart small and build up the amount you trade as your expertise grows.2. Using ______________, traders have the opportunity to maximizeprofits and make consistent returns without the need to predictmarket direction.Answer: B—Delta neutral strategies.Discussion: Delta neutral strategies help take some of the guesswork out of trading options. Trading directional strategies can beprofitable, but the move must be large enough in the predicted direction and within a certain time period. The key to long-term success inthe options game is to make consistent returns. It’s nice to hit a homerun now and then, but the consistent base hitter tends to have thebest results all told. Delta neutral trading enables investors to makemoney regardless of market direction—a revolutionary approach intoday’s volatile markets.3. Ultimately, only ______________ can take care of your money.Answer: C—You.Discussion: Too many traders have found out that listening solely toa broker or financial guru is detrimental to their trading accounts’health. Though we can learn from brokers and various web sites andnewsletters, we are the only ones who really care about the successof our trading accounts. It might seem easier to rely on stock and option selections from someone else, but when things go wrong, youneed to take responsibility and learn from your mistakes.4. A directional trader has to be right about which of the followingassessments?Answer: D—All of the above (direction, magnitude of the move, timeframe of the move).Discussion: All three of these assessments need to be right in orderfor a directional trader to see profits. This doesn’t mean directional
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trading can’t be profitable, but delta neutral trades are often easierto profit from because they do not need to see a certain market direction. Ultimately, it is the disciplined traders who are successful,regardless of what strategies they implement.5. True or False: Understanding volatility is one of the most importantcomponents of becoming a successful options trader.Answer: True.Discussion: Too many new traders believe that their experience in thestock market will transfer over to success in trading options. Though itis important to have a basic understanding of the stock market, including technical and fundamental analysis, options do have additionalconcepts that need to be learned. Mainly, if we do not trade optionswith the appropriate implied volatility for the given strategy, losses canoccur even when our analysis of the underlying stock is correct.6. Which one of the following strategies would not fit a scenario of lowvolatility with a bearish bias?Answer: D—Bull put spread.Discussion: A bull put spread is a credit strategy that is bullish in nature. When volatility is low, we normally want to be the buyer of options. Though the bull put spread uses puts, it is a bullish strategy anddoes not fit a low-volatility market with a bearish bias. Any tradeshould be viewed in a risk graph before it is entered to get an idea ofwhat risks there are to the trade and if your expectations will createan appropriate profit.7. ______________ is merely another way of expressing a driving needfor perfectionism.Answer: C—Greed.Discussion: Perfection has become a driving standard for many people, given the high expectations and competitive nature of today’s society. However, perfection is impossible to achieve in the tradinggame. The successful trader is disciplined and unafraid to take a losswhen needed or to take a profit even if it isn’t at the apex of the possible gain. Option traders are going to have losses, even when they doeverything right. However, it is the disciplined trader who is able toget rid of the emotions of greed and fear who is successful.8. Which of the following is/are key for a trader to become successfultrading options?Answer: D—All of the above (a bargain-hunting instinct with theability to identify undervalued and overvalued options, a sound and
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well-designed game plan that provides consistent action over timeand that prospers in all market conditions, and the discipline to followthe game plan).Discussion: All three of these elements are key for traders if they wantto be successful. As a trader, you need to understand if an option is under- or overvalued in order to enter the best reward/risk trades. Youalso need to have a plan set up in advance, so that emotion does nothinder your decision making process. Finally, try to develop tradingdiscipline so that you have the courage to stick to your trading plan.9. What are the three questions every trader should ask before gettinginto a trade?Answer:1. What is the market entry?2. What is the profit exit?3. What is the loss exit?Discussion: Before you enter any trade, you should have a set entrypoint and exit based on profit and loss. Just like an airline flight attendant who tells passengers where the exits are before takeoff, a tradershould have a similar plan. Emotion is the major obstacle for bothnew and experienced traders, and having preset entry and exit pointshelps alleviate a large amount of emotion-based uncertainty.
FINAL WORDRegardless of whether you decide to trade stocks, futures, options, or allthree, there are certain characteristics that all successful traders possess. These attributes are very important for any trader to acquire if heor she wants to make it in this business over the long haul and continually bring in profits.The first characteristic and probably the most important is discipline.It is absolutely paramount that a trader has full control of his or her emotional state of mind to be successful at trading. Discipline allows the traderto be more objective and enhances the capacity to identify an opportunity.In addition, it provides the trader with the necessary confidence to refrainfrom taking action because many times traders feel they must always be involved in the markets. Knowing when to stay out is as important as knowing when to take advantage of an opportunity. This all requires self-control,discipline, and the courage to pull the trigger at the appropriate time.Next, a good trader needs to be persistent. This means a trader should
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never take losses personally. Instead a determined trader will attempt tolearn from prior mistakes and persist in developing successful trades.This is a fine line, however, because although it is important to learn frommistakes and admit when you are wrong, it is also important to knowwhen not to quit. This type of mentality is also vital when searching for atrading methodology best suited to your style.Patience is another critical attribute. Many times the trader must waitfor the right opportunity versus acting on the wrong ones. Since there aremany incorrect actions one can take in the market, it is important to waitfor the right opportunities. Many traders are fearful of missing somethingif they are not always in the market. The patient trader has the confidenceto wait for the correct opportunity to present itself.Another key attribute a good trader must possess is the ability tothink independently. Most successful people in any business are independent thinkers. This often requires going against the crowd and establishing a point of view different from the norm. This can be uncomfortable formany people. As a trader, it is important to filter out the opinions offriends, associates, and brokers. Trading strategies and the actual execution of trades involve a singleness of purpose and firm resolve. That iswhy it is so essential for a good trader to develop independent thinkingand avoid the herd mentality.Contrary thinking is also an important characteristic. People have ahard time going against the crowd. Cultivating the art of contrary thinking allows the trader to take actions that oppose the majority. This is important because (generally) the majority is wrong and public losses arecommonplace. So it is essential to be able to evaluate what the crowd isthinking and have the courage to take an independent approach to themarket. Contrary opinion will also help the trader avoid being trappedwhen panic takes hold of a market. In this way, a good trader will be ableto take advantage of the emotional extremes in the market and profitfrom them.Good traders must also be truthful with themselves and accuratelyassess their strengths and weaknesses. This is rarely easy and is sporadically done by most traders. However, recognizing the truth is a keyrequirement for achieving success as a trader. A good trader must continually engage in a process of self-reflection. Learning to take an honest inventory of your own motivations, priorities, and actions willenable you to accentuate your strengths and work on the weaknessesthat make you vulnerable in the market.A dedicated trader must be able to act quickly and flawlessly executehis or her trading plan. There is a clear and important distinction betweendeveloping a sense of urgency and acting impulsively. A good trader wantsto constantly pay attention and be poised to take action without being too
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spontaneous or whimsical. The market can move very fast at times, so it isimportant not to get overwhelmed by indecision and fear. Otherwise thetrader gets a sense of paralysis and no action will be taken. It is notenough to be in the right place at the right time; you must also be able totake correct action.These key attributes have to be part of a trader’s skill set for thetrader to be successful over the long term. I encourage you to review thepreceding paragraphs as your trading career progresses. Continually trying to improve in all these areas is a lifelong commitment. Your efforts aresure to be well rewarded in the form of future trading profits.Good luck and great trading!GEORGE A. FONTANILLSMiami Beach, FloridaDecember 2004
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