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More Praise for
The Index Trading Courseand
The Index Trading Course Workbook“George and Tom have done it again! They’ve created another comprehensive resource for traders, this time thoroughly covering the index market.The sector and broad market indexes are ideal vehicles for the many specific options strategies taught by these trading experts. Both new and experienced traders will find plenty of valuable techniques here.”—Price Headley, Founder, BigTrends.com“There are few people in the entire country who come to the financialmarketplaces with the type of pedigree George Fontanills brings. He is notonly an incredibly gifted and accomplished trader in his own right, with apassion for the mechanics and strategies that drive trading success, but healso combines it with a fervor to teach those strategies to thousands of individuals across the world each and every year. The Index Trading Courseand The Index Trading Course Workbook—George’s most recent additions to his ever-expanding library—represent another of his ‘must reads’for anyone involved in the marketplace at all.”—Laurence J. Pino, Founder and CEODynetech Corporation“Fontanills and Gentile have once again demonstrated why they are sorespected in the field of options trading. Because indexes representsuch a volume of transactions, second only to the foreign exchangemarkets, they present characteristics that these experts have verydeftly managed to take advantage of to create some new and excitingtrading systems. A thought-provoking read for anyone looking for somefresh trading ideas.”—John Paul DrysdaleFounder and Managing DirectorThe Hubb Organisation (www.hubb.com)“Any investor or trader who utilizes equity options today will find thispractical, logical, and highly usable index trading course by two acknowledged industry experts to be the perfect guide to expanding your skillsand knowledge into this fast-growing but still underutilized segment of theoptions world.”—Albert H. Brinkman Jr., DirectorEquity Derivatives MarketingPhiladelphia Stock Exchange (PHLX)
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The IndexTradingCourse
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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.The Wiley Trading series features books by traders who have survivedthe market’s ever changing temperament and have prospered—some byreinventing systems, others by getting back to basics. Whether a novicetrader, professional, or somewhere in-between, these books will providethe advice and strategies needed to prosper today and well into the future.For a list of available titles, visit our web site at www.WileyFinance.com.
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Copyright © 2006 by George A. Fontanills, Tom Gentile, and Richard Cawood. All rightsreserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.No part of this publication may be reproduced, stored in a retrieval system, or transmittedin any form or by any means, electronic, mechanical, photocopying, recording, scanning,or otherwise, except as permitted under Section 107 or 108 of the 1976 United StatesCopyright Act, without either the prior written permission of the Publisher, or authorizationthrough payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc.,222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respectto the accuracy or completeness of the contents of this book and specifically disclaim anyimplied warranties of merchantability or fitness for a particular purpose. No warranty maybe created or extended by sales representatives or written sales materials. The advice andstrategies contained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any lossof profit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.For general information on our other products and services or for technical support,please contact our Customer Care Department within the United States at (800) 762-2974,outside the United States at (317) 572-3993 or fax (317) 572-4002.Wiley also publishes its books in a variety of electronic formats. Some content that appearsin print may not be available in electronic books. For more information about Wileyproducts, visit our web site at www.wiley.com.Library of Congress Cataloging-in-Publication Data:Fontanills, George A.The index trading course / by George A. Fontanills and Tom Gentile ; with aforeword by Frederic Ruffy.p. cm.— (Wiley trading series)Includes index.ISBN-13 978-0-471-74597-6 (cloth)ISBN-10 0-471-74597-9 (cloth)1. Stock price indexes. 2. Stock options. 3. Stock price forecasting.4. Stocks—Prices. I. Gentile, Tom, 1965- II. Title. III. Series.HG4636.F65 2006332.64'5—dc222006005660Printed in the United States of America.10
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This book is dedicated to Ruth Cawoodwho inspires us all to live up to our full potential.
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Contents
Foreword
ix
Acknowledgments
xv
About the Authors
xvii
CHAPTER 1
A Look Back
1
CHAPTER 2
The Index Market Today
11
CHAPTER 3
Trading the Market
29
CHAPTER 4
Understanding Options
47
CHAPTER 5
Basic Strategies Using Call Options
73
CHAPTER 6
Basic Strategies Using Put Options
93
CHAPTER 7
Complex and Advanced Strategies
111
CHAPTER 8
Catalysts
133
CHAPTER 9
System Trading
157
CHAPTER 10
Getting an Edge with Indicators
181
CHAPTER 11
Sector Trading
221
CHAPTER 12
Tracking and Trading Volatility
257
CHAPTER 13
Making Adjustments
287
CHAPTER 14
Risk Management
309vii
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CONTENTS
CHAPTER 15
Important Index Facts and Strategies
327
CHAPTER 16
Getting Started
343
APPENDIX A
Important Tables and Lists
357
APPENDIX B
Focus on Technical Analysis
373
APPENDIX C
Option Strategy Reviews
389
Index
403
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Foreword
S
hortly after I heard George Fontanills and Tom Gentile speak at anoptions trading course in the year 2000, I quickly realized that theyshared my passion for trading. At the time, the Internet boom wasgoing full throttle and this particular hotel conference room in Silicon Valley was packed full of enthusiastic listeners. There being no empty seats, Istood in the back, listening as well.George Fontanills took the stage. After an introduction, he listed offand explained various strategies that were working well in the volatilemarkets of the time. Among the trades, he outlined a scenario for the NASDAQ 100 Index Trust (QQQQ), or “Qs,” that had profit potential regardlessof directional bias. It made money whether the NASDAQ went higher orlower. Since it happened just before the great tech wreck, a time wheneven Aunt Mildred had her portfolio tilted towards high-technology stocks,the trade suggestion proved extremely insightful at the time.Prior to that, I had worked on an options trading desk of an institutional firm in New York, so options were not new to me. However, some ofthe strategies were. In a nutshell, Tom and George were taking advancedconcepts used by market makers on the options exchange trading floorand presenting them in a format that individual investors could easily useand understand. Many of these strategies involved stock options, but others were applied to the index market. As an index trader, I found it fascinating. I began working with their system, Optionetics, shortly thereafter.Six years later, I was excited to hear about The Index Trading Course.Although the bookstore shelves are lined with investment books, a qualitybook about index options trading has clearly been missing. After readingthe first draft, I am convinced that Tom Gentile and George Fontanills haveput together another winner. I think the reader will come away with several things from this book, and these are the same things I have been fortunate enough to learn through my association with the authors.ix
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First, options are one of the most versatile and exciting investmentvehicles today. I have traded funds, foreign exchange, stocks, futures, andoptions on futures. Strategies using options on stocks and indexes havebecome my favorite and most lucrative trading endeavors. In addition,given the liquidity and the opportunities in the options market, I have littledoubt that options trading will remain one of the fastest growing areas ofthe financial markets. In short, one of the first lessons is that the optionstrading world is the place to be.The second thing readers should come away understanding is that,when trading options, there are strategies and rules. It pays to follow whatthe gurus have already learned! We’ve all speculated at times, experimented, placed bad bets, and eventually lost money. Why do we do thiswhen there are proven strategies that work? I guess it’s just human natureto figure things out the hard way. In the financial markets, that can be anexpensive proposition. So, lesson two: I’ve learned that it pays to learnfrom those who have been around the block a few more times than I have.While options strategies and the associated rules can be learnedthrough study, investors today also have a lot of tools and informationthat simply weren’t available when I first started trading. Unlike today, financial television was not very helpful. Nobody used the Internet. At thattime, the only real source of information was the newspaper. I don’t knowwhat Tom and George used when they first started trading (smoke signalsand ticker machines maybe?). It was someplace far away from the hereand now that Internet access provides. Today, we are inundated with information from print, web sites, e-mails, and television. It can easily leadto information overload (or “analysis paralysis,” as George likes to call it).Victims of this malady spend too much time digesting information and notenough time understanding the basic tools that help successful tradersmake money over the long term—strategies, rules, and risk management.Fortunately, another thing I learned is that you don’t have to knowand understand it all to make money. In fact, sometimes less is more. Asimple trading system with easy entry and exit rules can generate a lotmore money than spending hours each day watching TV and reading webreports to figure out what is moving the market and why.The key to a successful trading system, however, is in its development—back-testing and evaluating what works and what doesn’t. Systemshave become the tools of choice for many traders because they are objective. A system follower adheres to a specific set of guidelines that leavesno room for guesswork. Don’t get me wrong—we are not all systemtraders. But understanding how systems are developed and why systemswork can help traders at any level. Tom Gentile has done a lot of workwith systems and he reveals some interesting trade secrets in this powerful book.
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In that respect, traders today have another important advantage overtraders of the past: They have access to sophisticated software that allowsfor system backtesting and development. Until recently, these programswere available only to the big players—the large financial institutions andfunds. That is no longer the case. Software developers are creating greattrading programs that are within affordable price ranges. So another thingI learned was to use the tools that are out there. It is certainly possible totrade without the latest technology, but having it saves a lot of time andexponentially increases the odds of success.Good traders are also good risk managers. This is extremely important, especially for new traders. You don’t have to be right all of the timeto make money. That’s something that I struggled with earlier in my trading career. I felt that being wrong about the direction of the market or on astrategy meant that I was a bad trader. Today, I believe that good tradersare wrong just as much as bad traders. The difference is that they knowwhat to do when they’re wrong. If you plan on trading, understand thatyou will be wrong at times, and know what to do when it happens. GeorgeFontanills once told me, “Before I take a trade, I always ask myself, ‘whatif I’m wrong?’ ”This book takes George and Tom’s Optionetics philosophy and applies it to the index market. Index trading is quite different from tradingstocks. Obviously, the trading instrument is different. An index represents a basket of securities. It is more diversified and will behave differently, often with less volatility. In order to trade profitably over time, itmakes sense to understand the product you are trading. The IndexTrading Course provides the most comprehensive discussion of the index market to date.Moreover, this book goes beyond simple explanations and providesspecific trades and money-making strategies for the index market. Manytrading books use an inordinate amount of space explaining strategies,trading tools, and investment vehicles. This book goes to the next stepand shows readers how to trade successfully. It takes readers beyond thetheoretical aspects of index trading and into the real world where the serious index trader lives, breathes, and makes money.Anyone who has watched the market for more than a few dayshas probably used an index. For instance, a news reporter mightsay, “The Dow is up 96 points and the NASDAQ is 21 points higheron Wednesday.” The Dow and NASDAQ are market averages or indexes.These powerful tools help make sense of what is happening in the stockmarket and offer insight into whether more stocks are moving higheror lower.Traders can also use indexes to make money. Options on the S&P 500Index ($SPX), the NASDAQ 100 Index Trust (QQQQ), and the Dow Jones
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DIAMONDS (DIA) are some of the most popular instruments for tradingthe market. They are exciting, fast-growing markets that can help investors build and protect wealth.In order to successfully trade the market averages, however, tradersmust develop a plan that often involves determining how the stock marketwill perform and where the market averages will be in the future. In addition, index traders must ask questions like, will the market trade quietly orwill volatility spike higher? Is this a bull market or a bear market? Is thecurrent trend going to last or is there a chance of a reversal? Ultimately,successful index trading requires a certain amount of skill and knowledgethat is not shared by many. It is a different set of skills when compared totrading futures, stocks, or stock options.The Index Trading Course offers specific tools for predicting marketmoves, not just in the major averages like the Dow Jones Industrial Average and the NASDAQ, but also in specific sectors, industry groups, as wellas in individual stocks. The reader is also introduced to specific optionsstrategies that yield profits from these anticipated moves. So the book isdesigned to help investors understand what indexes are, how they areused, and, most importantly, how to make money with them.In addition, since it is the fourth book in a series (following The Options Course, The Stock Market Course, and The Volatility Course), notmuch space is given to the basics of the options market, the difference between puts and calls, or how options prices are calculated. There is somemention of delta neutral strategies, the option Greeks, and complexstrategies like butterflies and backspreads. But the book primarily assumes the reader has a rudimentary knowledge of options trading. Instead, it is more focused on trading the markets and how to make profitswith indexes.However, while options are not covered in as much detail as their earlier books, indexes and exchange-traded funds are discussed in depth.During the past few years, a large number of new index products havestarted trading. There are so many, in fact, that it’s impossible to trackthem all. Consequently, several chapters in this book are dedicated to explaining the various index tools, as well as listing the ones that are worthwhile trading vehicles (not all of them are).Various trading strategies are presented in Chapters 5 through 7. Thestrategies include examples from the index market and include rules forentry and exit. These “rules” have been developed from decades of experience in the options market and are well worth reading and adhering to.Volatility is an especially important aspect of successfully trading the index markets because it has an important effect on option prices. In fact,an entire chapter (Chapter 12) is dedicated to dissecting volatility in theindex market.
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Trading systems are becoming more possible as technology makessystem-building more readily available to smaller traders. A trading system provides specific buy and sell signals that leave nothing to the imagination. We discuss system building, including examples of trading systemsand how to build them in Chapter 9. Risk management and trading rulesare key elements to any kind of trading system. Both topics are discussedextensively throughout the text.The myriad of ideas, indicators, and trading systems are included hereto give readers the tools to better trade the markets. A lot of it can be usedas reference material and to look at what has happened in the past, in order to gauge what might happen in the future. There is no need to use allof the indicators, strategies, and ideas. In fact, plenty of money can bemade using just one or two. Pick the ones that are right for you—the onesthat make sense.Some approaches to the index market look at fundamentals, anddecisions are based on macroeconomic factors such as changes in interest rates, overall levels of corporate profits, retail sales activity, andenergy prices. Geopolitical events such as elections, terrorism, and natural disasters can also affect the market. Other traders rely heavily oncharts and technical indicators. Still others use trading systems that arebased on very specific rules, and often leave the trading decisions tocomputers. There is no right or wrong way to trade as long as themethod yields profits.The final chapter is designed to empower the reader to actuallystart trading. More experienced traders probably understand this information already. However, new traders are encouraged to pay special attention to this chapter. Trading in the index market is exciting, but it isnot without risk. For that reason, we encourage new traders to startslowly and to move at their own pace. There is no reason to rush intothe market. Instead, spend time learning and test strategies that seem tofit your trading style. Then practice them on paper before putting hardearned money on the line.While George and Tom are confident that their students and readerscan achieve success over the long run, they are also aware of the pitfallsthat many new, inexperienced traders sometimes face. In that respect, inaddition to providing a detailed discussion about index trading, this bookis intended to be a shortcut along the options trading learning curve. It isdesigned to teach winning strategies while avoiding the pitfalls and mistakes new traders often encounter.I believe that it is never too early or too late to learn something. Inthat respect, the cost of this book is a small price to pay for the numberof years of experience and research that have been put into writing itspages. Without a doubt, I have learned a great deal from Tom Gentile,
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FOREWORD
George Fontanills, and the other Optionetics instructors, as well as thestudents. We all share the same goals of becoming even better tradersand developing solid financial security for our families. In theserespects, The Index Trading Course is certainly going to empowerthose traders who wish to improve their skills and successfully trade inthe index market.FREDERIC RUFFYSenior Writer and Trading Strategist,Optionetics
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Acknowledgments
W
e wish to thank the many people who put in a lot of hours helpingto bring The Index Trading Course to print. As full-time tradersand instructors, our writing time seems to grow shorter andshorter each year. So we count on a lot of people to help us put our ideasand strategies into an organized and presentable format.This book would have never been possible without the hard work ofthe entire Optionetics writing and editorial staff, including two of ourfinest writers and instructors, Fred Ruffy and Clare White. These two accomplished traders put forward a supreme effort to make this book a success. They put a phenomenal amount of time and effort into researchinginformation for both this book and the accompanying Index TradingCourse Workbook, and we are deeply grateful to them both. Additionally,Fred Ruffy wrote the Foreword for this book, and his expertise as an indextrader shines through brilliantly. We also want to thank our other amazingwriters—Jeff Neal, Andrew Neyens, Jody Osborne, and Chris Tyler—fortheir contributions.In addition, Kym Trippsmith, Optionetics’ Editor-in-Chief, has been invaluable in organizing and leading this effort. Her 10 years of hard workand dedication to Optionetics have been one of the most important reasons for our ongoing success. We thank her once again for taking on therole of Senior Editor for this project. We also appreciate the indefatigableefforts of her assistant, Kim Diehl, who helped out immensely as well.Meanwhile, back at headquarters, Richard Cawood, our CEO, andTony Clemendor, Chief Operating Officer, provide a rare type of leadershipthat continues to fuel Optionetics’ growing success. These two gentlemenwork relentlessly to keep the business operating smoothly and to bringnew talent to the organization. Both have been amazing leaders in handling the day-to-day operations of Optionetics and allowing us to focus our
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ACKNOWLEDGMENTS
time on trading, and on developing new strategies and tools to teach ourstudents.In 2006, we celebrated our 14th year of success at Optionetics. Overtime, we have seen thousands of students succeed and move from a verybasic level of trading knowledge to develop advanced options tradingskills. We want to acknowledge these students as well. They continue tomotivate us. Through the questions they ask, the ideas they present, andthe experiences they share, our students teach us well. Without their hardwork and dedication it would not be possible to develop such a comprehensive book of index option strategies.Good luck and great trading!
GEORGE A. FONTANILLSFounder, Optionetics
TOM GENTILESenior VP and Chief OptionsStrategist, OptioneticsCo-founder, Profit StrategiesGroup, Inc.
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About the Authors
George A. FontanillsFounder, OptioneticsOptionetics was pioneered in the early1990s by master trader GeorgeFontanills. The development of this innovative trading approach is a testament to human will and perseverance.Fontanills’ journey was not an easyone. Having struggled to overcome alife-threatening illness as a youngman, George received his MBA fromHarvard Business School and went outto conquer the world. His first business failed. Undaunted, he started asecond business that never left thestarting gate. Running low on money, George became a real estate investorand did quite well until the bottom fell out of the real estate market.George’s next move was to begin trading. Rather than concentrate onhis losses, he began studying successful traders to see what they were doing differently. Using the analysis skills he learned at Harvard, he conducted a comprehensive investigation to determine what differentiatedthe winners from the losers. Risking money he made in real estate, Georgetested his conclusions and eventually developed a creative approach thatused options to mathematically control risk every time a trade is placed,thereby consistently producing profits without the stress of unbridledlosses. In 1993, he founded Optionetics to teach traders to profit usingthese strategies. Today, more than 250,000 people in over 50 countrieshave seen Optionetics high-profit, low-risk, low-stress trading techniquesin action.As his net worth soared, George gained a reputation as one of theworld’s most respected traders. As a highly regarded expert in optionsxvii
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ABOUT THE AUTHORS
trading, George’s trading strategies have been featured in the Wall StreetJournal, Barron’s, Red Herring, CBS MarketWatch, TheStreet.com, andother publications, and have led to numerous guest appearances on radioand television shows throughout the country.Today, George spends much of his time concentrating on his own active stock and equity trading while his strategic trading approach istaught through the popular Optionetics seminar series. Specializing instock and index options, he has instructed thousands of traders in theU.S. and overseas.In addition, George has four best-selling hardback releases (co-written with Tom Gentile): The Options Course, Trade Options Online, TheStock Market Course, and The Volatility Course (all published by John Wiley & Sons). These definitive trading guides have added to his critical acclaim as one of the best options trading instructors in the country andaround the globe.
Tom GentileCo-Founder, Profit Strategies Group,Inc.; Senior Vice President and ChiefMarket Strategist, OptioneticsFrom his humble childhood as the sonof a steel-working family, Profit Strategies’ co-founder Tom Gentile has become not only a very successful traderbut a renowned educator, author, andbusinessman as well. In addition tomanaging the Profit Strategies seminar instruction team, Tom is responsible for the development of tradingsystems, risk management software,and trade research.Like many before him, at an early age Tom sought the opportunitiesWall Street had to offer and headed to New York in search of his nichetrading the markets. He began his trading career in 1986 and made thejump to full-time trading in 1993, landing a job at the American Stock Exchange. A stroke of luck afforded him the opportunity to connect withand work alongside famed trader and author George Fontanills. Throughthat relationship, Optionetics was born. Since then, Tom has developed aunique style of trading that could be described as fundamentally contrar-
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ian, yet 100 percent technical. He also played a key role in the development of the synthetic straddle, a strategy developed as an off-the-floortrading approach to rebalance a position.In addition to playing an essential role with Profit Strategies, Tomalso serves as the senior vice president and chief options strategist forOptionetics, and is a contributing writer for numerous publications, including Technical Analysis of Stocks & Commodities, the Wall Street Journal,Barron’s, and others. Online appearances have been numerous with regular spots and articles at RadioWallStreet.com, TheStreet.com, Barron’s.com,Bloomberg, Reuters, and a host of others. He is a noted consultant to trading firms and hedge traders and is a regular speaker at Omega World andThe Money Show. He also co-wrote The Stock Market Course and TheVolatility Course with George Fontanills (published by John Wiley & Sons).You can listen to Tom online every Saturday morning on his ProfitStrategies radio show at 9 a.m. Pacific time (www.profitstrategiesradio.com). The latest webcast is also available for download for up to sevendays after the live broadcast. This online radio broadcast includes insightful interviews and market highlights, and encourages listeners to call in ore-mail Tom with trading questions and comments. As an up-and-comingmarket wizard, Gentile’s passion for trading and down-to-earth style areboth refreshing and sensible in today’s trading world.
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CHAPTER 1
A Look Back
T
he stock market has changed quite a bit since 1792 when 24 NewYork City stockbrokers and merchants signed the ButtonwoodAgreement to form the beginning of the New York Stock Exchange(NYSE). At that time a handful of securities traded hands, including threebonds and two banks’ stocks. These days, stocks trade across the globewith markets open at every hour of the day and billions of shares tradingdaily.The participants in today’s global marketplace share a common objective: to make profits and build wealth. Some are large institutional investors making purchases on behalf of their clients. Others are investorsbuying shares of promising companies. Still others are speculators, looking to profit from the stock market’s swings higher and lower.Taken together, the buying and selling of shares among investors andtraders causes stock prices to rise and fall. At times, global markets behave similarly. For instance, stocks in the U.S. rise, and the momentumspills over into Asian markets and then into Europe. So-called bull markets occur when optimism is high and investors are buying shares, makingprices move up around the world. Conversely, global equity markets maytumble together, such as during the global financial crisis in 1998.Yet there are also times when equity markets in one part of the globeperform well while others perform poorly. In fact, even within one specificmarket, there are times when some stocks perform well and others donot. For example, during the first half of the year 2005, U.S. stocks put in amixed performance. Some groups, like companies involved in energy andutilities, did well while others involved in finance and technology did not.1
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THE INDEX TRADING COURSE
Indexes help investors make sense of what is moving higher, what ismoving lower and what is simply not moving at all.