the investorand interest payments cease. Maturity is the number of years until the principal amount of a bond is due and payable by the issuer to its bondholders.Treasury bill: Short-term government obligation that matures in 90 daysor less.Treasury bond: Long-term government obligation that has a maturity ofup to 30 years.Treasury note: Government obligation with 5 to 10 years until maturity.Yield: Refers to the annual interest on a bond divided by the marketprice of that bond. The current yield is the actual income rate of returnas opposed to the coupon rate or the yield to maturity.
CHAPTER 16
MasteringtheMarket
SUMMARYThis chapter offers guidelines and suggestions to enhance a trader’s abilityto find profitable trades. It introduces several concepts including low risk,time requirements, and risk tolerance as well as casting a glance at riskprofiles and investment criteria. In order to become successful, tradersneed to figure out their own risk tolerance. Some of this has to do with theamount of capital available, and part has to do with time and stress.Nonetheless, every trade should consist of a high reward-to-risk ratio, resulting in a high probability of success.Another part of successful trading has to do with money managementand setting up the appropriate system. Since emotions play a huge part intrading, traders are encouraged to avoid emotional trading. Fear and greedmove the markets, but good traders stick to their plans, using preset exitpoints. Exit strategies include time exits, profit exits, and loss exits. It isvery difficult to rid yourself of emotion when trading, but by understanding your exits and goals in advance, you can gain control of this detrimentto trading success.Ultimately, you need to rely on your own knowledge and research tobecome a successful trader. Many who have relied on analyst commentsand advice from self-proclaimed gurus have ultimately found failure.There are many companies available to help you learn the rules of trading,including Optionetics, but ultimately it is up to you to do the researchnecessary and to enter and exit a trade correctly.
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QUESTIONS AND EXERCISES1. Name as many elements of a good investment as you can.________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________2. ______________ of any investment must take into account the following elements: potential risk, potential reward, the probability ofsuccess, and how long the investment takes to make a return.A. Limiting the risk.B. The reward/risk ratio.C. The delta neutrality.D. All of the above.3. Studying a risk profile can show you the potential increasing or decreasing profit and loss of a trade relative to the underlying asset’s______________ over a specific period of time.A. Volatility.B. Volume.C. Price.D. Change in direction.4. The best investments will have an opportunity for ______________with acceptable risk and a high probability of winning on a consistent basis.A. High reward.B. High volatility.C. High liquidity.D. Major market movement.5. True or False: If you do not have the time to sit in front of a computerday in, day out, then your best investments will be day trades.6. Your risk tolerance level is directly proportional to your______________.A. Knowledge of the markets.B. Computer availability.
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C. Time requirements.D. Available investment capital.7. Name a few investment objectives.________________________________________________________________________________________________________________________
MEDIA ASSIGNMENTThis chapter discusses risk tolerance and how to take emotion out of trading. Having a set plan in advance for entering a trade is an important keyto lowering the part emotions play in our trading success. If traders takerisks that do not fit their risk tolerance, this will increase the emotions feltwhile trading. For this media assignment, take the time to write downyour risk tolerance and goals. This includes writing down the time youhave available to trade, the amount of capital that will be used to trade,and the profit goals you have set for your trading account. From the firsttrade, keep a trading journal that tracks not only the details of each trade,but the emotions and feelings you had as the trade progressed. You’ll beamazed at how much knowledge can be gleaned from reading the information found in a trading journal.
VOCABULARY LISTBear market
Capital gains
Bull market
Interest income
Capital
Price/earnings (P/E) ratio
SOLUTIONS1. Name as many elements of a good investment as you can.Answer: A good investment has low risk, a favorable risk profile, andhigh potential return. It meets your time constraints, risk tolerance
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level, and investment criteria. It also meets your investment capitalconstraints and can be easily understood.Discussion: This might seem like a lot to remember, but it all makessense. However, it is amazing how often new traders enter trades thathave horrible risk profiles or that don’t meet their time constraints.Initially, a new trader might need to go through each of these criteriato make sure a trade makes sense. After a while, this type of analysiswill become second nature, allowing a trader to make healthy profits,even while limiting risk.2. ______________ of any investment must take into account the following elements: potential risk, potential reward, the probability ofsuccess, and how long the investment takes to make a return.Answer: B—The reward/risk ratio.Discussion: All traders want to make as much profit as possible withthe capital used in their trades. By looking at a risk graph, many of theproblems with a trade can be uncovered. The reward/risk ratio can helpyou to determine the validity of a trade. However, you also need to understand the probability of success and how long the reward will take toaccumulate, in addition to the basic risks and rewards possible.3. Studying a risk profile can show you the potential increasing or decreasing profit and loss of a trade relative to the underlying asset’s______________ over a specific period of time.Answer: C—Price.Discussion: A risk graph helps a trader view how the trade willchange in value given a move in the underlying security’s price. Ofcourse, there are other variables that can impact an option’s value,but the main component is the price of the underlying. It is easy tocreate a risk graph for simple strategies like long calls and long puts,but more complicated strategies might require the use of a computerprogram to view a correct risk graph.4. The best investments will have an opportunity for ______________ withacceptable risk and a high probability of winning on a consistent basis.Answer: A—High reward.Discussion: It wouldn’t make sense for a trader to enter a trade thathas a loss potential of $5,000 when the maximum reward is just$1,000—that is, unless the probability of success is very high. This is thevery reason why we do not suggest naked option strategies, as thesetrades are extremely high risk and offer only a small reward. Though
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they have a high probability of success in most cases, the one timewhen the trade goes against you can ruin your entire trading account.5. True or False: If you do not have the time to sit in front of acomputer day in, day out, then your best investments will be daytrades.Answer: False.Discussion: Day trading requires the attention of a trader on a minuteby-minute basis. This obviously wouldn’t be appropriate for a professional who trades only occasionally. Before entering a trade, a tradershould look at the time needed to manage the trade. If this time commitment can’t be made, move on to a trade that can be handled in thetime you have available.6. Your risk tolerance level is directly proportional to your______________.Answer: D – Available investment capital.Discussion: Though there are traders with large accounts who havevery low risk tolerances, normally the amount of capital available isthe largest determinant for a trader’s risk tolerance. When trading options and individual stocks and futures, we should never use moneywe can’t afford to lose. Though we don’t plan on losing the money, ifwe can’t afford to lose it our emotions will take control of our trading.7. Name a few investment objectives.Answer: Interest income, tax-free government securities, capitalgains.Discussion: Most traders view their main investing objective as making money. However, this has many meanings depending on the traderand his or her situation in life. Older individuals who are in retirementmight be concentrating mainly on income. Others might have taxproblems that require a large amount of money to be placed in government securities. Even traders looking for capital gains should have anunderstanding of how their trades will be impacted by taxes.
MEDIA ASSIGNMENTSetting up a trading journal will be a real eye-opener. By reading backthrough your thoughts and feelings during a trade, you’ll learn a lot aboutyour state of mind and how controlled you may be by emotion. Not only
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should you keep track of the details of a trade, but write down these feelings and review them consistently. By looking back on past trades, you cangain a better understanding of what you did right and what went wrong.
VOCABULARY DEFINITIONSBear market: A declining stock market over a prolonged period, usuallylasting at least six months and normally not more than 18 months. Usuallycaused by a conviction that a weak economy will produce depressed corporate profits. Also, a market in which prices of a certain group of securities are falling or are expected to fall.Bull market: A rising stock market over a prolonged period, usually lasting at least six months and normally not more than 18 months. Usuallycaused by a conviction that a strong economy will produce increased corporate profits. Also, a market in which prices of a certain group of securities are rising or are expected to rise.Capital: The amount of money you have invested. When your investingobjective is capital preservation, your priority is to try not to lose anymoney. When your objective is capital growth, your priority is to try tomake your initial investment grow in value. Capital also refers to accumulated money or goods available for use in producing more money or goods.Capital gains: The profit realized when a capital asset is sold for a higherprice than the purchase price. Your costs (when you buy) include thecommission you paid your broker and are deducted from the proceedswhen you sell.Interest income: A type of income generated from interest-bearing securities. The closer to retirement a person gets, the more important interestincome usually becomes. Government bonds and high-dividend-payingstocks provide this type of income.Price-earnings (P/E) ratio: A tool for comparing the prices of differentcommon stocks by assessing how much the market is willing to pay fora share of each corporation’s earnings. It is calculated by dividing thecurrent market price of a stock by the earnings per share.
CHAPTER 17
How to SpotExplosiveOpportunities
SUMMARYNo two traders are exactly alike. Some, like stock investors, spend a lotof time studying individual companies, earnings reports, or financialstatements. Others, like currency traders, are more focused on economictrends, interest rates, and geopolitical events. Still others, such as futures traders, are often more focused on charts and graphs. One methodis not better than any other, but you will find that many successfultraders specialize in one approach and become experts in that particularfield of study.In this chapter, the reader is introduced to a wide variety of methods—including fundamental, technical, and sentiment analysis—that canbe used to help locate profitable trading opportunities. Readers are alsoencouraged to use various media sources, including The Wall Street Journal, Investor’s Business Daily, and CNBC. In addition, a few informaltechniques—from using the contrarian approach to critiquing productsyou own, as well as some effective stock indicators—are explored.
QUESTIONS AND EXERCISES1. What are the two general forms of market analysis?1. _________________________________________________________2. _________________________________________________________194
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2. ______________ analysis is primarily concerned with the underlyingfactors of supply and demand regarding a stock or commodity.A. Fundamental.B. Technical.C. Sentiment.3. Name some factors of fundamental analysis.________________________________________________________________________________________________________________________4. ______________ analysis is primarily concerned with statistics generated by market activity and the resulting patterns and trends.A. Fundamental.B. Technical.C. Sentiment.5. Name two common tools of technical analysis.1. _________________________________________________________2. _________________________________________________________6. ______________, probably the simplest and most widely used technical tool, calculate price action over a specified period of time as amean or average.A. Technical charts.B. Moving averages.C. Momentum indicators.D. Contrarian approaches.7. A ______________ utilizes price and volume statistics for predictingthe strength or weakness of a current market and any overbought oroversold conditions.A. Technical chart.B. Moving average.C. Momentum indicator.D. Contrarian approach.
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______________ analysis is primarily concerned with the nature andimpact of crowd psychology on financial markets.A. Fundamental.B. Technical.C. Sentiment.
9. Name some tools of sentiment analysis.________________________________________________________________________________________________________________________10. If you use ______________, you will be trading against the majorityview of the marketplace.A. Charting techniques.B. Moving averages.C. Momentum indicators.D. The contrarian approach.11. True or False: Fundamental and technical analysis are mutuallyexclusive—traders should learn to use one or the other.12. By studying the daily reactions of specific markets to ______________,you can begin to forecast which strategy can be used to make thelargest potential profit.A. Interest rates.B. Seasonal changes.C. Government reports.D. All of the above.13. Name three ways you can spot potentially profitable investmentswhen shopping in a retail store.1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________14. Name four ways to spot potential investments in your everyday life.1. _________________________________________________________2. _________________________________________________________
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3. _________________________________________________________4. _________________________________________________________15. Data service providers can relay information in which three ways?1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________16. True or False: If you are going to sit in front of a computer all daylong, then you don’t really need real-time feeds.17. ______________ was born from the Financial News Network (FNN),which was watched widely by the investment community.A. CNN Business.B. CNBC.C. CBS.D. FOX.18. The best investments have ______________, which should be monitored over both a short and a long period of time.A. Cheap options.B. Low margin.C. Momentum.D. Low volatility.19. An increase in a stock’s ______________ signals movement and agood opportunity for investment.A. Price.B. Volume.C. Perceived risk.D. All of the above.20. The best investments have a reasonable ______________ relative tothe industry average.A. Settle.B. Yield and percent.C. P/E.D. Open interest.
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21. Name six ways to spot potential profit-making stock opportunities.1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________4. _________________________________________________________5. _________________________________________________________6. _________________________________________________________22. A low-priced market trades for less than ______________.A. $10.B. $20.C. $30.D. $50.23. Why is it easier to make money on low-priced markets?A. You can make a high return much faster.B. You have less invested to lose.C. You can play more stocks with less money.D. All of the above.24. The theory behind ______________, the basis of a mutual fund, is thata larger group of stocks will even out the chances of winning in thelong run.A. Diversification.B. A broad portfolio.C. Both A and B.D. None of the above.25. Momentum investors are much more ______________ oriented thanmutual fund investors or money managers.A. Short-term.B. Long-term.C. Volatility.D. Profit.
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26. A long-term indicator of momentum can be measured by looking for achange in price of a stock over the previous ______________.A. 15 days.B. 30 days.C. 60 days.D. 90 days.E. Both A and B.F. Both C and D.27. If a stock has increased or decreased in price more than______________ since yesterday, this can be used to indicate amomentum investment.A. 5 percent.B. 10 percent.C. 15 percent.D. 20 percent.28. If a stock trades less than ______________ shares daily, try to avoid itin short-term trading.A. 100,000.B. 300,000.C. 500,000.D. 1,000,000.29. To apply the contrarian approach, look at the ______________ list tofind stocks that have made major moves down (50 percent or greater)and then look for a rebound.A. Price Percentage Gainers.B. Price Percentage Losers.C. Volume Percentage Leaders.D. Lifetime High and Low.30. The blow-off bottom may have occurred when a stock is coming off anew ______________.A. High price with high volume.B. High price with low volume.C. Low price with high volume.D. Low price with low volume.
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MEDIA ASSIGNMENTThe purpose of this media assignment is to find a reliable source forstock charts and indicators. There are a number of ways to do so. Anumber of web sites offer stock charting capabilities—including theInteractive Wall Street Journal, Bloomberg.com, Stockcharts.com,BigCharts.com, Optionetics.com, and a host of others. If you have abrokerage account, your firm might also offer real-time charts. Subscriptions to more advanced charting programs such as TradeStation,eSignal, and ProfitSource sometimes make sense for more activetraders who are looking for more sophisticated charting tools.Whether using free trading capabilities online or using a more sophisticated software package, readers will want to begin reviewing charts on aregular basis. The first step is to select a small number of stocks that areactively traded. Look at the graphs over different time frames—daily,weekly, monthly. Understand that a trend can easily go from an uptrend toa downtrend depending on the time frame used in a chart. For example,what appears to be an uptrend on a daily chart could well be a downtrendon the monthly chart.Next, apply indicators. Some important indicators have been discussed throughout the chapter. Moving average convergence/divergence(MACD), Bollinger bands, and Elliott Wave analysis are examples of common indicators that can be applied to charts using almost any softwareprogram or web-based charting tools. Look at a number of differentstocks and consider how various indicators can help identify turningpoints in different situations. In conclusion, readers should begin chartingstocks and applying indicators. Doing so provides a quick and easy way tosee the price action and technical trends of a stock or index.
VOCABULARY LISTBar chart
Fund manager
Blow-off bottom
Fundamental analysis
Blow-off top
Momentum
Capitulation
Moving average
Contrarian
Moving averageconvergence/divergence (MACD)
Data feedDiversification
Mutual fund
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On balance volume (OBV)
Sentiment analysis
Price-to-earnings ratio (P/E)
Technical analysis
Real-time data
Volume
Seasonal patterns
SOLUTIONS1. What are the two general forms of market analysis?Answer: Fundamental analysis and technical analysis.Discussion: Technical analysts rely heavily on charts, volume information, and trends. Fundamental analysts are more concerned withthe company or the industry. So, instead of looking at charts, the fundamental analysts will spend more time with news releases, earningsreports, and other financial statements.2. ______________ analysis is primarily concerned with the underlyingfactors of supply and demand regarding a stock or commodity.Answer: B—Technical.Discussion: Technical analysts will look at a chart along with volumeinformation to study the balance of supply and demand with respect toa specific stock or commodity. Technical analysis is based on the theorythat market prices display repetitive patterns that can be tracked andused to forecast future price movement.3. Name some factors of fundamental analysis.Answer: Products, customers, consumption, profit outlook,management strength, supply and demand with regard to outputs,and economic data.Discussion: Fundamental analysts are concerned with the profitability of a company or industry. Often, the focus will be on hard factssuch as earnings, market share, and growth rates. The ultimate objective is to determine whether the market price of the stock or commodity reflects its true value. If the market price is too high, then it wouldmake sense to sell short the investment. If the price in the market istoo low relative to the true value of the company or investment, the investor may want to buy the asset or place a bullish options strategy.4. ______________ analysis is primarily concerned with statistics generated by market activity and the resulting patterns and trends.Answer: B—Technical.
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Discussion: Technical analysts want to determine if the buying pressure or selling pressure is increasing relative to a specific stock or investment. When buyers are gaining greater control, prices are likelyto rise. When sellers seize control, prices will fall. Statistics based onmarket activity along with patterns or trends can help determinerelative levels of buying and selling pressure.5. Name two common tools of technical analysis.Answer: Moving average and momentum indicator.Discussion: Moving averages and momentum indicators areamong the more commonly used technical indicators, but there aremany more.6. ______________, probably the simplest and most widely used technical tool, calculate price action over a specified period of time as amean or average.Answer: B—Moving averages.Discussion: A moving average is the average of a given amount ofdata plotted on a stock chart using different time frames. For example, a 14-day average of closing prices is calculated by addingthe last 14 closes and dividing that number by 14. This simple toolis an easy way to see long-term trends and identify areas of supportor resistance.7. A ______________ utilizes price and volume statistics for predictingthe strength or weakness of a current market and any overbought oroversold conditions.Answer: C—Momentum indicator.Discussion: Momentum trading is the practice of buying or selling aninvestment based on its price trend. For instance, if a stock has beenmoving higher on heavy volume for a considerable period of time, itis said to have strong upward momentum. Momentum traders will attempt to profit from this inertia by purchasing that stock during theupward move.8. ______________ analysis is primarily concerned with the nature andimpact of crowd psychology on financial markets.Answer: C—Sentiment.Discussion: Sentiment analysis gauges investor sentiment by analyzing the group consciousness of the marketplace, using various
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market criteria that define the market’s “state of mind.” The goal is todetermine if investors, or “the crowd,” are bullish or bearish towardthe market. When studying market sentiment, the technical analystgenerally takes a contrarian approach. That is, if investors are predominantly bullish, the analyst will be bearish (sell stocks). If, on theother hand, the crowd is bearish, the analyst will turn bullish (buystocks). Examples of indicators used in sentiment analysis includethe following: survey of newsletter writers, amount of margin debt,and mutual fund cash levels. The interpretation of these criteria, however, is subjective. Luckily, market analysts do agree that certainmeasurements strongly suggest a predominantly bullish or bearishtone to the market, but sentiment analysis requires the combinationand interpretation of several measurements to reach a conclusion.9. Name some tools of sentiment analysis.Answer: Volatility Index (VIX), VXN, put/call ratios, advisor sentiment,confidence index, odd-lot short sales, mutual fund liquid assets ratio,short interest ratio, over-the-counter (OTC) relative volume, marketP/E ratio, and the Dow Jones Industrial Average dividend yield.Discussion: A wide variety of sentiment indicators exists fortraders to explore. Two of the most popular include the VolatilityIndex (VIX) and put/call ratios. VIX reflects the implied volatilityand premium paid for SPX options and can rise dramatically duringperiods of uncertainty as investors scramble to hedge portfolioswith SPX puts. VIX tends to stay within a range for long periods ofmonths or years. When the VIX either exceeds or drops below thisrange, a mood of either pessimism (a high VIX) or optimism (a lowVIX) prevails.Put/call ratios are used as a contrary indicator. Since calls makemoney when shares or indexes rise, they often represent bullish betson the part of investors. Conversely, puts increase in value when astock or index moves lower and, therefore, reflect bearish bets.Again, studying put/call ratios is an exercise in contrary thinking.Specifically, if most market participants (the crowd) are buying puts,it is a sign of negative sentiment and reason to turn bullish. Conversely, a low put/call ratio is interpreted as a market negative sincethe crowd is excessively bullish, but probably wrong.10. If you use ______________, you will be trading against the majorityview of the marketplace.Answer: D—The contrarian approach.
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Discussion: Contrarians bet against the crowd. The idea is that themajority of investors can’t be correct all of the time. When the majority view becomes too one-sided, it pays to bet against that view. Thus,the contrarian investor does the opposite of what the general consensus may be. Even though this may sound suicidal, time has repeatedlyproven this strategy’s wisdom.
11. True or False: Fundamental and technical analysis are mutuallyexclusive—traders should learn to use one or the other.Answer: False.Discussion: Many successful traders use a combination of technicaland fundamental analysis. In general terms, fundamental analysis isthe study of the company and technical analysis is the study of thestock price. As a trader, use what works for you.
12. By studying the daily reactions of specific markets to ______________,you can begin to forecast which strategy can be used to make thelargest potential profit.Answer: D—All of the above (interest rates, seasonal changes, government reports).Discussion: Seasonal patterns, economic reports, and changes in interest rates are all factors to consider when studying the day-to-dayaction in the markets and developing options strategies. Ultimately,these are the factors that can trigger market volatility and end longterm trends.
13. Name three ways you can spot potentially profitable investmentswhen shopping in a retail store.Answer:1. What products are hot.2. Which products have the most store shelf exposure.3. Which products a clerk says are literally flying off the shelf.Discussion: A simple way to look for investment opportunities is topay more attention to what is happening in your local area. Visitingretail stores, for example, and understanding what consumers arebuying can sometimes help uncover the next great investment.
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14. Name four ways to spot potential investments in your everyday life.Answer:1. When you are driving around, take notice of companies and franchises where you get a good deal as to price, quality, and quantity.2. Critique what you already own.3. Ask your children what’s hot and what’s not.4. Look around where you work for popular products and services.Discussion: The day-to-day trends in your local area often reflectbroader trends throughout the economy. A question to ask is, “Who ismaking money and is there a way for me to profit as well?”15. Data service providers can relay information in which three ways?Answer: Real-time, delayed, and end-of-day.Discussion: Many active traders use real-time quote services totrade. However, the cost of real-time quotes can be quite high. Alternatively, traders can use delayed or end-of-day data, which are a bitslower but also less expensive.16. True or False: If you are going to sit in front of a computer all daylong, then you don’t really need real-time feeds.Answer: False.Discussion: Day trading requires real-time quotes. Obviously, end-ofday data will not work because day trading attempts to capture pricemovements throughout the trading day. Delayed quotes will be tooslow. So for those traders who have decided to spend the day in frontof the computer, it makes sense to pay extra fees and get real-timedata feeds to be as competitive as possible.17. ______________ was born from the Financial News Network (FNN),which was watched widely by the investment community.Answer: B—CNBC.Discussion: CNBC, now the most watched financial television newschannel, originated from the Financial News Network.18. The best investments have ______________, which should be monitored over both a short and a long period of time.Answer: C—Momentum.
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Discussion: Prices move in trends. Momentum is a sign that a trendis healthy and is likely to have staying power. The best investmentswill therefore have positive momentum. The best shorting opportunities will have downward momentum.19. An increase in a stock’s ______________ signals movement and agood opportunity for investment.Answer: B—Volume.Discussion: Volume is the engine that makes an investment go. Ifthere is no volume behind an advance or decline, the trend is lesslikely to have staying power. Rising volume during a stock’s advanceis a possible sign of an attractive investment opportunity.20. The best investments have a reasonable ______________ relative tothe industry average.Answer: C—P/E.Discussion: Valuations are an important consideration when looking for stock purchases. A high price-earnings (P/E) ratio is a signthat shares might be overvalued. Therefore, investors will want toensure that the stock’s P/E is reasonable compared to other companies in the industry.21. Name six ways to spot potential profit-making stock opportunities.Answer:1. Stocks with greatest percent rise in volume.2. Stocks with an increase in price greater than 20 percent.3. Stocks with a decrease in price greater than 20 percent.4. Stocks with strong (buying)/weak (selling) earnings per share(EPS) growth.5. Stocks with strong (buying)/weak (selling) relative strength.6. Stocks making new 52-week highs or new 52-week lows.Discussion: Technical-oriented traders rely heavily on price and volume data. By studying patterns and relationships, these traders canincrease the odds of entering into winning trades. In that respect, thesix situations listed have stood the test of time.22. A low-priced market trades for less than ______________.Answer: B—$20.
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Discussion: Stocks trading for less than $20 are considered lowpriced for options trading purposes.23. Why is it easier to make money on low-priced markets?Answer: D—All of the above (make a high return faster, have lessinvested to lose, play more stocks with less money).Discussion: An investor with a fixed amount of money to investcan generate better returns with low-priced stocks because (1)with lower-priced stocks each dollar move represents a larger percentage move, (2) there is less invested to lose, and (3) you canparticipate in a greater number of different stocks with the sameamount of money.24. The theory behind ______________, the basis of a