, because a move in the priceof a stock will typically have a magniﬁed effect on the price of the op-tions.  This  magniﬁcation  is  due  to  a  number  of  factors,  including  theleverage  the  options  provide  you.  Therefore,  it’s  a  lot  easier  to  make  a100  percent  return  on  your  money  using  options  on  stocks  (as  well  asoptions on futures). However, I have to caution you: It is also easier tolose  100  percent  of  your  investment  with  options.  If  you  want  to  tradeoptions,  never  underestimate  how  important  it  is  to  keep  learning  asmuch as you can about them.
Look for Price Increases or Decreases of More Than 20 Percent in the Past 60 Days
Momentum creates opportunities for both buying and selling. Momentuminvestors  are  very  widespread;  however,  they  are  a  very  ﬁckle  group.When a stock (or future) gains momentum and then starts to lose momen-tum, there is usually a ﬂurry of activity to take the market in the other di-rection.  I  like  to  invest  when  the  momentum  is  strengthening  orweakening, because these are the best short-term opportunities and theyoften create longer-term opportunities.
Momentum  investors  are  much  shorter-term-oriented  than  mutualfund investors or money managers. A momentum investor may be lookingfor momentum over the next few seconds, minutes, days, weeks, or evenmonths. This creates many different time frames in which investors andtraders  are  viewing  the  markets.  When  a  market  starts  to  move  quickly,then all these players may jump aboard. The momentum may last, but usu-ally, on a short-term basis, prices will reverse as investors become disap-pointed when the market dies.
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How do I measure momentum? I look for a change in the price of thestock over the previous 60 or 90 days. I use this as my long-term indicator.If I am building a longer-term portfolio of stocks, I want stocks that areshowing a minimum of 60-day strength.
As previously mentioned, many technical analysts use momentum in-dicators. These indicators are very speciﬁc. They might show the changein  stock  price  relative  to  a  set  prior  period  (i.e.,  ﬁve  minutes,  one  day,etc.).  Perhaps  they  use  a  moving  average  to  locate  a  change  in  momen-tum. When the current price moves below the moving average, they sell;when it moves above, they buy.
Look for Price Increases or Decreases of More Than 30 Percent since Yesterday
This  is  the  most  important  indicator  I  use  for  momentum  investments.The  30  percent  rule  is  the  minimum.  I  prefer  a  much  higher  number  toshow even stronger momentum. Typically, the higher the percentage, thestronger the momentum. How does this work? You can either look at theprice  percentage  gainers  and  losers  lists  from  the  newspapers  or  checkout our web site to access this information from your computer terminal.If  you  are  receiving  real-time  or  delayed  quotes,  then  you  can  get  thisinformation from your data feeds during the day.
When I look at the lists, I look for the stocks that have gone up themost in price over the previous day’s closing price—the basis for the per-centage gain or loss. However, it is important to note that stocks with thehighest percentages do not necessarily have the most interest or momen-tum. Sometimes a stock that was trading for only $1 moves up to $1.75. Al-though that’s a 75 percent increase, it doesn’t always mean high proﬁts.
In order to get a better understanding of a stock’s proﬁtability, I alsolook at price range and trading volume. I typically trade only stocks start-ing at $5; however, sometimes I do trade lower-priced stocks if they showsigniﬁcant trading volume. Generally, I trade stocks that have increased involume  signiﬁcantly.  If  a  stock  trades  less  than  300,000  shares  a  day,  Iavoid it. Maybe it will make a move, but there is not enough interest fromother investors for me to believe the trade will be proﬁtable. I like to seemore than one million shares trading. This shows commitment on the partof  the  investors.  Once  again,  the  more  volume  the  better.  When  buyingshares, I want them to be on the price percentage gainers list.
I consult the price percentage losers list to ﬁnd shares that have mademajor moves down (30 percent or more) and then look for a rebound. Thisis when I ﬁnd buying opportunities. This may sound strange, as most in-vestors may think this shows more weakness coming, but remember that Ilike the contrarian approach. Also, understand that when a stock moves
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so far down so fast there is usually negative news regarding the company.Perhaps  the  quarterly  ﬁnancial  results  are  disappointing  Wall  Street,  orthe company has presented information that future earnings will be disap-pointing. Most importantly, this usually creates a panic and what is calleda blow-off bottom. This means that the fast move down has made everypotential seller panic. After the sellers have all sold, buyers tend to pro-duce a rebound.
How often does this occur? Sometimes on a daily basis I ﬁnd at leastone stock that has dropped at least 30 percent (50 percent or more is evenbetter).  These  declines  appear  to  come  in  spurts,  especially  around  thetime in each ﬁscal quarter when companies are reporting earnings. Whenthe market opens, I watch these shares closely and wait for them to startgaining momentum to the upside before buying. I wait for a movement ofat least a 20 percent price move off the lows, with heavy volume of at least300,000 shares. I like to see large blocks (5,000 shares or more) increasing,as this shows the institutions are buying.
When this scenario occurs, I look to buy the shares, but prefer to buythe  call  options  (if  there  are  options  available).  Remember,  I  get  moreleverage with options and also have the beneﬁt of limited risk. All I canlose is the amount I paid for the options.
Let’s  take  an  example  of  a  trade  using  SyQuest  Technology,  Inc.SyQuest’s stock price was increasing on heavier-than-average volume andhad an average daily volume of around 200,000 shares. One day, the stockprice  moved  from  $5  to  $6  (a  20  percent  increase)  on  volume  of  morethan  1  million  shares  trading.  This  was  an  obvious  clue  that  somethingwas happening that was creating a great deal of interest. I contacted mybroker to see if there was any news to account for this movement. Therewas none. The shares price had been much higher before dipping to tradejust around $5 for the past few months. I considered buying it. However,2,000 shares would cost me $12,000 (2,000 × 6 = $12,000). Instead, I de-cided to buy the 7.50 (strike price) call options at .875 each, making surethere was plenty of time left to expiration. I prefer to buy options with atleast  three  months  remaining,  especially  on  momentum  investments.Thus, I paid $87.50 for each option representing control of 100 shares ofstock.  In  comparison,  buying  100  shares  of  the  stock  would  have  cost$6,000.
Although the options did not represent the shares on a one-to-one ba-sis, any move up in the price of the shares would double the value of theoptions quickly. Approximately four days later, the shares had doubled invalue  (a  100  percent  move).  This  enabled  me  to  sell  each  option  for$537.50—a proﬁt of $450 per option. My choice to buy call options insteadof  purchasing  the  shares  straight  out  led  to  a  500  percent  return  in  justfour days!
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Let’s review this trade:
Trade Initiation
Current stock price:Previous stock close:Percent increase:Average daily trading volume:Most recent day’s volume:Margin required:Option price:
$6 per share$520 percent200,000 shares1,000,000+ sharesZero (cost of options)$87.50
Note: I used a 20 percent rule in this example due to the dramatic
increase in trading volume.
Trade Closing
Shares price:Option price:Shares price up:Option price up:
$12$537.50100 percent500+ percent
This simple technique can provide you with proﬁts greater than you
ever imagined could be made in such a short period of time.
Look for Shares Reaching New Highs or Coming Off New Lows
When  used  in  conjunction  with  lists  of  price  percentage  gainers  andlosers, this is one of the most powerful indicators. When a stock is on oneof the gainers lists and it’s making new highs as calculated over the previ-ous 52 weeks, then it may be a buy (especially if it’s making new historicalhighs). Also, when the stock has made new lows and is coming off newlows, the blow-off bottom may have occurred.
Buy a Small Number of Shares or Contracts
Until  you  have  the  experience  to  make  money  consistently  in  the  mar-kets,  start  off  as  a  small  investor.  Regardless  of  whether  you  have  athousand  dollars  or  a  million,  until  you  really  understand  what  you’redoing,  you’ll  be  much  better  off  with  small  investments.  How  small  issmall? This question is virtually impossible to answer. Just be cautiouswhen you start out, until such time as you are a consistent winner. Thenbuild up slowly.
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Build Your Conﬁdence
It  is  important  to  earn  your  conﬁdence  through  winning  investments.However, be vigilant that you do not build a false sense of conﬁdence. Al-though  I  have  been  investing  for  many  years,  I  still  spend  considerabletime ﬁguring out ways to improve my trading. If you develop a sense oftemperate  conﬁdence,  you  will  most  likely  be  a  survivor.  That  meansyou’ll actually be around to enjoy the beneﬁts of this business.
Often,  when  a  trader  starts  to  make  a  little  money  in  the  markets,  afalse sense of conﬁdence drives them to make much bigger trades. This is abig mistake. As they say on Wall Street, “Pigs get fat, hogs get slaughtered.”
When You Make a Good Return, Sell
What  is  a  good  return?  Every  trader  or  investor  will  probably  tell  yousomething different. I like to make 100 percent on my money when trad-ing stock options, and a minimum of 20 percent when making commoditytrades. With stocks you usually have to settle for a lower return (10+ per-cent). These are the numbers I use based on my experience with winningtrades;  however,  these  are  benchmarks,  not  hard-and-fast  rules.  My  exitstrategies are usually based on momentum shifts, which means that someof my trades have returns much higher than 100 percent.
I  also  have  losing  trades  (nobody’s  perfect).  However,  a  disciplinedtrader will get out of losing trades quickly and learn how to stay with thewinners.  It’s  very  much  like  being  a  surfer  waiting  for  the  big  wave.  Awave  might  approach  that  has  the  characteristics  of  a  winner  but  thenstarts to look like a loser. Instead of wasting time riding the loser to shore,the experienced surfer will get off that wave and look for another oppor-tunity. You too are looking for the big winners. So don’t forget to get out ofthe  losers  quickly  so  that  you  can  use  your  capital  in  the  most  efﬁcientmanner possible.
CONCLUSION
Proﬁtable trading opportunities come from an inﬁnite number of sources.The trick is to foster the growth of your own personal trading antennaethrough cultivating a variety of sources. Remember, you will never have asmuch time as you would like to study the markets. You have to use yourtime efﬁciently to ﬁnd the best possibilities for proﬁtable trades.
In  many  ways,  the  maxim  “in  on  greed,  out  on  fear”  captures  theessence of traditional trading methodologies by cutting through the hypeand complexity that drives market momentum. This emotional motivation
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sets up quite a paradox. On the one hand, trading appears to be a very drybusiness. However, the emotions of hope and fear impel traders to placetrades and exit them creating erratic market swings. These swings can bedevastating  to  traders  who  simply  buy  stocks  hoping  prices  will  rise.  Infact, directional traders are always at risk of losing money when marketsreverse course in the middle of a trend. That’s because directional trendsdepend on trader optimism—as unlikely a source for stability as you canﬁnd, especially these days.
As sellers scramble to exit a market, fear drives prices down until anew low inspires buyers to get involved again. This cycle feeds on itself—winners and losers trading back and forth at the whim of human emotion.Meanwhile, thousands of analysts spend countless hours poring over fun-damental, technical, and sentiment data looking for clues to price move-ment. Analyzing markets can be overwhelming, especially to traders whoare just getting their feet wet for the ﬁrst time.
To trade successfully, it is essential to develop comprehensive marketinsight and the moral conviction to stand strong against the mass psychol-ogy that drives market behavior. Market insight comes from studying mar-ket  movement  and  a  certain  familiarity  with  trading  strategies  that  takeadvantage of speciﬁc conditions. Market movement is an extremely com-plex subject. There seems to be an endless stream of directional analysistechniques.  Each  may  offer  a  piece  of  the  greater  puzzle—but  no  tech-nique holds all the answers.
Trading might as well be a foreign country to the uninitiated. It has itsown  language  and  its  own  customs.  It’s  up  to  you  to  ﬁnd  your  favoritehaunts  by  exploring  the  territory  and  ﬁnding  out  what  suits  you  best.  Iftechnical  analysis  feels  comfortable  and  ﬁts  in  with  the  rest  of  yourlifestyle,  then  read  all  you  can  about  it.  Trading  is  a  game  of  odds,  andthough no one can be 100 percent correct in their decisions, by using thedata  available  and  then  placing  hedged  positions,  traders  can  see  niceproﬁts without the risk of losing everything in their portfolios. Whateveryou  choose,  make  sure  you  dedicate  yourself  to  really  understanding  it.Familiarity may breed contempt, but when it comes to trading, familiaritybreeds prosperity.
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CHAPTER 18
Toolsof theTrade
O ptions  traders  today  have  a  wide  array  of  tools  at  their  disposal.
Thanks to the Internet and the proliferation of ﬁnance-related websites, a great deal of information is available at no cost at all. In addi-tion, many online brokerage ﬁrms today provide a large amount of research,information, and analytical tools to their customers. At the same time, soft-ware and premium services like Optionetics.com Platinum are available fora fee and can greatly speed up the decision making process. However, theabundance of tools and information can also be a double-edged sword whentraders  get  bogged  down  by  information  overload  and  subsequently  losesight of the real objective of options trading—making proﬁts.
In this chapter, we examine some of the tools traders use. Not all ofthem  are  necessary.  Some,  like  stock  charts,  may  seem  essential;  but  anumber  of  successful  traders  can  even  get  by  without  those.  So,  whenreading  through  this  chapter,  and  learning  about  some  of  the  featuredtools of the trade, keep in mind that not all of them are absolutely neces-sary. Instead, think of them as shortcuts that are designed to make yourtrading life a great deal easier.
WHAT YOU REALLY NEED TO KNOW
Successful  options  trading  requires  a  certain  level  of  knowledge  that  isgenerally  not  taught  in  schools  or  universities.  Options  traders  shouldknow  the  basics  of  the  stock  market  like  understanding  stock  symbols,quotes, placing orders, and the factors that cause prices to rise and fall. In
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addition, traders should also understand options basics like the differencebetween puts and calls, the relationship between the strike price of an op-tion and the price of the underlying asset, the impact of time decay, expira-tion dates, and the difference between opening and closing transactions. Inshort, trading options requires a basic understanding of how the stock andoptions markets function. The ﬁrst few chapters of this book should havehelped you to develop such an understanding.
In addition to this book, a visit to the library or a bookstore can helptraders acquire a basic knowledge of options trading. A visit to the local li-brary  will  produce  hundreds  of  books  on  the  stock  market  and  optionstrading.  Watching  ﬁnancial  television  such  as  CNBC  during  the  day  andthe Nightly Business Report in the evening can help you get a better un-derstanding of the ﬁnancial markets. Doing a search on the Internet willyield thousands of free articles that cover the markets and trading strate-gies.  Optionetics  offers  free  trading  education,  brokerage  reviews,  arti-cles, commentary, and market data information on its web site.
Once  a  certain  foundation  of  trading  knowledge  has  been  attained,and an individual wants to begin trading, most brokerage ﬁrms will pro-vide  the  required  tools  including  the  ability  to  place  orders,  assistancefrom  a  broker,  and  price  quotes.  So  since  learning  the  essentials  of  op-tions trading can be done for a small cost, it is possible to become a suc-cessful options trader through self-learning.
While  much  of  the  information  and  tools  required  to  successfullytrade options is widely available at no cost, some products and servicescan increase the odds of success by making life easier. For example, at-tending a seminar can save an enormous amount of studying time by pro-viding  a  structured  set  of  courses  of  proven  strategies.  In  addition,students  can  ask  their  instructors  questions  directly  before,  during,  andafter the seminars.
Technology and the Internet have also helped immensely. When I startedteaching options trading strategies more than 10 years ago, most traders re-lied on magazines and newspapers to make trading decisions. More experi-enced  traders  knew  how  to  use  options  pricing  models,  the  Internet,  andcharting software, but the process of ﬁnding trades and creating risk graphswas extremely costly and time consuming. Today, a number of software pro-grams greatly simplify the process of creating hypothetical trades, viewingvariables  (such  as  implied  volatility,  delta,  and  theta),  and  creating  riskgraphs. Again, using computer software is not essential to trading success,but  it  greatly  simpliﬁes  the  decision-making  process—especially  astraders become more experienced and develop a greater need for moresophisticated information.
In order to determine what type of information they need, we encour-age new students to focus on one or two strategies and paper trade them
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until they feel comfortable enough to create trades with real money on theline. The initial ﬁrst step should be to develop a basic understanding of themarket and options trading. The fact that you have made it this far in thisbook indicates that you are, or already have, accomplished the ﬁrst step.From there, new students can begin creating hypothetical trades on paperusing one or two strategies. In the beginning, the goal should be to mastera small number of strategies. Don’t try to become a “jack-of-all-trades” tooquickly. Too many products and too many strategies in the early stages ofthis process can prove to be a distraction rather than an aid.
Stock  options  trading  in  the  United  States  began  in  the  early  1970s.Obviously, many of the tools and services that exist today were not avail-able to those early traders. So, if you are not sure what type of informa-tion you need, put yourself in their shoes for a few months. Rely almostexclusively on the resources available in your local library like Value LineInvestment  Survey, The  Wall  Street  Journal,  and  Investor’s  BusinessDaily. Do the math by hand and paper trade one or two strategies. Doingso will help you better understand the calculations and get a better feelfor how option prices change on a daily basis. From that point, you canuse an online portfolio service to track your paper trades. Paper tradingwill help you to understand which tools, products, and services you mightneed to foster consistent options trading success.
CHARTS
Technical traders rely heavily on charts and indicators. In today’s market,most of this is done with computers and trading software. We will examinesome of the software programs available to traders later in the chapter. Fornow,  let’s  examine  the  three  most  commonly  used  chart  types:  the  linechart, the open-high-low-close (OHLC), and Japanese candlesticks.
The simplest type of chart is the line chart. This type of chart is plottedusing only closing prices over a period of time. On the vertical axis, we havethe underlying asset’s price. The horizontal axis plots the time used—daily,weekly, monthly or annually. Figure 18.1 provides an example of a line chartusing the PHLX Bank Sector Index. When the graph moves higher, it tells usthat the bank index, which is an index consisting of 24 banks, is increasing inprice. When the chart moves lower, the BKW is losing value. Simple enough.The open-high-low-close (OHLC) chart (see Figure 18.2) is the one Iuse  most  often  and  is  a  common  way  of  viewing  the  performance  of  astock,  index,  or  futures  chart.  Also  known  as  the  range  bar  chart,  thegraph provides the technical analyst with a great deal more informationthan the line chart because it includes more than just the closing price.
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FIGURE 18.1 Line Chart (Source: Optionetics © 2004)
It is constructed using the high of the day and the low of the day, alongwith the closing price.
The chart shown in Figure 18.2 provides an example of an HLC for Mi-crosoft (MSFT). In this example, we have created a daily range bar chart,which  means  that  each  bar  (vertical  line)  represents  one  day  of  tradingdata.  The  length  of  the  bar,  or  the  highest  and  lowest  points,  reﬂect  thehigh and low prices of the stock on each day. When the bars are long, itsuggests that the stock traded in a wide range and when the vertical bar isshort, the stock traded in a narrow range. Finally, a small horizontal lineon the right side of each bar indicates the close, which is the last trade ofthe  day.  Some  charting  software  allows  traders  to  create  OHLC  charts,which include the opening price as well. In that case, the open appears asa small horizontal dash on the left side of the chart.
Each  OHLC  bar  gives  a  better  idea  of  whether  bulls  or  bears  are  incontrol of a stock or market. In a healthy advance, the bulls are ﬁrmly incontrol and driving prices higher. As evidence, the technical analyst wantsto see the stock closing near the highs of the day. This is easy to do withan OHLC chart. Recall that the right horizontal on each OHLC bar repre-sents  the  closing  price.  When  these  closing  lines  appear  near  the  top  ofeach vertical bar on the chart, it suggests that the bulls have the stock in
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FIGURE 18.2 High-Low-Close Bar Chart (Source: Optionetics © 2004)
control. However, when the bears seize a stock, the chartist is looking tosee if the stock is closing near the low price of the day. For example, onthe MSFT chart, during the decline in mid-October, the stock was ﬁnishingmost  trading  sessions  near  the  lows  of  the  day,  which  was  a  sign  thatbears were ﬁrmly in control of MSFT during that time.
The third type of chart that has become popular among traders is theJapanese candlestick chart. A candlestick is composed of two parts knownas the body and the shadows. The body represents the range between theopening and closing prices. The shadow is the thin vertical line that can pro-ject outward above or below the body and represents the full price rangefor the stock, index, or futures contract. As a result, if there were no pricesoutside the range of the open to close, then there would be no shadows.
If  the  market  closed  above  the  opening  price,  the  body  is  often  col-ored  green  or  left  blank  (white).  If  the  price  closes  below  the  openingprice,  the  body  is  colored  black  or  red.  The  colors  will  vary  from  one
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charting software package to the next, but green and red seem to be themost common. This color-coding of the body makes it easy to immediatelysee if the market closed above or below the opening price for the giventime period. An OHLC bar gives you the same information, but the color-coding  of  the  candlestick  bar  can  be  a  bit  more  convenient.  Figure  18.3provides an example of a six-month candlestick chart using Microsoft ren-dered in black, white, and grey.
CHARTS, VOLUME, AND VOLATILITY
A visual look at a chart can also give important information regarding astock’s volatility and, for that reason, it is extremely important to optiontraders. Since the length of each bar in an OHLC chart is determined bythe high and low prices of the day, short bars suggest that the stock is
Microsoft Corp
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FIGURE 18.3 Six-Month Candlestick Chart (Source: Optionetics © 2004)
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exhibiting low volatility. In that case, the trading ranges between the dailyhigh  and  low  prices  are  small.  On  the  other  hand,  when  the  bars  arelonger,  it  means  that  there  is  a  bigger  difference  between  the  highs  andlows of the day. Therefore, longer bars suggest greater vol