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Given, No-Hype Options Trading

  
  Education
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Options trading can be daunting, in large measure because “the risk-adjusted return of any options strategy will tend toward zero over time.” (p. 16) It doesn’t matter whether a person engages in high-probability or low-probability trading, whether the spread of choice is an iron condor or an out-of-the-money vertical spread. Without robust risk management the options trader will over time end up with a huge goose egg in his account for all his efforts.

The author focuses on calendars, double diagonals, butterflies, and condors. His analyses don’t follow a standard pattern, but generally speaking he discusses trade structures, the rationale for various positions, and ways to enter and manage trades, including adjustments. At the conclusion of each chapter is a set of exercises to test the reader’s understanding of the material. Answers are provided at the end of the book.

Here I’ll sample his chapter on butterflies. The first important distinction is between at-the-money and out-of-the-money butterflies. An ATM butterfly, especially on a broad market index, is “a delta-neutral income generation trade.” An OTM butterfly is normally a speculative directional trade; it is an inexpensive, low-probability, high-risk trade. But an OTM butterfly can also be used as a “what if I’m wrong” trade. Let’s say the trader expects a stock to trade higher and has opened an appropriate bull call spread. But, in case the stock doesn’t trade as expected, an OTM put butterfly below the stock’s current price can serve as an inexpensive hedge.

The author outlines two ways to manage an ATM butterfly, a simple and a more advanced. The simple technique has eight steps. Here are a few of them. Sell the ATM options and buy one option at one standard deviation OTM and one option at one standard deviation ITM. Buy extra calls and/or puts on the wings to get as close to a delta neutral position as possible. Close the trade when you are down 20%. Close half of the contracts and take your profit if you are up 25% or more. Close the trade on the Friday before expiration week. (pp. 103-105)

No-Hype Options Trading is a practical book for the trader who has a modicum of knowledge about options but needs help with delta-neutral strategies. Whether this book will enable him (with lots of practice) to generate steady monthly income, the alleged goal of non-directional trading, is another matter. Markets don’t always accommodate the delta-neutral trader. Strongly trending markets present significant challenges and highly volatile markets are “the worst-case scenario.” (p. 153) by Kerry W. Given, aka Dr. Duke (Wiley, 2011) might be just the ticket. The book (for those who care about the sometimes dueling camps in the options world) reflects some of the techniques taught by Dan Sheridan, who was one of the author’s mentors.No-Hype Options Trading: Myths, Realities, and Strategies that Really WorkFor the options spread trader, especially the non-directional trader, who is looking for strategies and trade management ideas

Swope and Howell, Trading by Numbers

  
  Education
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The title of this book by Rick Swope and W. Shawn Howell is somewhat misleading. It’s not intuitively obvious, or at least it wasn’t to me, that Trading by Numbers: Scoring Strategies for Every Market (Wiley, 2012) is primarily about options.

But let’s start, as the authors do, with their trend and volatility scoring methods. The trend score has four components: market sentiment (the relationship between a long-term moving average and a short-term moving average and the position of price in relation to each moving average), stock sentiment (the same parameters as market sentiment), single candle structure (body length relative to closing price), and volume (OBV trend). The range is -10 to +10. Volatility scoring has three legs: historical market volatility, historical stock volatility, and expected market volatility. The range is 0 to +10.

Before moving on to the standard option strategies, the authors address risk management, which they wisely describe as nonnegotiable. Risk management again has three legs: risk/reward, concentration check, and position sizing. 

And, with chapter five (of sixteen), we’ve reached covered calls. The reader who has no experience with options will be lost. Even though the authors push all the right buttons (ITM, ATM, OTM strategies; the Greeks; position adjustments), they push the buttons almost as if they were playing a video game. Very fast.

Assuming that the reader is not new to the option market, what can he/she learn from this book? Let’s look very briefly at three strategies and see how they reflect three different market or individual stock conditions: a long call, a straddle/strangle, and an iron condor. Traditionally described, in the simplest of terms, the first is looking for a significant bullish directional move, the second anticipates a surge in volatility, and the third expects a rangebound market. (more…)

Brooks, Trading Price Action Reversals

  
  Education
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The third and final volume of Al Brooks’s series is Trading Price Action Reversals: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley, 2012). A trader does indeed have to be serious to read all three volumes because, according to the author himself, the task is daunting: some 570,000 words.
Only half of the final volume is about trend reversals. The rest deals with day trading, the first hour (the opening range), and putting it all together, including 78 trading guidelines, some of which you may not have encountered elsewhere.
This volume is the most accessible of the three, but then my very tired eyes did a lot of work before getting here. It would be difficult to skip the first two volumes and expect to understand the third.
Brooks himself is not primarily a reversal trader. As he writes, “I prefer high-percentage trades, and my most common trades are pullback entries and trading range fades. I especially like breakouts because when they are strong the probability of follow-through is often more than 70 percent. I look less often for reversal trades, because most reversal attempts fail, but I will take a strong reversal setup.” (p. 463) (more…)

Diary of a Professional Commodity Trader -Book Review

  
  Education
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Brandt uses high/low/close bar charts as his primary trading (not, he stresses, forecasting) tools. He is for the most part a longer-term discretionary pattern trader who enters on breakouts that meet his stringent requirements. Since he knows that only 30 to 35% of his trades will be profitable over an extended period of time and up to 80% will be unprofitable over a shorter time frame, he is exceedingly cautious about leverage. For instance, his trading assets committed to margin requirements rarely exceed 15%.

In the first two parts of the book Brandt offers the reader a thorough course in identifying and categorizing trading signals, placing initial protective stops and subsequent trailing stops, pyramiding, and taking profits. The course addresses traders at all skill levels. For instance, he describes his own trading plan as simple, but some of its elements require a degree of judgment and sophistication that can only come with extensive practice. One example: “time phasing is a hurdle all traders must clear in order to be consistently successful.” (p. 88)

The third part of the book is Brandt’s five-month trading diary, and it’s a fascinating read. Not only does it describe individual trades but it shows how good traders evolve. Take month four, where the author is in a drawdown period. He writes that he has always known that there were flaws in his trading plan but that “good times provide cover for the deficiencies of a trading plan.” During tough times “markets have a way of exploiting flaws in a trading plan. … The challenge is to find the fundamental flaws, not just to make changes that would have optimized trading during the drawdown phase. … Almost always the changes [the author has made to his own plan] have dealt with trade and risk management, not with trade identification.” (p. 189) (more…)

Ferri, The Power of Passive Investing

  
  Education
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He cites several studies and some of his own tests that demonstrate the futility of seeking alpha. Among the findings, a single actively managed fund has a 42% chance of beating a comparable index fund over the course of a single year, a success rate that drops to 12% over 25 years. The statistics get much worse as you add more active funds. If you own ten funds, you have a 27% chance of beating an all index fund portfolio over one year and a mere 1% chance over 25 years.

Ferri’s own work analyzed the returns of actively managed funds within a generic asset class over five years. He found that a portfolio of five randomly selected active funds had only a 16% chance of beating an index fund, that only 5% of them won by 0.5% or more, and that 63% of them lost by 0.5% or more. When the portfolio was expanded to ten active funds, the numbers were much worse. Only 8% were winning portfolios, 1% of them won by 0.5% or more, and 70% lost by 0.5% or more. Ferri then massaged his model to see whether the numbers could be significantly improved; they couldn’t. As he summarized the results, “Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout for those winning funds does not compensate them enough for the shortfall from being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more. That’s a lot of headwind!” (p. 92) (more…)

Trade Like an O’Neil Disciple -Book Review

  
  Education
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The CANSLIM enthusiasts, and they seem to be legion if the reviews on Amazon are any indication, have nothing but praise for Trade Like an O’Neil Disciple by Gil Morales and Chris Kacher (Wiley, 2010). I decided to be a little more focused and less ebullient in this post and write about a trade setup not found in the standard O’Neil repertoire. Consider this a follow-up to yesterday’s discussion about the eye of ambiguity.

The setup is alternatively described as a pocket pivot or buying in the pocket. It is “an early base breakout indicator, which is designed to find buyable pivot points within a stock’s base shortly before the stock actually breaks out of its chart base or consolidation and emerges into new high price ground.” (p. 128) The pocket pivot indicator provides direction in what might be seen as an ambiguous situation. It is, the authors claim, particularly valuable in sideways moving markets.

A major virtue of a pocket pivot buy point is that it is a low-risk entry point—relatively close to support and far enough from resistance to be profitable even if the stock can’t break through to higher highs. Or, as the more optimistic authors claim, “the pocket pivot buy point technique can get an investor into a stock at a lower-risk price point and thereby make it more possible for the investor to sit through a pullback if the all-too-obvious new-high breakout buy point fails initially and the stock retrenches, corrects, or sells off.” (p. 129)

What are the characteristics of a pocket pivot buy point? “[A] stock should be showing constructive price/volume action preceding the pocket pivot. … [T]ighter price formations, that is, less volatility should be evident in the stock’s price/volume action as viewed on its chart. The stock should have been ‘respecting’ or ‘obeying’ the 50-day moving average during the price run that occurred prior to the time the stock began building its current base. … Except in very rare cases, … pocket pivots should only be bought when they occur above the 50-day moving average. Ideally, the stock’s price/volume action should become ‘quiet’ over the previous several days, which contrasts with the much larger and stronger volume move that comes on the pocket pivot itself. On the pocket pivot you want to see up-volume equal to or greater than the largest down-volume day over the prior 10 days.” (pp. 132-33)

The authors offer a series of variations on this generic trade setup. For instance, there’s the continuation trade: buying on volume after a pullback to the 10-day moving average. Or the bottom-fishing trade where a stock, after carving out a bottom, pushes through its 50-day moving average. They urge caution if a pocket pivot is too extended from its 10- or 50-day moving average when it begins its move or if a stock has been “wedging” upward instead of drifting downward before a pocket pivot. As they write, “context is everything.” (p. 162)

This setup is certainly not a revolutionary breakthrough in the world of technical analysis. In fact, anyone familiar with the literature might recognize several patterns rolled into one here. In the context of yesterday’s post, it is a “fast-follower” strategy because it requires a volume spike, created by the “first movers.”

Short Selling

  
Analysis, Education
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Recommended books on short-selling:

1) How to Make Money Selling Stocks Short by William O’Neil (Wiley, 2005) – [Technical, Swing & Position Trading]
2) Sell & Sell Short by Dr. Alexander Elder (Wiley, 2008) – [Technical, Day Trading]
3) The Art of Short Selling by Kathryn Staley (Wiley, 1997) – [Fundamental]
4) Sold Short by Manuel Asensio (Wiley, 2001) – [Fundamental]
5) Sell Short: A Simpler, Safer Way to Profit When Stocks Go Down by Michael Shulman (Wiley 2009) – [Macro]

The best way to become an effective short seller is by making it a habit of studying hundreds and even thousands of charts every week. Train your eye to see the setups, the accompanying volume, how the MA’s line up, etc. The only way to do this is with practice. Short-selling can become very profitable due to the simple fact that stocks drop faster than they rise (in most cases) and for me, it typically only takes about 1-3 days to make a decent profit of 10% or more.

Trade only the best setups to increase your odds. I do recommend the use of stop losses above key resistance areas due to the fact that losing short positions can cause serious damage if left unattended.

Dalton, Jones, & Dalton, Mind Over Markets

  
  Education
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Mind Over Markets, the book that popularized (and expanded on) Peter Steidlmayer’s Market Profile, was first published in 1990. Anyone who bought the book expecting a self-help manual would have been sorely disappointed because what they got instead was a pretty complicated alphabetic model for organizing the distribution of market data along price and time axes. Twenty-three years later James F. Dalton, Eric T. Jones, and Robert B. Dalton are back with an updated edition of their text, Mind Over Markets: Power Trading with Market Generated Information (Wiley, 2013).

The book itself is organized according to the Market Profile trader’s achievement level—novice, advanced beginner, competent, proficient, and expert—with the greatest time spent on the competent level. The expert trader gets a mere two pages. (more…)

Book Review -The Risk of Trading by Michael Toma

  
  Education
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 Michael Toma’s The Risk of Trading: Mastering the Most Important Element in Financial Speculation (Wiley, 2012)

If I had to choose the two key sentences in this book they would be: “Risk management is not limiting losses. It is the art of maximizing profits for a given optimal risk.” (p. 173) That is, contrary to commonly-held views, risk management goes far beyond placing stops or calculating position size. It also goes beyond the purely mathematical, even though it would still behoove traders to be familiar with the seminal works of Ralph Vince (The Mathematics of Money Management, 1992) and the many books and papers that followed in a similar vein.

Toma, a corporate risk manager and the author of Trading with Confluence, offers a simple, math-free analysis. (Well, here and there a spreadsheet comes in handy.) He is at his best when discussing how to track performance.

One recommendation that I consider especially sound is that the trader track opportunity risk. “Auditing ‘opportunity risk’ is equally as important as measuring your actual trades. … In all the risks associated with trading, I find opportunity risk, whether in the form of unexecuted trades or pretarget exits, to be the difference between traders who reach that much-talked-about top 10 percent in the profession and those who remain in the novice pool, struggling to keep their heads (and P&L) above water.” (p. 126) If you were presented with a valid trade setup in your plan and you sat on your hands, track that trade. Are you actually skilled at overriding your system or should you, as Toma argues, take advantage of every opportunity that your plan presents?

Toma recommends that every trader construct his own key performance indicator (KPI) dashboard. Keep it simple, sticking to five to eight measurable items initially. And keep it balanced in scope. “The indicators should represent a balanced monitoring synopsis of performance, compliance, and business metrics. A common gap in KPI programs is that it is completely dominant in trade result metrics. A measure that detects rule breaking is far more indicative of trading success than a KPI that measures current win percentage over a small time period.” (p. 133)

(more…)

Books on short-selling

  
  Education
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1) How to Make Money Selling Stocks Short by William O’Neil (Wiley, 2005) – [Technical, Swing & Position Trading]
2) Sell & Sell Short by Dr. Alexander Elder (Wiley, 2008) – [Technical, Day Trading]
3) The Art of Short Selling by Kathryn Staley (Wiley, 1997) – [Fundamental]
4) Sold Short by Manuel Asensio (Wiley, 2001) – [Fundamental]
5) Sell Short: A Simpler, Safer Way to Profit When Stocks Go Down by Michael Shulman (Wiley 2009) – [Macro]

The best way to become an effective short seller is by making it a habit of studying hundreds and even thousands of charts every week. Train your eye to see the setups, the accompanying volume, how the MA’s line up, etc. The only way to do this is with practice. Short-selling can become very profitable due to the simple fact that stocks drop faster than they rise (in most cases) and for me, it typically only takes about 1-3 days to make a decent profit of 10% or more.

Trade only the best setups to increase your odds. I do recommend the use of stop losses above key resistance areas due to the fact that losing short positions can cause serious damage if left unattended.

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