Top Dog Swing Trading Course

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Dr. Barry Burns TOP DOG TRADING INTERMEDIATE COURSE: SWING TRADING WITH CONFIDENCE

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Dr. Barry Burns Copyright 2008 Wealthstyles LP IMPORTANT-READ CAREFULLY: Reproduction, translation, or distribution in any form or by any means, or storage in a data base or retrieval system, of any part of this work beyond that permitted by Section 107 or 108 of the 1976 United States Copyright Act without the permission of the copyright holder is unlawful. Requests for permission or further information should be directed to: Wealthstyles LP

1534 N. Moorpark Rd, #222 Thousand Oaks, CA 91360-5129 (805) 491-3541 This publication is sold with the understanding that neither the publisher nor author are engaged in rendering legal, accounting, investment or other professional services. Trading and investing involves substantial risk. Financial loss, even above the amount invested, is possible and common. Seek the services of a competent professional person before investing or trading with money. By accepting this trading course you agree that use of the information of this course is entirely at your own risk. Neither the author nor the publisher is a registered investment advisor or a broker dealer. You understand and acknowledge that there is a very high degree of risk involved in trading options, futures and securities. Past results of any individual trader are not indicative of future returns by that trader, and are not indicative of future returns which may be realized by you. Neither the author nor publisher assume responsibility or liability for your trading and investment results. This course is provided for informational and educational purposes only and should not be construed as investment advice. The author and/or publisher may hold positions in the stocks, futures or industries discussed here. You should not rely solely on this Information in making any investment. The information in this course should only be used as a starting point for doing additional independent research in order to allow you to form your own opinion regarding investments and trading strategies. It should not be assumed that the information in this manual will result in you being a profitable trader or that it will not result in losses. Past results are not necessarily indicative of future results. You should never trade with money you cannot afford to lose. The information in this product is for educational purposes only and in no way a solicitation of any order to buy or sell. The author and publisher assume no responsibility for your trading results. There is an extremely high risk in trading. This course discusses the use of options. Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital, which you can afford to lose. This course is sold "AS IS," without any implied or express warranty as to its performance or to the results that may be obtained by using the information. Factual statements in this course are made as of the date the course was created and are subject to change without notice. HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER OR OVERCOMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.

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TOP DOG SWING TRADING COURSE

TABLE OF CONTENTS DIFFERENCES BETWEEN SWING TRADING AND DAY TRADING............... 4 Advantages and Disadvantages of Swing Trading ..................................................... 4 Support/Resistance...................................................................................................... 6 4. Gaps ...................................................................................................................... 10 Diversification........................................................................................................... 17 Position Sizing .......................................................................................................... 19 News ......................................................................................................................... 25 VOLUME ..................................................................................................................... 26 Volume Histograms .................................................................................................. 29 My 7 Rules of Volume Patterns................................................................................ 29 Volume Moving Average ......................................................................................... 40 On-Balance Volume (OBV) ..................................................................................... 43 FINDING THE BEST MARKETS TO TRADE....................................................... 46 Scanning the Market for Setups................................................................................ 47 Measuring Relative Strength..................................................................................... 50 HEDGING YOUR POSITIONS AGAINST MAJOR LOSSES ............................ 63 Option Pricing........................................................................................................... 65 It’s All Greek To Me................................................................................................. 70 Using Options to Protect Your Trades and Investments........................................... 76 Digging Deeper Into Options.................................................................................... 96

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DIFFERENCES BETWEEN SWING TRADING AND DAY TRADING Advantages and Disadvantages of Swing Trading I simplify trading time periods into 3 general categories: 1. Day trading: Using short-term intra-day charts and not holding a position over night. 2. Swing trading: Using long-term intra-day charts or daily charts in which you do hold positions over night. 3. Investing: Using weekly and monthly charts in which you are looking to hold positions for a year or more. Personally, when I swing trade I’m mostly using daily charts. This is because I also day trade and that takes a lot of concentration during the day. I don’t want to look at or even think about my swing trades during market hours. There are some real advantages of swing trading over day trading: • • • •

The “technicals” are often more reliable on longer term charts because you avoid a lot of the noise on the short-term day trading time frames. You can hold a job during the day and swing trade when you get home. If you use daily charts for your swing trading, you don’t have to make any entries or exits during market hours. Place your buy and sell stops and your limit orders before or after market hours and let the market get you in and out. You have much more time to make a buying or selling decision. Day trading can be very stressful and emotionally taxing. You also have to be “quick on the draw” and be able to concentrate for long periods of time, keep your focus, analyze a situation, and execute a trade at a minute’s notice. Commissions and trading costs are a smaller percentage of your gains than with day trading.

Of course like anything, compared with day trading there are some potential downsides of swing trading as well: • •

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The profit potential can be less because you are not able to “turn over” the same money as frequently. You have fewer trades and therefore you may be frustrated by a need for more trading “action.” It also gives you less trading experience, therefore lengthening your learning curve on the way to becoming a profitable trader. On average, using daily charts you will only have one trading opportunity per month because we are only looking to trade cycle highs and lows, and not even all of those are tradable. You have the “wild card” of overnight risk to be concerned about. Bad news can come out overnight which could dramatically and traumatically affect your position, causing it to gap against you beyond your protective stop. Of course this slices both ways and the market can gap in your favor as well.

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o o o

Daily Chart gives 2-4 half cycles (cycle low to cycle high) per month Weekly Chart gives about 8-12 half cycles per year Monthly Charts gives about 1-3 half cycles per year

These numbers are based on trading one market. So one way we will look to trade more frequently is to trade more than one market. That will be a major emphasis in this course and I’ll be showing a couple ways to find the best markets to trade at any given time.

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Support/Resistance Swing traders do not have some of the standard support and resistance levels available to day traders such as the previous day’s high, low, close and the floor trader’s pivots. For this reason other support/resistance levels take on more importance. Remember that all support and resistance lines are not really “lines!” Yes, they look like lines, but looks can be deceiving! They are really “ZONES.” Understanding this is important because it is rare for the market to move to a support level and stop right on it. I could stop short of it, or go through it a little. Either way, if the market hesitates or bounces off that level, we consider that the market has acknowledged that level. This is why we normally take profits “inside” of support and resistance. We want to make sure our targets are filled. The following levels are the ones I use in swing trading:

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1. The standard moving averages. I use the same moving averages I do on day trading charts; however on a daily chart these moving averages are even more significant than they are on intra-day charts. The reason is simple: there are more people looking at a 50 SMA (Simple Moving Average) on a daily chart than there are looking at it on a 5 minute chart, a 1 minute chart, a 144 tick chart, etc. The more people looking at a level, the more likely it is that the market will respond to that level.

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2. Fibonacci levels. Again, because traders use so many different time intervals for day trading, the highs/lows used to draw Fibonacci levels can vary dramatically from one trader to another. Thus, the Fib levels come in at different points on the chart and therefore they are not as strong. On a daily chart, however, everyone is seeing the same highs and lows and therefore it’s more common for people to use the same highs and lows to draw their Fibonacci levels. I draw the Fibonacci levels from the extreme high and low of the range I’m using.

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3. Horizontal lines off previous significant highs/lows. Drawing these levels is one of the first things I learned to do in technical analysis, but I don’t see many traders doing it any more. I believe these levels are more important than Fibonacci levels because they are very concrete and are the same for everyone. I think this may be a difference between pros and amateurs. Many of the pros still do this, but a lot of the amateurs are more enamored with Fibonacci levels. These lines should be drawn from the real bodies of the candles, not the extreme highs and lows.

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4. Gaps Gaps can provide support resistance, both as the market comes back to attempt to fill them and then after it has filled them, and they are always a significant pattern traders are watching.

Gaps are simply price moves that leave “holes” in the price pattern where 2 consecutive price bars do not overlap and there is vertical space between them. Gaps are very significant and are noticed by all professional traders. Therefore they should be integrated into your trading plan as well. The trading of gaps fits into the category of our rules for parabolic moves. This means that if you’ve only taken my Foundations Courses and are trading the sine wave cycle patterns, the rules have to stay out of these types of moves – at least not trading the first retrace. In my advanced courses I teach a method for trading parabolic moves, but it discards the cycle indicator and the moving averages and employs completely different rules because it’s a completely different energy.

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Normally gaps are often caused by a dramatic news announcement, but it can also be a rumor, or sometimes the reason is unknown. There is speculation that the floor traders and specialists may intentionally gap the market through significant support/resistance levels to avoid dealing with the market resistance that naturally occurs at these levels. The most commonly known rule of gaps is that they get “filled.” So retail traders often look to trade the fill, but these fills may come much later than amateurs think, or they may not come at all. You should mark gaps on your charts with horizontal lines to show that there is support/resistance at those levels. Mark them with a different color line that you know will represent a gap fill for you. That way if you’re looking at a chart months in the future when you can no longer see the gap in the price pattern, you will see the line color and know that price is heading toward a remaining gap. The rule for volume with regard to gaps is the same as with everything else. If the gap is filled on heavy volume, expect that the market may continue in the direction of the fill. If the gap is filled on light volume, expect that the market may barely fill the gap and then continue on in the direction of the original gap. The significance of a gap varies dramatically depending on where on the chart the gap appears. There are 3 types of commonly accepted gaps:

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Breakaway gaps. This is a gap that occurs out of consolidation or very early in a new trend. These gaps, especially when accompanied with solid volume, often mark the beginning of a new trend and may not be filled for a long, long time.

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Measuring gaps. These are gaps that occur in the middle of a trend. It simply shows renewed energy in the trend.

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Exhaustion gaps. This is a gap that occurs at the end of a trend and is often accompanied with huge volume and wide range bars. It often marks the end of a trend and is the most common type of gap to fill.

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And now, putting it all together:

Although this course is primarily about swing trading, looking at the bigger picture can serve day traders as well. Most day traders will see a gap in the morning without any knowledge of where that gap occurs on the bigger picture of a 60 minute or daily chart. Having this birds-eye view could serve the day trader very well as they attempt to determine whether they expect the gap to close or not. Volume is also an important consideration when looking at gaps. The key to volume with gaps is that you don’t want to little or too much. If the market gaps up on little volume, this lack of commitment in the direction of the gap could indicate a quick closing of the gap. Day traders may also want to look at premarket volume to see how much volume created the move up that appears as a gap on the open.

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If the market moves up with a huge volume spike, it could be exhaustion volume, especially if it’s at the end of a long running trend on a higher time frame. The gaps least likely to fill (at least in the near future) are those with stronger than average volume that occur early in a trend.

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Diversification I generally only trade 1 or 2 markets at a time when I day trade. I trade very short-term charts and so I have to be continually watching them for trade setups. My attention cannot be effectively focused on more than 2 markets at a time, and often I’m only trading one market (I day trade futures contracts). I prefer trading one of the stock index futures (S&P eminis, Russell 2000, Nasdaq 100, Dow). Then along with that I may trade a currency (the Euro or the Yen) because they are not correlated with the US stock market and may provide a good trading environment on a day when the stock market doesn’t. When I Swing Trade, however, I’m always looking to spread my money into multiple markets at the same time to achieve diversification. This is an advantage to Swing Trading because diversification is preferable to having “all your eggs in one basket.” Unfortunately, day trading is just too fast and requires too much attention to allow diversification … at least for my limited mental capacity! We don’t diversify just for the sake of diversifying. We can only do it when we find valid setups. However we’re always looking for those valid setups. This is why I am always reviewing my watch list which is pre-designed with a wide variety of markets that are often uncorrelated to each other. Actually there are 2 reasons for creating that list: 1. To become as diversified as possible in an attempt to mitigate overall risk. 2. To find and catch a raging bull market or a raging bear market that I can ride to big long-term profits. So what type of markets are we watching that will help us diversify? • • • • • • • •

The various stock market sectors. The various stock market industries. Currencies. Indexes of countries from around the world. Agricultures (corn, wheat, soybeans, etc.) Interest Products (bonds, dividend paying ETFs) Metals (gold, silver, etc.) Energy (oil, clean energy, gas, etc.)

I primarily use ETFs (Exchange Traded Funds) for swing trading, but I also trade some stocks that catch my interest from time to time. Personally I don’t Swing Trade futures. The most leverage I’ll use to Swing Trade is the Ultra ETF funds which are designed to produce twice the return of its normal ETF equivalent.

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The exact list I use is provided in this course in the section on “How to Find the Best Markets,” but there’s no magic to my list and I change it from time to time.

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Position Sizing With the issue of diversification, naturally follows the question of position sizing. If you’re going to have positions in multiple markets concurrently, how much should you invest in each one? Again, I don’t claim to have the magic answer for everyone, but I’ll share with you how I do it. You can evaluate whether this is right for you or not. I like to be diversified with at least 5 positions at the same time. More positions give you more diversification of course, but will also require more capital. So this is a limiting factor. The larger your account size the more you can diversify, and potentially therefore reduce risk. This doesn’t mean that I always have 5 positions live in the market at any one time, but it’s how I plan my Swing Trading Portfolio. In other words, I will only enter a position that has met my trading setup, but I allow myself enough sideline capital to be in 5 positions at the same time. Therefore I could put a maximum of 20% of my account into each position … however I never do that. I would rather put 10% of my account into each position, and use the balance to hedge each of those 5 positions, plus leave some money left in cash so I’m never maxing out my account and always have flexibility to take advantage of any tremendous opportunities that may come along. I never want to be trading my last dime. “Hedging” your positions is very important. It means to take a position with another instrument (usually options) that “protects” your stock or ETF position against a major loss. I share how I do that later in this course in the section: “Hedging Your Position Against Major Losses.” The math on this is very simple. Here’s an example: If my total account size is $100,000, then I would use $50,000 of that for trading my primary stock/ETF positions. That means I will invest $10,000 in each of 5 positions, and then figure my position sizing (number of contracts I’m going to buy) from there. So if I buy EEM (iShares Emerging Markets Index Fund) at 25.05, then I would simply divide that price of my entry into $10,000 to determine how many shares I would buy: $10,000 divided by 25.05 = 399.20159. In this case it’s so close to 400, that I would buy 400 shares of EEM at $25.05 (I round up or down to try to keep it within 2% of the amount allocated for each

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trade (within $200 of $10,000 in this case) because the main issue is to have each position with an equal amount of capital committed to it. Doing it backwards for confirmation: 25.05 (entry price) X 400 (shares) = $10,020.00 (of my trading account). That’s simple enough, but there is one more issue that must be addressed that many people neglect … and it is VERY important! It is true that you have a total of $10,000 at risk in the trade. But while that possibility is there, it is diminished by 2 factors: 1. If you trade ETFs of sectors, industries, commodities, etc. as mentioned above, there is very little chance that your market will go to zero. If it does, then the entire economy is going to have bigger problems than your $10,000 loss! 2. You can offset the vast majority of that risk with your leveraged position, as we’ll see later in the course. These 2 factors mean that while you must certainly balance the weighting of your position based on the cost of the trade (since that is money out of pocket), your more probable risk is different than the value of your position. Your probable risk is the difference between your entry and your stop … or of your entry and where your leveraged position kicks in (which should be designed to protect you if the market gaps through your protective stop). To clarify, let’s look at an example. You’re looking to buy 400 shares of EEM tomorrow if it hits 25.05. You place a buy stop limit order that will automatically get you in anywhere from 25.05 to 25.11. You don’t want to spend more than that, but you’re willing to allow 5 cents of slippage if it’s necessary in order to get all 400 contracts filled (I generally allow about ¼ of 1% for this when placing my orders: 25.05 X .0025 = .062; 25.05 + .062 = 25.112). Tomorrow the market goes up and you get an average fill price of 25.10 on your 400 shares. Your stop loss goes 1 cent below the cycle low (this is just a hypothetical example, but in this case we’ll say your stop is 24.50). So your stop is 60 cents from your fill price, and therefore your probable risk in the trade is 60 cents X 400 shares = $240.

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Of course your REAL worst-case scenario risk actually is $10,040 (400 shares times your entry price of 25.10) should the index go to absolute zero. Therefore to offset this, you would want to have your hedging position protect you at your stop price of 24.50 or better … but more on that later. The point to understand in this section of the course is that you want to have your probable risk relatively constant in all 5 of your positions. In this case they should all be in the neighborhood of $240. Here’s why: You can have 5 positions in which you have committed approximately $10,000 of your account. But the probably risk on each trade could be very different depending on the price of the markets and the distance from your entry to your stop on each trade. That means you’re protected evenly in a worse-case scenario, but you are not evenly protected against the vast majority of losses you will actually experience. You could have 4 winning trades, and 2 losing trades. But the losing trades could have a wide distance from your entry to your stop, and therefore produce losses that are twice the losses of your winning trades. If this happens, you have twice as many winners as losers, but it’s still possible that you made no money! To flesh out this issue, here are a couple of chart examples:

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As you can see, the first trade, PGJ, has only a probable risk of $136.50, whereas the second trade, UTH, has a probable risk of $455.20, even though we’re committing an even amount of capital ($10,000) to each trade. That’s an enormous difference! You have to ask yourself – what is more likely? That these major market indexes will go to zero and cease to exist, or that your stop will simply be taken out? Obviously the latter is much more likely, but being as conservative on these matters as I am, I still consider the worst-case scenario. Now let’s ask ourselves why there is such a dramatic difference between these 2 risks scenarios. There are several reasons:

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UTH is simply much more expensive than PGJ. That accounts for a big part of the difference with regard to the dollar amount difference. It’s more than 4 times as expensive ($126.51 vs. 28.93). The stop is only 1 bar width on PGJ, whereas it’s 2 bars on UTH. In addition, the bars on UTH are wide range bars. Most importantly, the distance from the entry point to the protective stop on UTH is farther away on a percentage basis than it is on PGJ. (4.5% on UTH and 1.3% on PGJ). This is calculated by taking the entry price (126.51 in UTH) and dividing it into the dollar risk per share from the entry to the stop (5.69 in UTH). 5.69 divided by 126.51 is 0.0449 or 4.5%.

We use this information to arrive at solutions to this problem, and the basic solution for me is this: • •

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I target risking 1% of each position on each trade. If I’m committing $10,000 to each of 5 positions, I’m targeting a probable risk of roughly $100 on each one. I target risking no more than 3% of any stock’s value on a given trade. That means the distance from the entry to the stop should be no more than 3% of the price of that stock/ETF. As given in the example above, UTH had a risk of 4.5% of its price and therefore I would simply not take that trade even though it had a valid setup. The reason is that it had moved too far in the direction of my trade already, thus affecting my risk/reward ratio. If a trade does not meet these parameters, I can do one of 2 things: o Pass on the trade o Adjust my hedge so that the risk parameters are met.

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News I am a technical trader in that my trading decisions are largely based on technical analysis. However from my early years of study with my dad, I was taught the tremendous affect that news has on the markets. While it can be tricky to trade the news, you must still be aware of when known news releases are coming. Sometimes the markets will move up on good news. This is to be expected. Other times it will move down on good news. That may be counter-intuitive, but it will happen when the market has already discounted the news (very common) or the market sentiment is so bearish that people don’t care what optimistic news is released, they are just going to sell. The news itself does not move the market. It’s the traders reaction to the news that moves the market, and that’s what makes it hard to predict. Still, one must be aware of when important news hits the wire because one way or another it often does have an effect, and it can be very dramatic. In fact, news can be so powerful that it’s a common saying that “news trumps technicals” and I agree with that. When day trading we are aware when economic indicators and other such reports are coming out. The importance of these vary from time to time. As swing traders we can be aware of those as well, but also have to watch for news that is often released before or after the market is closed. Most notably, are the earnings reports that companies release quarterly. You should definitely consult an earnings calendar and always be aware of when earnings are being announced, especially for a stock you are trading. There are several good ones available for free online: http://www.earningswhispers.com/calendar.asp http://biz.yahoo.com/research/earncal/today.html http://www.bloomberg.com/apps/ecal I personally don’t trade the earnings unless it aligns with a new trade based on my technical analysis. Still, remember that news can decimate the best technical set up, so I recommend beginning traders not trade during earnings releases.

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VOLUME Volume is another “energy” that we can add to the 5 energies we learned in Foundations Courses 1 and 2. Consider it the 6th energy. Business is about the balance of supply vs. demand, and nothing measures supply and demand as well as volume. Supply/demand is what essentially moves the market, and thus the importance of measuring volume. • •

Increasing volume as the market moves up indicates rising demand with low supply. Increasing volume as the market moves down indicates rising supply with low demand.

Many students are surprised that I don’t include volume in the first 2 courses because they have heard from other traders how critically important it is. There are several reasons I chose not to include it in the Foundations Courses: 1. In the Foundations Courses I introduced the energies that I consider on every trade I take. Contrary to what others may teach, I don’t find volume to be as telling on every trade setup. 2. Volume can be tricky to read. Like price, it isn’t easy for most traders to “see” how to read volume in a way that will help them trade. 3. The discussion of volume is a rather lengthy one and there is only so much information that students can absorb at one time. Given reasons 1 and 2 above, the discussion of volume was decided to be relegated to a later course. 4. Volume is more valuable for swing trading and investing than it is for day trading. This is because the pattern of volume on every intra-day chart is roughly the same – a long cupping pattern with high volume in the morning and afternoon with low volume throughout the midday.

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Many traders’ charts include several indicators such as moving averages, stochastics, RSI, MACD, etc. Indicators do as their name implies: They only “indicate.” They do not tell you what will happen. They actually don’t even really tell you what is happening right now, at least not directly. That’s because they are derivatives of something else. Usually they are mathematical formulas based on price and/or volume. Therefore 2 things we can look at on a chart which are not derivatives, but from which indicators are derived, are price and volume. Again, let’s be very clear that volume is not an indicator. It is a direct measurement of the number of shares or contracts that are processed in a given time period. Volume is a fact, as price is a fact. So if price and volume are the “absolutes” in the market, then why not just trade using them and abandon all the indicators?

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Some traders do that. And I even know a few who do it successfully. I’ve followed their methods and found that by adding carefully chosen indicators I can trade more effectively than without them. This is because indicators can help us “see” things that may be there in price and volume, but indicators visually present them in a different form that is clearer to the average trader’s eye and easier to interpret.

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Volume Histograms Volume histograms are the most common way of plotting volume. They simply post a line at the bottom of the chart directly under each price bar that measures how many contracts/shares are trading during that bar. Some charting platforms allow you to change the color of the histogram bars depending on whether the bar closed up or down compared to the previous close. This is my preferred way to plot volume as you’ll see.

My 7 Rules of Volume Patterns •

RULE 1: Expect volume to increase in the direction of the dominant trend and for it to decrease on retraces against the dominant trend.

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RULE 2: If you see volume increasing on trend retraces, and/or decreasing in the direction of the dominant trend, it may be a precursor to a trend change (this is one way that volume can lead price).

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RULE 3: A dramatic spike in volume can be an “exhaustion signal,” marking cycle or wave tops and bottoms (short term or long term) as both buyers and sellers are taken out of the market. This does not necessarily mean the market will reverse direction. It could just go into a consolidation period. These are often good support/resistance levels to mark. on your chart. Look for reversal candlestick patterns to accompany these volume spikes: o Hammer o Hanging man o Engulfing bars o Dark cloud cover o Shooting star o Doji This course is not about candlestick patterns, but you can find a good summary (with diagrams) of candlestick patterns at:

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:candlestic k_pattern

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• •

RULE 4: Huge volume spikes on narrow range bars (especially in consolidation patterns) are often signals that the market is getting ready to make a big move. Trade in the direction of the breakout.

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•

RULE 5: At major tops and bottoms look for a climax of volume. Then wait for the pullback and look for a retest of that high or low. On that retest you want to see lower volume. Consult the example of the down move in the chart below. The market makes a significant move down to put in a low, then it bounces up and then goes back down to retest the low (could be an equal low, or a slightly lower low, or a higher low). That is often a good entry point because the lower volume on the retest demonstrates that there is less conviction to that second down move.

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RULE 6: When a market breaks through support/resistance, and then comes back to test that level, you want volume to be high on the break (or better – approaching the break) and you want volume to be low on the retrace to that level as support in order for that level to hold price. The same reasoning applies here as it does for the double top/bottom rule. You want to have a lot of energy on the initial break to make it successful. But then if that level is to hold, and not break on the retest, there should be little energy (as measured by volume) when the market comes back to that level.

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• •

RULE 7: Mark the level of volume at significant price highs and lows (waves). As the market approaches those levels again, is volume more (showing strength) or less (showing weakness) than the last time the market was at that level?

IMPORTANT: In my opinion, volume is a short-term signal. None of these volume patterns give you a long-term analysis of what the market will do. Volume is best correlated with Cycles and the timing of its validity is tied directly with the half cycle. As mentioned above, reading volume is not always as easy as one would like (what is with the markets?).

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In an up trend, price doesn’t move straight up, but rather it moves up and down in a seesaw pattern on its way along an up trend. So too with volume, when traders are accumulating a “tradable”, volume doesn’t always move in a neat and clear pattern to the upside. It is often erratic in its movement, reflecting the erratic behaviors of the traders involved in the market. That being said, becoming skilled at reading volume can be an extremely powerful addition to your trading skills. Like price, volume doesn’t lie. It is what it is. And one of the most exciting aspects of volume is that it can, at times, lead price.

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Volume Moving Average Because raw volume, like raw price, can be hard to interpret, we can use indicators to help bring visual clarity to the raw data. With volume there are 2 indicators I recommend: a moving average and OBV (On Balance Volume). You can use one or both of them. Using a moving average of volume gives you an easy visual reference that can tell you 2 things: 1. Whether volume is increasing or decreasing in general, smoothed terms. 2. The relative strength of volume over the recent past. You can use a length of your preference, but I use a 20 period moving average since it measures the volume over the period of the last month (on a daily chart). Look at the angle of the moving average to get a feel for whether volume is generally increasing or decreasing. More importantly, look at the histogram highs in relationship to the moving average. I don’t pay much attention if the volume histogram is just above or just below the moving average line. That means it’s in the same range as volume has been for the last 20 days. Remember that line is just a smoothing of the value of volume over the last 20 periods. What I’m most interested in is when the histogram gets above or below the moving average by 50% or more. You don’t have to measure it. Just know that you’re looking for significant moves of the histogram breaking the pattern of the moving average. We’re looking for some new, extreme activity of buying or selling. Interpreting these volume signals is dependent on the context of the chart and the market behavior when these signals occur. • • • • •

After an expansion cycle, when volume gets significantly below its moving average, it can signal that a contraction period in the market is coming. After a contraction cycle, when volume gets significantly above its moving average, it can signal that a breakout or significant move is about to occur. At cycle highs and lows, when volume gets significantly above it’s moving average, it can signal that the cycle high or low is about to be put in. Immediately after a cycle high or low, and at the beginning of a new cycle, when volume gets significantly above its moving average, it can signal that the cycle may have good range (follow through). Early in a wave formation, when volume gets significantly above its moving average, it can signal that there may be several waves yet to come.

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Volume is easier to read and has more significance on markets that are heavily traded than those that are lightly traded. Stocks that trade at least 1 million shares per day are the best candidates for using volume, and the more volume the better. This is because the heavily traded stocks have the participation of the major market movers and are not as influenced by the fickle moves of the retail traders.

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There are also some potentially deceptive seasonal patterns you should watch out for when swing trading and investing. • • • • •

The beginning of the year often brings a lot of money into the market as people look to invest their money after claiming losses at the end of the previous year. Summer is notoriously low in volume as a rule, as people travel more and trade less. Holidays naturally have very light volume, including often the days leading up to holidays. Options expiration days are often heavy volume days. The end of the year can result in a lot of selling as people look to lock in losses for tax purposes.

Having said all of this, understand that the big institutional investors are not as concerned about the daily price and volume fluctuations as you probably are. Since they are accumulating and distributing positions over time, they are more concerned with ranges in the market. Therefore volume spikes in the markets do not always lead to a long-term follow through in price.

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On-Balance Volume (OBV) Joseph Granville created an indicator called On-Balance Volume. It is a popular, accumulation/distribution indicator. It works like this: When a stock closes higher than the previous day, OBV adds that volume to the equation. When a stock closes lower than the previous day, OBV subtracts that volume from the equation. The OBV indicator plots a line, which I then plot over the price histogram. So that it’s not confused with the moving average of volume, I make OBV thicker and a different color than the volume moving average and I use the standard period of 14. Like volume itself, OBV can lead price at times. I use the indicator by drawing trend lines and horizontal levels on OBV. If OBV breaks above these lines before price does, that may be a leading indicator that price is going to break out in that direction. This can be especially powerful for reversal patterns after extended trends.

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Here’s a little secret: OBV will often roughly duplicate the pattern on MOM. This is because volume is what tends to create momentum. If you have a hard time reading MOM, as some students say they do, you may find it easier to read OBV. Just remember, they are NOT identical and they are not actually measuring the same thing. For my eyes, MOM is easier to read, but everyone’s eyes are a little different and you may find that OBV is easier for you to see. I prefer MOM to OBV for another reason however. On forex you can’t use volume. And on all intraday charts, volume tends to be a saucer formation. So MOM, reading price rather than volume, works better in both of these situations. On daily charts I use them both and compare to see if one is telling me something the other isn’t. I make special note when they are giving different indications.

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FINDING THE BEST MARKETS TO TRADE Now it’s time to introduce the 7th Energy: Relative Strength. This is the measurement of a market’s performance compared with other markets. When most traders think of becoming successful, they envision the secret residing in some magical indicators or a superior trading system. While good indicators and a great trading method are indeed crucial to success, you can often make money even if you’re a mediocre trader … IF you’re trading the right market. Think how easy it was to make money in tech stocks during the .com boom. Everyone trading then thought they were a genius. But then the .com bust came. And most of those same “geniuses” lost all the money (and sometimes more) that they had made. They didn’t make money because they were good traders. They made money because they were in a market where it was hard to lose! The ideal scenario is to have both factors on your side: • •

Be a great trader. Trade great markets.

They say that there is always a raging bull market somewhere and a raging bear market somewhere. Your job is to find them and focus your trading on them. Then, using your trading knowledge and skill, you manage your money so that when the market finally turns, you don’t go down with it. Why make things hard on yourself by just trading the general stock market, or whatever stock or market that someone else says you should be trading? Become self-empowered to find the best markets – the ones that are RAGING in one direction or the other. Money doesn’t come easy in trading, so give yourself every edge you can … and finding a raging bull or bear market is one of the things you can do to make life easier for yourself. There are 2 ways we find the best markets to trade. We scan for stocks that match our technical setups criteria and we create a watch list of major markets and measure their relative strength.

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Scanning the Market for Setups When using an electronic scanner for setups that match our technical criteria, it’s important to understand that even though you are scanning through thousands and thousands of stocks, you are not actually screening thousands of different possibilities. Most stocks move in a highly correlated fashion to the major stock indexes. Therefore the number of opportunities that present themselves every month will be approximately the same numbers that present themselves in the overall stock market. Of course there are always some sectors, industries, and even individual stocks that are out of sync with the overall market. Using scanning software can help you find these rogue opportunities. The software we use for this is http://www.StockFetcher.com The reason for using this software is because it is accessible to everyone taking this course. • • • • • •

It’s very inexpensive ($8.95/month). It doesn’t matter what charting platform you use. It can scan daily and weekly charts at the same time (critical for your multiple time frame confirmation). It returns scan results blazingly fast. It comes with good charts. The “programming” language is very user friendly and intuitive so you can customize the scans I give you for your own purposes.

You may have another scanning program that you would like to use these formulas in, and you’re welcome to take the formulas I give here and rewrite them into any other scanning software program. Please don’t ask me to do that for you however. It’s a very time-consuming process and I’m not familiar with other scanning programs. If other students create scans for other programs I’ll be happy to pass them along in the future. The formulas are saved in a text file you can download from the Members Section for this course. I put them in a text file rather than printing them in this manual, so you can simply copy and paste them into Stock Fetcher. These scans will NOT always give you a “perfect” setup. In fact most of the time they will not give you a valid setup at all. The setups are more sophisticated than that. For example, the scans cannot help determine how many waves have formed in a trend or whether there is a mini-divergence or not. The scans are designed to filter the universe of stocks down to a select few that are meeting certain key elements we look for in our setups. Once the scan results are returned, you will have to pull up the charts and look at them individually to determine whether the stock is actually in a trading setup or not. Stock Fetcher allows you to

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quickly and easily pull up charts on all the stocks that the scan returned as possible candidates. The scans are also designed to allow you flexibility in editing them so you can determine how aggressive or conservative you want to be in the scanning process. This course gives you scans for the following price formations: • • • • • • • • • • • • • • •

Retrace in an uptrend. Retrace in a downtrend. Rubber Band long Rubber Band short Symmetrical triangle long Symmetrical triangle short Descending triangle long Descending triangle short Ascending triangle long Ascending triangle short Contraction cycle long Contraction cycle short Double bottom Double top ETF relative strength to S&P 500

Below is an example of one of the scans so you can see how to customize the scan to your own needs.

TOP DOG SCAN CODE FOR A LONG IN AN UPTREND: Show Stocks where the 3 day slope of the MA(50) is above .01 and the Stochastic %K(5,3,2) is below 45 and the Stochastic %K(5,3,2) has been increasing for 1 day and the Stochastic %K(5,3,2) 1 day ago was below and the Stochastic %K(5,3,2) two days ago and the Stochastic %K(5,3,2) 1 day ago was below 22 and the MACD fast line(5,20) has been increasing for 1 day and the weekly Stochastic %K(3,1,3) has been increasing for 1 day and the weekly Stochastic %D(3,1,3) has been increasing for 1 day and the weekly MACD fast line(3,10) has been increasing for 1 day and the Average Volume(90) is above 100000 and close is between 10 and 100 This scan has a lot of qualifiers in it, so you if leave the scan to be this strict, you won’t get many results. I put them all in the scan primarily so you have the code and you can use various combinations of it without having to learn it or find it yourself. Now let’s analyze the formula:

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Show Stocks where the 3 day slope of the MA(50) is above .01 This defines the 50 SMA as moving up. If you want the 50 SMA to be angling up even more, you can increase .01 to a higher number. and the Stochastic %K(5,3,2) is below 45 Since we’re going long, we want to enter while the cycle indicator is still at the lower end of the range. and the Stochastic %K(5,3,2) has been increasing for 1 day We need the %K to be angling up for a setup bar on the chart. and the Stochastic %K(5,3,2) 1 day ago was below and the Stochastic %K(5,3,2) two days ago This, along with the previous statement, means we have a “hook” from down to up on %K. and the Stochastic %K(5,3,2) 1 day ago was below 22 We want %K to have at least touched 20 at its lowest point. and the MACD fast line(5,20) has been increasing for 1 day This is not a strict part of the rules, but it adds to the probability of a successful trade if you can a hook on MOM at the same time you get a hook on %K. and the weekly Stochastic %K(3,1,3) has been increasing for 1 day This is part of our next higher time frame confirmation. %K isn’t much of a confirmation on the weekly, but I put it here as an extra qualifier for you if you want it. and the weekly Stochastic %D(3,1,3) has been increasing for 1 day Though not necessary, when we get both MOM and %D confirming on the higher time frame it is a stronger signal than if we just have MOM confirming. and the weekly MACD fast line(3,10) has been increasing for 1 day This is MOM confirming on the higher time frame. and the Average Volume(90) is above 100000 This is where you can stipulate the type of stocks you want to scan for. This formula restricts the results to stocks that have a 90 day average daily trading volume of more than 100,000 shares. and close is between 10 and 100 This is where you can stipulate the price range of the stocks you want to trade. You may not be interested in expensive stocks if you can’t afford to buy them. You also may not be interested in penny stocks. If you leave all of these filters in, your results will be far and few between. Feel free to take some of the filters out and edit others. Most of the time when you run these scans you won’t get any valid trade setups. Remember, on a daily chart there are only an average of 2-4 half-cycles each month. And only have of those could possibly be tradable (in the direction of the trend or a valid trend reversal). So don’t expect that just because you’re running a scan you’re going to uncover a lot of trading setups. As mentioned above, most markets move in line with the overall market anyway. Again, I know that some students are hoping these scans will just drop perfect trades in their laps. These scans will not do that. But they will filter out the majority of stocks and give you the few that meet at least some of the criteria we look for.

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Measuring Relative Strength This is my personal favorite approach to finding the best markets to trade and I’m constantly watching for this. When trading relative strength plays, I prefer to use Exchange Traded Funds (ETFs) rather than individual stocks. ETFs represent broader markets that can provide a substantial and sustainable divergence from the S&P 500. Individual stocks are subject to news, rumors and investor knee-jerk reactions that may not be sustainable or significant enough to trade. There are 2 approaches to find the best swing trading opportunities attempting to out perform the market: 1. GROWTH: Find the best stock in the best industry in the best sector. 2. VALUE: Find the most under-priced and over-looked stock that is about to rebound. Both approaches are valid, but I personally prefer the Value approach. By the time a market shows up as a growth opportunity, it has already made a significant move. This can certainly still continue for a long time, and I’ll sometimes take advantage of them, but my preference is to find those markets that have been under-performing. I like to be one of the first to jump on board and be early to the party. Of course the risk of being this early is that sometimes these parties fizzle out before they really get going. I’m going to show you how to find both growth and value plays. There are three ways.

1. Stock Fetcher Formula: TOP DOG ETF RELATIVE STRENGTH TO S&P show stocks where market is ETF and the comparative relative strength(^SPX,90) is above 1.0 and compare with ^SPX and the Average Volume(90) is above 100000 and close is between 5 and 100 As you know from the comments on the formula above, you can edit this to your liking. The formula as it stands looks for an ETF (Exchange Traded Fund) that has been out performing the S&P 500 (the world’s benchmark for the stock market) over the last 90 days. Because there are a lot of thinly trades ETFs, this formula limits the results to those that trade between $5 and $100 and trades an average daily volume of 100,000 shares over the last 90 days.

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2 Stock Fetcher “Sectors and Industries” sorter in the “Quick Picks” section on the home page of Stock Fetcher.

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This area of Stock Fetcher allows you to view the percentage change over the last 1 day, 1 month and 1 year. You start with the sectors, but the first page won’t bring the all up, so you must click on “View All Sectors” at the bottom of that section.

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Once you click on that link you will be able to see all of the sectors the Stock Fetcher follows. This view will also give you the percentage change based on the last day, week, month, 3 months, 6 months, 1 year and 2 years.

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When you click on each sector, it will bring up all the stocks in that sector. BUT if you click on the “+” sign to the right of each sector name, it will bring up the industries within that sector.

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Now if you click on one of the Industries, it will bring up a list of the stocks in that industry.

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If you click on the link that says “View Results as Charts” it will bring up all the charts for side-by-side comparison.

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3. Relative Strength Charts. This is a “percent change chart.” Rather than tracking the change in PRICE, it tracks the PERCENT CHANGE of a market from a point you designate (I normally like to go 3 months back). I use line charts for this rather than candlesticks, because all I’m looking for is the relative strength. Once I find a market that shows relative strength, then I’ll look at it on a regular chart with candlesticks and my indicators. I use Tradestation for this, but if you’re charting platform doesn’t provide this functionality, you can go to http://www.stockcharts.com and click on their tab for “Free Charts” and then click on the box for “Performance Charts.” They have some pre-sorted performance charts or you can enter your own symbols.

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I create a list of ETFs that represent different markets and I simply pull up their charts one at a time and take a quick glance at the Relative Strength Chart. I don’t do this every day, but I do it at least once per week. I also have some charts that plot 6 or more of these ETFs all on one chart. This way I can see which are relatively strong or weak at a glance. When doing this I’m generally looking for markets that have been underperforming and are now showing signs of a turn around. This is another cycle we often see – markets go from under-performing, to over-performing, to under-performing, etc. It’s tricky to time this, so you just have to watch for it. What I watch for are little clues such as a market making a higher high when others are not. Or a market breaking a trend line before other markets.

You can also use an indicator that will measure the difference between the 2 markets

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you are tracking. This simplifies analysis by giving you just one line upon which you can draw support and resistance lines as well as trend lines. On Stock Fetcher this will be a line drawn on the chart called “Comparative Relative Strength.” You find this in the “indicators” section of the web site and you can add it to your charts like any other indicator. Here’s the formula: show stocks where the relative strength(^IXIC,45) is above 1.25 You can change this to show relative strength to any other market, change the time frame or the amount of relative strength. Also you can add volume and price requirements and any other parameters you want.

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Again, I prefer to use Tradestation for this. You simply use the “Spread – Diff” indicator. Most other good charting software may have a similar indicator but it may be called something else. You simply have to ask your provider if they have it and what it’s called in their software. What to ask them for is simply this: 1. The ability to put 2 symbols on the chart at the same time and in the same frame. 2. An indicator that will measure the difference between those 2 symbols. So how do we use this?

For a benchmark you can use the S&P 500 (which is the most common way to do it) or you can use a total market index such as the Vanguard Total Stock Index ($TSJ.X) to give a broader market.

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In general we are looking for trend line breaks of the indicator to show when the market we’re watching is beginning to outperform the benchmark. At the first sign of that, we then look at a regular chart and look for the next entry according to our trading methodology. Sometimes you’ll get a good one and sometimes you won’t. Remember, like all of our other indicators, by itself this is useless. It is only when it aligns with other energies that we’re going to use it in our trading. I have to warn you that relative strength charts can be tricky. It’s tempting to interpret the indicator as bullish when the line goes up and bearish when the line goes down. But it’s not that simple.

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IMPORTANT: Before taking any trade based on relative strength, you must pull up a chart on the market you are going to trade and make sure you have a good setup on its own, not just in relation to another market. In other words, the relative strength is not enough to enter a trade. You must look at a chart of the stock/market you’re going to trade and only enter when it forms one of our trading setups. In some of the examples above I plotted several months of data just to find examples to show you over different market conditions. However when I swing trade on the hard right edge I plot only 3 months of data. I use a percent change chart (though this isn’t necessary) and have both markets start 3 months ago at 0. This is because I want to find RECENT changes in relative strength. Remember, this technique is about finding markets that have been under-valued and are now shifting to gain relative strength over other markets.

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HEDGING YOUR POSITIONS AGAINST MAJOR LOSSES Hedging your stock or ETF positions means that you can take a position in another financial instrument to protect your primary position against a major loss. Some people choose to use a market that is inversely correlated to the primary market they are trading. However this approach has a couple of shortcomings: • •

The markets may diverge out of their inverse correlation at any time. Just because your market gaps dramatically against your position is no guarantee that your hedging market will gap in your direction to the same degree, or even at all.

For this reason, I prefer to use options for hedging my positions. They can be used for stocks, ETFs, currencies, and commodities. I don’t use them for day trading, but I do use them for swing trading in certain situations, hence their inclusion in this course. There are many complex option strategies that we won’t go into now since our focus is purely to protect a primary market position. Options are rather complex, therefore before you employ any of these strategies it is absolutely imperative that you engage in a thorough study of options so that you understand exactly how they work. Here are some links where you can learn more about options and their risks: A free online tutorial about the basics of options: http://www.investopedia.com/university/options/ Before trading options you must read this disclosure document explaining the characteristics and risks of options: http://www.optionsclearing.com/publications/risks/riskstoc.pdf Visit the web sites of some of the options exchanges. They each have their own educational materials, many of which are free: https://www.cboe.com/ http://www.bostonoptions.com/ove/ove.php http://www.nyse.com/futuresoptions/nyseamex/1218155409117.html http://www.nasdaq.com/asp/currency-options.asp http://www.ise.com/WebForm/homeDefault.aspx?categoryId=85&header0=true Another good web site for options research is: http://www.ivolatility.com/

People often ask me if I do any type of scanning for options or if I look at the chart of options themselves. The answer is that I used to do that, and it’s interesting and fun. But I’ve reduced everything down to make it as simple as possible.

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You can also trade the option instead of the stock as your primary position. But I won’t do that unless I can find an option on the stock that is cheap, has a tight bid/ask spread, good volume and open interest and I can get a good fill. Primarily I use options to protect my stock/ETF positions. Now let’s explain more about what options actually are and some of their unique properties that make them different than buying a stock. • •

A “call” is a “long” or bullish position A “put” is a “short” or bearish position

Buying an option is like giving a down payment on a house. It allows you to take a position in the market without paying the full price of the stock. You are buying the “option” of buying the stock at a set price. If you buy a “call” option on a stock agreeing to pay $50/share for the stock, and then the stock goes up to $100, you can then still buy the stock for $50! The downside is if the stock goes down in price, you can’t get your “down payment” back (you can sell the option to get part of your money back, but you will get less than you paid for it because the price of the option will normally go down in price if the stock goes down in price). The advantages of buying options: • • •

You get high leverage, similar to futures. You can’t lose more than you invest, unlike futures. They allow you more flexibility than simply investing in stocks.

The disadvantages of buying options: • • •

You pay a premium for your position. The bid/ask spreads and bad fills can cause a lot of “slippage.” There’s a bit of a learning curve to learn to trade effectively.

With education, you can learn to manage these disadvantages by learning to choose your options carefully and only taking positions that favor you (not unlike trading anything else).

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Option Pricing. Options, like futures, but unlike stocks, have a time limit, or expiration. There are many options for each stock – each with their own strike prices and expirations. Buying a CALL gives you the right, but not obligation, to BUY the stock at the “strike price.” Buying a PUT gives you the right, but not the obligation, to SELL the stock at the “strike price.” Puts are often used for “insurance” to hedge positions. Example: MSFT closed at $18.80 You want to buy an April 2009 $16.00 Call. The current bid is $4.35; the current ask is $4.45. One option represents 100 shares of stock, therefore it would cost you $445 to buy the call at the ask ($4.45 x 100 shares = $445). Instead of paying $1,880 for 100 shares of the stock (the price of MSFT is $18.80 X 100 shares = $1,880), you pay $445 and still control 100 shares. This is the LEVERAGE of options. See the “option chain” below. I’ve circled in red the areas we’ve referred to.

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Looking at this option chain (and this is only part of the actual option chain), you can see that if you want to do something as simple as buy a MSFT call, you have a lot of choices: •

• • • •

The expiration month (only December, January and April are listed in the picture above, but there are many other months to choose from). The strike price (the price at which you have the right to buy the stock). Make sure there is enough volume and open interest on that option (or your fill may be bad or you may not get filled at all) Make sure that the bid/ask spread is not too great. Make sure the price is a fair one, or better, find an underpriced option.

You could buy the call, and then turn around and buy the stock at $16.00. That’s what it means when you select a “strike price.” You are choosing the price at which you have the right (but not the obligation) to buy the stock.

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MSFT is at $18.80 and you can buy it right now for $16.00 if you buy the option at the $16 strike price! Is that a great deal? Not at all. Look at the math: You could buy 100 shares of MSFT at $18.80 for a total of $1,880. Or you could buy the option to buy 100 shares of MSFT at $16. Here’s the rub: If you buy the option at the $16 strike price, you will pay $445 for it as we saw above. Now you have the right to convert that into stock and buy 100 shares of MSFT at $16 per share for a total of $1,600. So your total cost to get in to MSFT will be $1,600 plus the price of the option of $445 for a total of $2,045, rather than the $1,800 to buy the stock outright. So why do you have to pay more when buying options? When you select a cheaper strike price, the market makes you pay more for the option itself. It builds in that difference into the price of the option. In fact the option will cost you even more than just the difference between the strike price and the current price. The options market makes you pay a premium that involves several factors. o

o

o o o

“Moneyness” (intrinsic value). A call bought with a $16 strike when a stock is trading at $18.80 will have an intrinsic value of $2.80 as the starting point for option pricing. Time value. The more removed from expiration, the more it will cost because you have more time to be “right.” Time value decreases exponentially the last 60 days before expiration. Volatility. The “implied volatility” – expected in the future Dividends that could be earned if one exercises their option Interest rates. The money the seller could make if they didn’t sell you the option

Let’s look at two of those more in-depth: •

Time value. Many people like to buy short-term options that expire in a month or two because they are cheap. Remember, you have to pay for the “time.” So an option that is going to expire in 1 month will be a lot cheaper than an option that will expire in 6 months, even if they have the same strike price. As time goes on, the price of the option you bought will go down based on time value (all other things being equal) even if the price of the stock stays the same. But here’s the kicker: the rate at which the value of the option declines based on time value is much slower from month 6 to 5 to 4 … than it is the last 60 days and the last 30 days. So the value of your option declines fast in the last 2 months, just based on “time decay” alone. Therefore the stock could go up and you could still lose money on the option!

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This time value is called “Theta” and is listed in the options chain for you to see. •

Implied Volatility (IV). This is one of the most important aspects of options trading (depending on the type of options strategies you choose). This number is based on how much the market “thinks” the stock will move in one direction or another. If the market thinks the stock will not move much, then the IV valued added to the price of the option will be small. However if the market thinks the stock will have a big move, then it will figure that into the price of the option, making it more expensive. This is why the standard saying is to buy low IV and sell high IV because the IV value can (and will) change over time. So you could buy a stock with a low IV, and if the stock doesn’t move, but the IV increases dramatically based on what the market thinks your stock will do in the future, and then the price of your option can still go up. Of course, if you buy an option with a high IV, and then the IV drops, the price of your option can drop without the underlying stock moving at all. The obvious question is: how does the market determine whether the IV is high or low? It’s a bit ambiguous and this is where some have accused the market makers of playing games with the price of options. However the option chain will give you a number called “Vega” which represents the expected change in the price of an option due to a 1 percentage point increase in the volatility of the underlying asset. There is also “historical volatility (sometimes called “statistical volatility”) which is based on hard history, but this should not be confused with IV.

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How do you know how much money you can make or lose? Options can limit your risk so that it is a known, and limited, amount. If you buy 1 MSFT call for $445, then $445 is the maximum you can lose. If you hold the option you bought past the expiration, the option will expire worthless and you lose all your money. Your option’s expiration day is the 3rd Friday of the stated expiration month of your option.

You have three choices to get out of your option position:

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• • •

Sell your call for the value at any time before expiration. “Exercise” your option and buy the stock at the strike price of the option. Hold your option until the expiration date when it will expire worthless.

EXAMPLE: If MSFT moves up from $20.00 to $30.00, how much will your option increase in value? The answer is that you don’t know for sure because option pricing does not necessarily move in alignment with the stock price.

It’s All Greek To Me Buying an option is not as simple as buying a stock. When you buy a stock you only have one choice: Buy this stock at this price now … or don’t.

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With options you have to choose a strike price and an expiration month. At any time there can be HUNDREDS of options to choose from on any one stock. You’ll also want to look at the volatility of the option and the rest of the “greeks” because they determine the price of the option. The “GREEKS” determine HOW THE PRICE OF THE OPTION WILL MOVE IN RELATION TO THE STOCK. It is possible for the stock to go up, but your call option to go down! Allow me to introduce you to the greeks: • •

• •

DELTA: The amount by which an option price is expected to change for each corresponding change in the underlying asset. The ATM (At The Money) delta value (when the strike price is the same as the stock price) is 0.5. Highest is 1.0 GAMMA: The expected rate of change for an option’s Delta for every 1 point change in the underlying asset. THETA: The amount an option’s price will decline due to the passage of 1 day. The closer to expiration, the faster time value decays. VEGA: The expected change in the price of an option due to a 1 percentage point increase in the volatility of the underlying asset. This has a major influence and can be a “wild card” in the pricing of options.

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You must look at 3 types of graphs when buying options: 1. Stock Chart

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2. Implied Volatility (IV) Graph. It’s best to buy low IV and sell high IV because you pay for it. If the IV is abnormally high, it will cost you more to buy the option because that is added to the price of the option. It means that the market is moving in bigger ranges and therefore bigger profits are possible. The options pricing model will make you pay for this up front in the price of the option. But abnormally high Volatility often returns to normal levels. If it does, that will bring the price of the option down when you are trying to sell it. This is one example of how the price of a stock can go up, but the price of your option can stay roughly the same or even go down. During times of abnormally high IV, many professional option traders prefer to be sellers than buyers of options for this reason. This is one way that options can put the odds on your side. If IV is extremely high, you can sell options instead of buying them. This can provide you a huge “edge” because IV tends to revert to the norm. Therefore, if the price of the underlying stock goes down or stays the same, or even goes up a little, you still make money. Plus, the longer the person who bought the option from you holds onto it, the lower the price will dive simply because of the time decay! Lots of people do nothing but sell options because all of these factors make it “hard to be wrong.” Of course you can be wrong and the market is always unpredictable. There’s a lot more to selling options than stated here. But it’s a good strategy to learn more about because it can be a powerful way of giving yourself an edge and putting the odds on your side.

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3. Options Risk Graph

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Using Options to Protect Your Trades and Investments Although may people trade options in place of stocks, they were originally created to hedge stock position and they can do that quite well if you know what you’re doing. I’ll share with you 3 different strategies on how you can use options to protect your primary positions, whether it be stocks, commodities, futures or currencies.

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Strategy #1: Buy a Put. Buying a put against your position is the most simple of the 3 strategies and therefore we look at it first. As we have seen, buying a put is like going short the stock, but it is less expensive because of the leverage provided by options. So if you were to buy 100 shares of IBM, you could buy 1 IBM put to protect you against your IBM stock from taking a dramatic gap through your stop. This is very much like buying an insurance policy. You are paying a small premium (the cost of the put) which you can afford to prevent a disaster (a huge gap against your position) which you cannot afford. Of course the price of the option cuts into your profits a little bit, so the market has to move in your direction more than it otherwise would have, in order for you to start making money. The closer the strike price of the option you buy is to the price of the stock, the more you will pay for the option. This is because the strike price is the price at which you generally start making money on the put if the stock goes down. Right now IBM is trading at $92.41.

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Below is an option chain that contains IBM puts. You’ll notice 2 things: 1. The lower the price of the strike, the cheaper the option. That’s because you’re buying less “insurance” when you buy the lower strike prices. 2. The April puts are more expensive than the March puts. That’s because you’re buying more time to be wrong with the April puts. The March puts will expire worthless on the third Friday of March (as long as that isn’t a holiday) and you’ll lose your entire premium and have no more insurance at that time. If you want to be “covered” longer than that, you’ll have to pay more.

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If you bought 1 contract of the April put with a strike price of 90, the risk graph below shows how much you would make or lose on the put as IBM goes up or down in price (please note that risk graphs can change over the life of an option). As you can see, if IBM goes below 90, you would of course lose money on your stock, but you would make money on the put, thereby offsetting the loss on the stock. The IBM April 90 put is expensive ($540) because you are buying the put so close to the current price of the stock and thus almost fully insuring your position. If IBM goes up, the price of your put will go down and you will lose money on the put you purchased. The most you can lose on the put itself is $540. But you can sell the put at any time at the current price (before it goes to 0) and not lose the entire amount even if IBM stock does go up. Of course then you lose your insurance.

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You can purchase a less expensive put, but then you’d either be giving up time, or insuring less of the move against your position. Another factor is the pricing of puts and calls when you buy. As discussed above, a significant part of the pricing of an option is the Implied Volatility. When “IV” is high, options tend to be more expensive, so buying options (whether they be puts or calls) is much more costly. For this reason some option traders watch IV very carefully and tend to use buying strategies when IV is low and use selling strategies when IV is high.

The risk graph below shows the bigger picture. The amount of money you can lose on your put is limited, as indicated by the risk graph line “flat lining” at $540 (the cost of the put). On the other hand, and this is VERY IMPORTANT, if IBM moves down dramatically, your put continues to increase in value, thereby covering a losing stock position no matter how far it may drop (as long as your put doesn’t expire and you are still able to sell the put on the exchange).

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You can buy cheaper insurance. You could save ½ the premium by purchasing the put at the 80 strike price for $235. The put starts to increase in value at a much lower stock price than the 90 strike option, so it’s like having an insurance deductible. You would be financially responsible for losses from 92.41 (the current price) to approximately 80, but the put could help offset your financial losses below that. Just like insurance, you pay a lower premium if you accept a higher deductible. Below is the risk graph for buying the April 80 put for IBM.

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One thing to be aware of is that these risk graphs change as time goes on. The first risk graph of IBM above is based on the time of entry. The second and third are shown at the time of expiration. Ideally you would want to draw several lines to represent different times in the life of the option. That’s another illustration that what I’m covering here is merely an introduction and is not a complete instruction on how to trade options. Before you trade options, take a thorough course on them and become intimately familiar with their nuances and their risks. The illustration below shows how the IBM April 2009 put with a strike price of 80 risk graph will change over time. I like to plot my risk graphs this way.

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Below is a risk graph that plots both the P&L of the stock position (the top blue line) and the corresponding P&L of the put position (the lower magenta line) on the same risk graph for comparison.

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Now let’s put it all together and give you a visual presentation of how much buying a put can actually protect you. The picture below shows a risk graph, at the current time, which plots the put, and stock and the composite position you have when you buy both at the same time. This is the best picture of your real position when you buy a put to hedge your stock position. This illustration is buying the IBM April 2009 put with a strike price of 80:

As you can see from the graph above, if you only owned the stock (the magenta line), you are exposed to a lot of risk as the market continues to move down. If IBM goes down to 50 (see stock price along the middle horizontal line), you are down more than $4,500. However, by adding the put to your position, your loss would only be about $2,000.

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Why $2,000? The risk graph above was created a few days after the option chain we looked at initially. Now IBM has moved up to $98. The price of the April 09 put with an 80 strike price is $1.70. So you’re buying IBM at $98, and you’re buying a put with an $80 strike price. Therefore you are not buying any “insurance” until the stock gets into the range of $80 – thus giving you exposure of $18 per share. Since you’re buying 100 shares, that will give you an exposure of $1,800. To that you must add the cost of the put you bought which was $170. 1,640 + 170 = 1,970. Notice also that the angle of the stock line continues to move down in a straight line. That is because you will continue to lose more and more money – giving you unlimited exposure to losses until the stock goes to 0. However the blue line, representing your profit/loss by owning both the stock and the put positions concurrently, shows that your risk in the trade flattens out just under $2,000 giving you limited exposure to the downside. If you want less risk in the trade, you simply buy a put with a strike price closer to the current price of the stock. Of course, that more insurance will cost you more too. Instead of paying $170 for the 80 strike price put, you’ll pay $390 for the 90 strike price put. Compare the graph above, in which a put with an $80 strike price was purchased, with the graph below in which a $90 strike price is purchased.

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Strategy #2: Covered Call. Buying a put to provide insurance against a major gap down in your stock position can be a good strategy, but as you have seen it can be expensive. There is another protection strategy that resolves this downside. You can protect your stock position without paying any premium. In fact, you can actually get PAID to provide protection on your own stock position! Of course anything that sounds that good is bound to have some shortcomings and it does, but first let’s look at how this very popular strategy works. A covered call, or a “buy-write,” is a strategy in which you buy a stock and you sell a call at the same time. You are making money because instead of buying an option, you are selling an option. So someone else is buying the option and they are paying you for it. You collect the premium rather than having to pay the premium. Notice that you are selling a call, not a put, in this strategy. There are several things to keep in mind: 1. You want to sell “out of the money” calls – meaning that the strike price is ABOVE the current price of the stock. If the stock goes high enough to reach the strike price of the option, then the option will likely be called away and you will lose money on the option. So buying a strike price far from the current stock price is better, but will pay you smaller premiums than strike prices closer to the stock price. 2. You want to sell short-term calls (generally 30-60 days before expiration) so that the stock doesn’t have as much time to reach the strike price. At expiration the option will then expire worthless and you get to keep the entire premium. As time goes by, the price of the option will decline even if the price of the stock doesn’t go up. You want the price of the option to go down or stay the same since you already sold it (you want to sell high and buy low). If the option goes down then the person who bought it, will not want to sell it (they want to buy low and sell high). 3. It’s best to sell options when Implied Volatility is high because that increases the price of the option, and if IV comes down, then the price of the option will come down even if the price of the stock doesn’t go up. 4. Your break-even point will be the strike price plus the option premium. The maximum profit of the combined position will be if the stock goes to the strike price because you receive the entire option premium and the biggest move on the stock you can get before the call goes in the money and may be exercised (the buyer of the call may decide to exercise his/her right to buy the underlying stock at the strike price). Of course if it gets close to this level, you can always buy back the calls if you choose (which will be a lot more expensive then so you will have bought high and sold low). If the stock goes down, you are only protected by the amount of the premium you received when you sold the call.

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Some of this may be difficult to follow for those new to options, so let me summarize it the upside and downside and then show some option risk graphs to illustrate the points: • •

The benefit of selling calls versus buying puts to hedge your stock position is that you collect money rather than spend money for the “insurance.” The drawback of selling calls versus buying puts to hedge your stock position is that your upside profit is limited and your downside protection is also limited.

Now let’s look at an example. It’s February and you decide to buy IBM stock at 98, and you want to sell a March call with a strike price of 105 because you figure it’s unlikely that IBM will reach 105 by the third week of March, which is only about 6 weeks away. You could also sell the 110 call if you wanted more room to be right, but that would pay you less premium. The April 105 call pays $115 The April 110 call pays $45 You decide to go with the call with the strike price of 105 for whatever reasons you may have. We’re not talking about the right/wrong analysis in this section, only explaining how these option strategies work. Your choice of which options to buy would be based on your technical analysis. Here’s the risk graph:

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Collar. We’re looking at collars last because they are a combination of the first 2 strategies. You buy a put and sell a call, but you get them at different strike prices. Normally you would use options of the same expiration month, but you can play around with using different months for the put and the call. Options are very flexible! You get the benefit of buying a put, in that you get the limited risk to the downside that the covered call does not provide. You overcome the problem of buying the put, in that the call you sell will cover, or nearly cover, the price of buying the put.

However you still have one of the limitations of selling a call in that your upside profit potential is limited. Below is an option chain for RIMM.

The stock is trading at 59.63 and it’s February. We could buy a March put with a strike price at 50 for $167 and we could sell a call with a strike price of 70 and collect $96. The net effect would be that the combined option position would cost us $71.

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This is a fairly typical scenario with a collar. While the ultimate goal would be to have the selling of the call cover the price of the put you’re buying, it normally won’t completely cover it. Still, it serves to dramatically reduce the cost of our insurance over simply buying the put. In fact it saves us 57.5% on our insurance in this case. If you want to get your insurance for no out of pocket cost, or even collect a premium, you can: • •

Buy the put farther from the stock price than the call, which will make it cheaper, but give you less protection. Sell a call in a month farther out from the put, which will pay you a higher premium, but also give the stock more time to move in the money thereby possibly having the option exercised.

If you decide to buy and sell options of different months, you will need to be even more educated about implied volatility (vega) because changes in volatility can have a dramatic effect on the value of your position when you have options 2 different expiration months.

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Below we look at a broader view of the same risk graph:

Since you are combining the buying of a put, with the selling of a call, it’s not surprising that the combined risk graph takes on characteristics of both. At first glance all of these options may seem undesirable because you are giving up something in return for the “insurance.” However there is always a cost for insurance. When you shop for homeowners, car, medical or life insurance you have choices as to: • • •

How much deductible you want. How high your premiums will be. How long your insurance will last.

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It’s the same with buying insurance on your stock positions. There is no “best” way to do it. You choose the “policy” that fits your budget, your risk tolerance and your time horizon.

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Digging Deeper Into Options If you’re new to options, this introduction likely produced one of two results. It either scared you away from trading options or it has excited you to find out more about them. Either way, the result is good. What you don’t want to do is trade options without being fully educated in them because that is a one-way ticket to ruin. They carry high risk and you can easily lose 100% of your investment. On the other hand, with the proper education, options can be a wonderful and rewarding way to trade, and an especially effective way to protect your positions from the occasional dramatic move against you. I’ve been asked many times to create a course on trading options, but others have done such a good job that I don’t feel I could improve on what they’ve done. Therefore I’d rather just refer you to others. I’ve spent thousands of dollars on options courses over the years. But the best courses for the money in my mind come from Options University. Their courses are reasonably priced (not the cheapest, but not the most expensive), the teaching is crystal clear and they offer home study courses (which I bought). If interested, you can view their web site here: http://Options.TopDogTradingOffers.com .

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