, surprising news only takes a few minutes to a fewhours to be digested. After that, the market goes back to its own moodsand undulations. For that reason, surprise news that moves the market ina direction that helps a short-term position you have on at the time can often be used as an exit opportunity.The market has a mind of its own. I once listened as two investorswith different viewpoints debated economic fundamentals. One, with abullish view, pointed out that interest rates have been reduced to very lowlevels, and historically that has always precipitated a bull market. Theother, with bearish leanings, countered that consumer debt had climbed torecord levels and would eventually cause consumer spending to slam intoa brick wall. The bull then argued that an aging population was continuingto pour dollars into retirement plans at a relentless pace, and that most ofthis ends up invested in stocks. Then the bear called attention to the plunging Japanese stock market and the tenuous situation of the Japanesebanks. On and on they argued, each one countering the other, back andforth. Fundamentalists can argue endlessly. Meanwhile, the market moveson, oblivious to both.Why did the market go down today? It went down because, on balance, several thousand more people needed to sell today than needed tobuy—for lots of different reasons. Add to that a few thousand others whowere waiting to sell but hoping for higher prices but, when they saw themarket dropping, caved in and sold today. Subtract from that several thousands of willing buyers whose price points were hit today. Mix in a fewdozen surprise news releases that caused some investors to make on-thespot buy or sell decisions. Finally, toss in the actions of tens of thousandsof short-term speculators. In the ﬁnal analysis, when you hear the newscaster give his or her reason why the market went down today, you canjust laugh.The markets have short, medium, and long-term trends. Thesecan be traded. From time to time the markets swing to incredible priceor volatility extremes and then return to sanity. Those are opportunitiesas well. Some believe that certain patterns, such as head-and-shoulderstops or double bottoms, are reliable to trade. I tend to agree. The reasonthese patterns exist is because of the well-known herding tendencies of
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investors. And speculative traders who use technical analysis probablyreinforce the patterns. Watch the markets and let them speak to you. Inthe end, the markets themselves are the ultimate authority.Approach the market as something to prepare for. If you do this,instead of rushing in willy-nilly, you’ll have much better success. Novicetraders should seriously consider all these principles if they are to becomesound, consistent traders.Here are some other excellent materials on options:The CBOE Prospectus from the Chicago Board Options ExchangeOptions as a Strategic Investment, 4th Edition, by Lawrence McMillanTrading Options Visually, by Paul ForchioneThe New Option Secret, by David CaplanThe Commodity Options Market, by Kermit C. Zieg Jr.A large number of free educational articles and trading tips are available at http://www.optionvue.com and http://www.optionvueresearch.com.Also, you may want to visit http://www.invest-store.com/optionvue for alarge selection of trading books and other resources.
THE PSYCHOLOGICAL BATTLEPeople were not made to trade. They were made with emotions. Emotionsare wonderful in life; I’m so happy I’m an emotional being! However, emotions play havoc with trading.The ideal trader is one who decides on a system and carries it out precisely. The ideal trader does not get discouraged after a loss or a string oflosses. He feels no remorse over an opportunity barely missed. He doesnot become elated or smug after a gain or a string of gains. During a swiftmarket move, when others may be panicking, he feels nothing. He justcontinues to follow his system. Day by day he follows his regular routine,analyzing the markets with the same interest, even after a period when hissystem has not been working.But who is really like this? I’m not. I don’t know many who are. Wecan strive to be perfect traders, but emotions will always be there. Sometimes you just have to acknowledge them and work with them. For example, during countertrend moves (e.g., a short-term rally during a bearmarket), I sometimes begin to feel the emotions welling up in me thatmust also be there in other market participants (i.e., optimism). Whenthat happens, I try to recognize what is happening and think contrarily.For example, after the market has moved up for several days, I’ll begin
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feeling optimistic. At that point, I stop myself and think, “I’m feeling optimistic about stocks. I’ll bet others are feeling this way too. That meansthe end of this run might be near.”Here are some other thoughts that might help in controlling your emotions as you trade. When in a position that you’re uncomfortable with (e.g.,when the market is making a run against you), it may help to ask yourself,“If I weren’t in this position already, would I be entering it now?” If the answer is yes, hold tight. If the answer is no, then get out. In other words,transport yourself into an imaginary situation where you’re sitting withcash, just calmly watching the market. Would you, in that situation, bejumping into the position you’re already in?Another thing I ﬁnd helpful is deciding ahead of time what I’m going todo. Off hours, when I look at the charts, I may get a feel for what I thinkthe market is going to do (I’m a short-term directional trader these days).I’ll decide right then on a plan. Then I’ll also imagine other tacks the market might take, and I’ll decide what to do if any of those scenarios play out.Sometimes I write down my plans, sometimes not, but at least I have themﬁrmly in mind. Having my responses preplanned allows me to trade mechanically instead of emotionally. This is especially helpful when your system is somewhat arbitrary (that is, depending on human judgment), asmine is. Not only does this help me trade mechanically, it also helps me doaway with useless remorse over trades that went bad or over havingclosed a position too soon. I remind myself that I was only following theplans that were made earlier in calm forethought.We do the best we can as traders. That’s all we can do.Options trader and writer Kenneth Trester also wrote a section onthe psychological battleﬁeld in his book The Complete Option Player. Ithought these words, reprinted with his permission, were especiallywell put.As you prepare to enter the options game, your greatest obstacle tosuccess probably will be the psychological battleﬁeld that you mustsurvive. To be a winner, most novice option traders think that allthey need is a little luck—a few big winners right off the bat andthey’ll be on Easy Street. It’s just a matter of being at the rightplace at the right time, or so they think. Of course, they couldn’t bemore wrong.Proper money management is just as important as using theright strategy, probably more so. Most people fail to realize that.For example, if they just buy options (even if they are theoretically undervalued), they could have a long losing streak and, ifthey’re not careful, lose their entire investment capital. Mostpeople aren’t careful. Typically, after a few losses traders become
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hesitant—they take proﬁts away so they can’t hit any home runs,and they run up their commissions by over-trading. Their goosewas cooked before they began, because they were emotionally unprepared to trade options.Your foremost opponent when you trade options is not the exchange and its members, nor the other traders. It’s your emotions,and if you can’t control them, you’re going to be licked. Don’t getdown about it though; most money managers have the same problem.The best way to keep your emotions out of your investment decisions is to have a well-deﬁned game plan. Write it down andstick to it.Decide how much money you are willing to risk in options during the next twelve months, and don’t blow it all in the ﬁrst fewmonths. This is really important—plan to spread your option tradesover the entire year. Can you risk that much money? Is the moneyyou could lose more important to you than the money you couldmake? Would a loss affect your life-style? If you answer “yes,” youshouldn’t be trading at all. You also should trade as if options arechips on a poker table—if you’re afraid to lose, you will.Plan to diversify, both over time and position. If you spreadyour purchases over one year, for example, and buy both puts andcalls on several stocks, you won’t be wiped out if the stock market isdull for months on end (it can happen). Also, you’ll have a betterchance of being around when things pick up and options pay off. Always invest the same dollar amount in each position. If you do,you’ll eliminate the risk of having small investments in the winnersand big investments in the losers.1
TRADING MISTAKES AND WHAT I LEARNEDMy number-one trading mistake, and one that has hurt me many times overthe years, is trading too much size—investing too much of my account inany one investment. I’m a gunslinger by nature, I guess.I enjoy a little gambling in Las Vegas whenever I can go. Interestingly,my money management is very good in Las Vegas. I can control my lossesand am usually able to stop gaming whenever my daily allotment of trading capital is gone. Perhaps the reason I’m effective in that environment is
1
Kenneth Trester, The Complete Option Player (Sarasota, FL: Bookworld Press,1997).
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because of the realization that with the next throw of the dice or deal ofthe cards, my odds of winning are just under 50 percent (knowingly oversimpliﬁed to make a point), so I know there is no sense in risking a largeamount. Also, the outcome of my bet is known very soon, and just a fewmoments later there is another play. There is something about the frequency of plays that keeps me satisﬁed with small bet sizes.In options however, I sometimes fool myself into believing that atrade has a higher probability of success than it really does. This happens more often in directional trading, where the odds of success arenext to impossible to quantify. This leaves me to my imagination, whichis not a very reliable predictor as it turns out. I realize that I need a moremechanical, systemized approach. And I know that I need to get better atmoney management.Sometimes you can run into problems with the mechanics of placingand executing trades—for instance, ordering calls instead of puts, and viceversa, or ordering to sell instead of buy. But I’ve been able to minimizethese occurrences by staying focused and being careful. Where I’ve beenhurt worse is in the execution and reporting of market orders. One time, Ibought index puts using a market order when I sensed the market wasfalling. But since it was a situation of “fast market conditions,” the ﬂoordid not feel obliged to return a ﬁll report to me anytime during the remainder of the day. The market continued to fall, just as I thought it would, and,had my position been conﬁrmed, I would have been able to sell them for abig proﬁt near the end of the day. But with conﬁrmation not forthcominguntil an hour after the close, I was forced to hold them overnight. The nextmorning the market opened up strongly and all I could do was sell my putsfor about even money.That was a long time ago, however. With modern electronic trading, Isuppose it is possible that nothing like that will ever happen again. Nevertheless, it’s important to pay attention to when an exchange declares “fastmarket conditions.” In a fast market, the professionals are not held to theirusual restraints. If you send a market order into a fast market, the marketmakers have license to, and sometimes will, have their way with you. Ifound this out the hard way one time when I placed a market order toclose a spread in orange juice. The spread was worth about 2 points, net,and was actually trading for about 2 points. However, they made me pay 4points to cover! I took it to arbitration but, with the buddy system theyhave out there in New York, it was no use. That one mistake took a big biteout of my account. I will never again place a market order in fast marketconditions, especially in futures options.Finally, I learned a long time ago to cut losses early. As a new trader, Isometimes allowed a loss to grow bigger. Without giving speciﬁc examplesright now, I know there were times when I stayed with a losing position
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day after day, week after week, grinding it out. Now I understand that ifthe market is telling me that I’m wrong, I might as well admit it and get outof the position right away. It gives me an immediate sense of relief (thatI’m not ﬁghting the market anymore) and frees me up to begin thinkingabout what I want to do next.
SOME THOUGHTS ON HOWTRADING FITS IN WITH REAL LIFEI have found that trading must be compartmentalized. That is because it isso out of touch with reality. When trading, you make decisions involvingthousands of dollars. In everyday life, you decide whether to eat out or eatleftovers and save $20. That is as it should be. You have to live like a realperson. To deal with the disparity, I ﬁnd it helpful to think of my trading account as not containing real money, but “trading money,” if you will. Itwon’t become real money until I call up the broker and ask him to send mea check. Some may object that not considering my account “real money”might cause me not to care sufﬁciently about it. But don’t worry—I’m serious enough about trading not to fritter away my capital!Another way the trader needs to compartmentalize is in how much hethinks about, and talks about, his trading. I believe it’s helpful to preparefor the next day’s trading soon after the markets close. That way I’m all ﬁnished; there is nothing more to think about. I may even have a large position on overnight and still sleep like a baby. While the markets are closedthere are no decisions to be made and nothing to worry about. (God helpus if they ever go to 24-hour trading!)I have also found that it’s best not to discuss trading with anyone inthe family, or among friends, unless they are genuinely interested in trading and can handle the kind of dollars you are dealing with. Otherwise,they will ﬂat out not be able to relate. I know of someone who regularlytalks about how much he made or lost that day in his trading. This is so obviously an ego trip for the person, I wonder how he cannot realize what heis doing and stop it.It’s okay to say in general terms how your trading is going, if someoneasks. But I would not talk in speciﬁcs with family members or friends. Itonly causes trouble. Talk about a big loss and it upsets them. Tell themabout a big gain and it will also upset them, because it gets them more excited than they need to be as they try to ﬁt what you’ve said into the framework of their normal, everyday life. For example, if you tell your teenagechild you made $20,000 that week, they might expect you to buy them acar. If you tell them the following week that you lost $20,000, they’ll think
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you’re a complete idiot for not taking the $20,000 out when you had thechance and buying them that car. They’ll remember for a long time howyou “lost their car.” They can’t compartmentalize like you can, so you haveto do it for them. Don’t talk about your gains and losses.Even when talking with other traders, it’s best not to brag. People havea tendency to brag about gains but not admit to losses. I’ve even seen myself do this! But that’s not being honest. In the end, all that matters is if andwhen you can withdraw some capital and bring it home. As I said, that iswhen it becomes real money.Finally, I would like to reﬂect on the moral aspect of trading. I wouldassert that there are many activities more worthwhile than making moneyat the expense of others losing it. For instance, things like reading a book,writing a song, spending time with family or friends, and so on. When itcomes right down to it, there is very little redeeming value to trading. I’mnot saying that it’s bad; only that it’s pretty close to neutral. The only goodthing that can be said is that you’re contributing liquidity to the markets.As a trader, you’re speculating, investing, or hedging, and all participantsplay an important role in greasing the wheels of capitalism. I would saythat the main reason I trade is the challenge of beating the odds. I like winning at a somewhat complicated game that I understand better than many.For me, there is joy in winning.Another aspect of this involves one’s heart. If you believe in God, as I do,you have to pay attention to what He says. Jesus said you cannot love bothGod and money. Now, I don’t know about you, but I intend to love God, notmoney. So I have had to ask myself if my interest in trading stems from alove of money. Honestly, I don’t believe it does. I’m interested in trading because of the challenge of beating the system in some way and overcomingbarriers within myself. I like having money, but I don’t love it. And it’s probably best if one’s motivation to trade stems from reasons other than the loveof money. What about you? Hopefully you would agree that before rushinginto trading (or anytime after you’ve begun), it would be good to ask yourself why you want to trade, and be aware of your true motivation.
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Encore
DIRECTIONAL TRADING USING PATTERN RECOGNITIONOne interesting way to trade is swing trading using pattern recognition.And I have a favorite pattern—it’s what I call a breakdown. It happenswhen a stock experiences a sharp sell-off, recovers somewhat, and thenrolls over and begins to drop again. I will buy puts at that juncture for a 1to 10-day play. I’ve made some good money this way in the past couple ofyears, especially during the Nasdaq bubble burst of 2000. Figures 8.1through 8.4 contain charts that illustrate successful patterns.Now, for all the breakdowns that work, there are as many that don’t.Figures 8.5 and 8.6 show some examples of breakdowns that failed to follow through.Fortunately, a stop level is easily selected, to limit your risk. I use astop equal to the stock’s recent high price, as marked in the ﬁgures. Usingnearby puts, I usually ﬁnd that, on average, half of my investment is lost ifthe stop gets hit. On the other hand, trades that work return anywherefrom one and a half to four times my investment.I like using the nearby puts for maximum leverage, even when the option has only two days of life left. While this may sound restrictive (and itis, from a time standpoint), I can’t resist the leverage. In the ﬁnal two daysbefore expiration, at-the-money options can usually be bought for just0.50 to 1.00. I have hit many home runs buying these low-priced options.Obviously you don’t put a lot of money into these kinds of wagers, asthere is a good chance of losing it all.161
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FIGURE 8.1 AOL (Two Good Breakdowns)
FIGURE 8.2 Genesis Microchip (Two Good Breakdowns)
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FIGURE 8.3 Sprint PCS (Two Good Breakdowns)
FIGURE 8.4 Bank of New York (Two Good Breakdowns)
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FIGURE 8.5 General Electric (Failed Breakdown)
FIGURE 8.6 IBM (Failed Breakdown)
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Note that the breakdowns I like to play are very much like coming offthe right shoulder of a head-and-shoulders formation, except the leftshoulder doesn’t have to be there. Other patterns may be traded as well,including all the technical analysts’ favorites—cup and handle, trianglebreakouts, head and shoulders, and so on.The reason I like breakdowns is that sell-offs seem to happen moreswiftly and reliably than up moves. Thus, down moves are usuallycleaner plays. A good sell-off goes for three or more days, sometimes culminating with a climactic selling day on high volume, which is often thebest day to exit.In contrast, uptrending markets tend to be choppy, with frequent retracements and consolidations that can last for days. Thus, swing tradingan up market is a challenge. How many times has the options traderlooked back on a beautiful 30-day rally, during which several of his favorite stocks doubled, and asked himself, “How did I manage to losemoney?” It was because the trader tried to play the 1- to 5-day moves andthe market did not behave predictably on that level.Therefore, up markets might better be played using longer-term (i.e.,30-day) positions. And the best option strategy for longer-term positionswould be spreads, because spreads have smoother performance and better proﬁt potential in that time frame. Or you can buy deep in-the-moneycalls, LEAPS or just the stock itself.
Recognizing a Good BreakdownHere’s how to recognize a good breakdown. The ﬁrst sharp sell-off (theone you’re not in on) tips you off that something may be seriously wrongwith the company. All the better if there is no news to account for it, or ifthe news that accompanied the fall is of the “ﬁrst shoe” variety. Thus youhave more possible “shoe drops” to look forward to. Following that, thestock often spends several days recovering some of its lost ground orperhaps just moving sideways. Then it begins to sell off again. That’syour entry point.The best option strategy for a sell-off, without question, is straight putbuying—not only because the move is often so swift and clean, but alsobecause increasing volatility usually accompanies the sell-off, pumping upall option values, including your puts.Exit timing is arbitrary. I’m sorry; I have no ﬁrm rule for exiting. I simply watch the chart and when it seems to me like the move could be spent,I exit. I do it largely by feel. Sometimes, as I said, there is a selling climax—one big down day with big volume. If there is, I’ll be sure and get outsometime that day.Another approach, for those who prefer to be more systematic, is to
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use a trailing stop from inception of the position. If the stock moves yourway at ﬁrst and you’re seeing a gain, you’ll want to protect that gain andnot allow it to turn into a loss. (Sometimes these sell-offs end abruptly in aquick rebound!) And if the stock moves the wrong way from inception, it’susually best to admit that the breakdown was false and get out quickly. After that, sometimes the stock moves sideways and upwards for a few days,then breaks down again—this time for real. You can always jump aboardagain at that point.Some of the most reliable breakdowns are ones where the stock experienced a signiﬁcant rally over the past several months. I think the reason these might be better stems from human behavior with respect toproﬁt taking. Investors, experiencing the good fortune of seeing theirstock go up, begin to think about selling. As the stock advances further,they feel more like taking their proﬁts. However, rather than selling whenthey feel like selling, they tend to play a game of “let’s see if it can go upjust a bit more.” As long as it keeps advancing, they keep holding on. Inevitably, the stock experiences a downturn, which triggers some investors to go ahead and sell. This cascades into more selling, and in a fewdays just about everyone who had their ﬁnger on the sell-trigger goesahead and sells. During this time, a sense of fear (of losing back any further proﬁts) tends to dominate.Figure 8.7 gives an example of a high quality breakdown. Nike fell forﬁve straight days after breaking its trend-line off a right shoulder formation, making this a real home-run trade for put buyers.One factor contributing to the success of this approach, I believe, isthe potentially large number of investors also noticing the breakdown.Many traders use trend-lines and moving averages. Therefore manyother traders will notice the breakdown and possibly place trades thatwill exacerbate the move. You just want to be in your position beforethe bulk of the crowd, if possible.
Overall Market BreakdownsThe breakdown pattern works with indexes as well as it does on individual stocks, perhaps even more reliably. The Nasdaq bubble burstin the spring of 2001 is a classic example. In Figure 8.8, we’re goingto focus especially on the brief period of time between March 7 andApril 14, 2000.The sharp drop beginning on March 7 was the ﬁrst hint that the bubblehad been pricked. High-ﬂying tech stocks with market capitalization in thebillions but little to no revenues or proﬁts were hit hardest. The subsequent rally was very noticeably an FTQ (ﬂight-to-quality) rally, with stockslike Cisco, EMC, and Dell leading the way. Dot-coms and biotechs did not
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FIGURE 8.7 Breakdown—Nike
FIGURE 8.8 Breakdown—Nasdaq
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participate. While the Nasdaq 100 hit a new high in this rally, the Russell2000 did not, tipping us off to underlying weakness.When the market came off this top (the “head” of the head-and-shoulders formation), it was a good opportunity to go short. Momentum quicklybuilt and the market plunged for six days, climaxing in a 400-point Dowsell-off and recovery in the same day. The market then paused and ralliedfor a few days, after which the next wave of selling started. This was thedrop off the right “shoulder”—one of the most powerful and reliable timesever to place a directional trade.Both of these sell-offs—the one off the head and the one off the rightshoulder—culminated in a degree of panic selling, as evidenced by a bigvolatility spike, making it easy to sense when to exit. Puts easily increasedtenfold during each sell-off, helped by expanding volatility. While justabout all tech stocks fell, the high-ﬂying dot-com and biotech stocks fellthe most spectacularly during these times.The retracements (rallies) may be played as well. However, going longusing straight call buying might not be the strategy to use. Options are veryexpensive at that stage—hurting your leverage and presenting you withvolatility risk—because as the market advances, the implied volatility levels of all options come down, making it seem like you’re ﬁghting an uphillbattle. It might be better to use bull call spreads, lean toward buying deepin-the-money calls, or simply buy the underlying stocks. If you do buystraight calls, treat them like hot potatoes; be ready to sell them near theend of a good, strong up day.
ConclusionOnce a market bubble has begun to burst, it goes to completion with greatforce. I think the reason this happens is because the herd behavior of investors rises up and overpowers all other market forces. Investors, seeingtheir proﬁts start to go away, all head for the exits at once. Such a time presents, to my knowledge, the best of all trading opportunities.As for trading individual stocks, certainly the breakdown strategyworks better when the overall market is in a downtrend. And I’d be willingto concede that perhaps the reason I’ve been able to make money at thisthe past two years was because I had the wind at my back. But that’s okay.If we go into a long-term bull market and my breakdown pattern stopsworking, I’ll put it away and use other strategies. When the bear marketcomes back, I’ll bring it out and start using it again.Meanwhile, I plan on continuing to reﬁne this approach. I have already built into my software the ability to scan for stocks exhibiting a
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breakdown pattern, and I am currently exploring whether stocks thathave recently experienced a signiﬁcant run-up make for more reliablebreakdown trades.
TIMING THE MARKET USING THE VIXAnother interesting way to trade is to use volatility index (VIX) reversalsto time the market. Having recently devoted some time to the study of VIXreversals, I can tell you that they are more than interesting. They aredownright exciting. After setting up a system for myself and doing someback-testing, I now give more weight to what the VIX is telling me than toprice pattern recognition.The VIX indicates how expensive OEX options are. OEX optionswere once the most heavily traded index options in the world. Whilethis is no longer the case, they are still very popular. Thus the VIX servesas a good indication of how expensive stock and stock index optionsare, in general.The VIX has been termed “the fear index” because it expresses a consensus view about expected future stock market volatility. While that istrue, I prefer to think of the VIX as a hedger’s expense index. The VIX riseswhen the market is falling, reﬂecting investors’ willingness to pay more forputs to protect their stock portfolios. On the other side of the trade, market makers require higher put prices as