Options-Intelligence

Market Insight and Psychology

October 7th, 2010 4 Comments

Here is the perfect quote from John Carters book, Mastering the Trade: This describes Options-Intelligence to the tee:

It is also important to remember that there is no need to spend wasted years looking for complicated setups or the next Holy Grail. There are very simple setups out there to use. Some of the best traders I know have been trading the same setup, on the same time frame, on the same market for 20 years. They don’t care about anything else, and they don’t want to learn anything else. This works for them, and they are the masters of this setup. They have nothing else coming in to interfere with their focus. If a setup doesn’t happen that day, then they don’t take a trade.

One of the biggest factors in traders washing out is over trading. Always having to play even when the deck is stacked against you is a losing game. Markets are very fickle, they have no emotion, and they know that most traders will wash out. It’s you against everyone else. You don’t have to be better than everyone, you just have to be better than the losers who continue to make the same mistakes over and over again until they are washed out. Traders believe there is some magical tool out there that will propel them to the top when in fact traders already have that tool inside their heads. Traders have to look at many, many, many charts until those patterns are ingrained on their brain and learn what the bars and candles are telling them. Two good books I recommend, Trading for a Living, by Dr Alexander Elder (a bit dated but chart patterns are highly relevant) and Mastering the Trade by John Carter.

There are specific patterns out there on different time frames that give us clues as to future movement. Once a stock has risen to heights that we believe cannot be sustained we begin looking for the classic signs of a reversal. First you will get a larger run-up on higher volume, then you get the final spurt higher on lesser volume. This is where you should be shifting your charts down to 2 day 10 minute charts to see the final ending of the run. Once you get that ending, switch to a 15 minute chart and finally to a 10 day hourly. If you get the confirmation on the hourly you can almost rest assured you will see it next on the daily 3 month chart. No need to use anything fancy here. I use a 10, 20, 50, and 200 period EMA, a DMI (14) with ADX and volume. This works on the downside as well. Remember stocks fall using an elevator and rise using the stairs. If you can catch the top, ride it.

Not always is the stock done on the initial fall. Many times it will regain footing (typically around the 20 period) and try to make a new high, sometimes just slightly beating the prior high or low to then turn vigorously in the opposite direction (this is highly frustrating as most set stops and limits based on the prior highs or lows as an exit if the trade goes against their thinking). You want to figure at least .20-.25 higher or lower than the previous high or low.

Probably the biggest secret in the market is never get locked into one directional thinking. You may swear there is no way in the world this market can go up, you fight it the whole way saying it has to come down, you washout and the market turns around and goes down just like you thought. I can’t tell you how many times my mind has been biased in one direction or the other only to see the stock market do just the opposite.

Case in point: Option Expiration week. I look at the charts, they may look terrible but I know that Oct has always been a good month for me. I do my research on the performance calculator and find that 75% of the time my choices will gain at least 25%. Three choices, AAPL, GOOG, and the Q’s have an average 70% chance to gain at least 50% in Oct. Do I go with the chart that looks terrible or go with my data that says no matter what I will most likely (75% chance) gain at least 25% over all the plays. This is a very hard choice. I put the plays out, that is exactly what I do. Why does it work? I have no clue, but who cares. We all make money and wait for the next cycle. Point is, don’t over guesstimate the game (and that is exactly what the market is). Option Expiration week is by far the most consistent game in town.

Setting Limits

September 5th, 2010 15 Comments

Setting Limits

Last month I talked about the importance of setting limit orders when trading with our option investing strategies. Limit orders are the means by which traders strategically lock in profits as soon as the market offers them. Carefully placed, limit orders put traders in a proactive position and generate the highest probability for producing profit with every trade. With the virtues of this important tool well established; it is time to turn our attention towards the obvious next question: How do traders determine where to set limits?

Every time Options-Intelligence recommends a trade the outcome is recorded into a database. As of this writing our database now has the results of over 2100 option trades spanning just over 8 years of market activity. With the results filter and statistics box found on the performance page, traders can utilize this data to find the historical, statistical probability for any trade to reach the result they are hoping to achieve. This important metric, referred to as the winning history, helps traders determine where to place their limit orders for any trade they enter.

Finding the winning history for a trade is really quite easy, simply set the parameters in the results filter to match the trade and click the “Apply” button. For example, if Options-Intelligence issues a Core Options Trading Strategy play for QQQQ, we would need to set the results filter to the following:

Type: Core Strategy
Month: Blank
Year: Blank
Symbol: QQQQ

This will limit the results, removing any trade that does not match the settings provided. Additionally, the statistics reported in the statistics box, including the winning history, will now be calculated by using this subset of trade data.

By default, the website counts winning trades as those that achieve at least a 1% return, which provides traders with the historical, statistical probability for the trade to return any positive gain. In this case, the winning history for any QQQQ trade issued from the Core Options Trading Strategy is currently 90.7%. This means 9 out of every 10 Core Options Trading Strategy trades issued for QQQQ have achieved a positive return and that 1 out of every 10 was a losing trade (failed to achieve a positive return). While this number serves a strong indicator of the general success of these trades, we still need more data to determine where to set our limit orders. To get this data, we are going to manipulate how the website determines which plays it counts as winners.

By raising the number in the “Win %” field, the website will reduce the number of winning trades used in calculating the statistics found in the statistics box. Incrementally raising this number and recording the effect on the winning history indicates the probability for success using different limit levels. Working with the example of QQQQ trades issued from the Core Option Trading Strategy currently produces the following:

Win % (required gain to count as winning trade)	Winning History (historical, statistical probability to achieve win %)
10%	86.05%
15%	83.72%
20%	82.56%
25%	81.40%
30%	80.23%
35%	74.42%
40%	68.60%
45%	67.44%
50%	65.12%

Armed with this data, we can clearly see that the key to determining where to place limit orders is merely a function of finding a comfortable level of risk and reward. Perhaps the best way to discover the right balance is to consider the risk (winning history) and reward (win %) in a real world manner. Rather than thinking of the winning history in terms of percentages, consider the effect on 10 trades. Again, working with our example:

For limit orders at or below 30%: These trades will win 8 out of 10 times
For limit orders above 30% and below 40%: These trades will win 7 out of 10 times
For limit orders above 40%: These trades will win 6 out of 10 times

In my own analysis of QQQQ trades issued from the Core Options Trading Strategy I found that 30% limit orders offered me excellent reward (30% returns) at the right level of risk (2 out of 10 losers). I found that using 30% limit orders instead of 25% had a marginal effect on reducing the winning history; however, moving to 35% from 30% dropped the winning history dramatically.

There are some important caveats that must be mentioned when using this method:

Make absolutely sure that the number of trades is high after you set the results filter to match your trade. You do not want to base your limit orders on the statistical analysis of fewer than 20 trades as this could cause the data to be skewed.
Although, it continues to work like a charm for me, I am legally obligated to indicate the following words of caution: This method is based on historical data which is not a sound indicator of future performance.
Always use your own judgment when entering trades. Every time I trade QQQQ with the Core Options Trading Strategy I always consider other factors before opening a position and setting my limit orders. Never forget to take a look at the political, economic, and emotional factors that are at play when entering a position.

With the method behind the madness of setting sound limit orders out of the way I want to sign off with a warning and a preview of my topic for next month: There is one tool in the trader’s arsenal that can quickly undermine the research and effort spent on placing limit orders. This over used, over appreciated, oft relied on order is designed to protect traders from loss but more often than not merely prevents them from taking in profits. I am of course talking about none other than stop orders. Ready for a shocking reveal? I don’t trade with stop orders, yet I still manage my risk. Sign in next month and I will spill all the juicy details.

Limitless options: A common mistake

August 15th, 2010 11 Comments

In the 10+ years Options-Intelligence has been offering trade recommendations we have noticed a single mistake traders continually make over and over again. It is a simple but terrible error made in defiance of charts, statistics, historical prices, and logic which often leads to detrimental effects on account balances and morale. So what is the dastardly slip up so many traders make? They fail to utilize sound limit orders.

All too often traders enter positions and immediately proceed to set stops to guard against unfavorable market activity but fail to take the same action on the upside. They choose to play for gains manually rather than utilizing reasonable limit orders for their exit strategy.

Fear often compels traders to guard against losses with stop orders but it is greed that prevents them from setting sound limit orders. Greed is why so many traders try to play the upside by using the ill-regarded “seat-of-your-pants” method for exiting positions. Utilizing this method, traders attempt to follow the market in hopes that they can chase the big, triple digit winners that riddle our performance data. Unfortunately, chasing the big gains more often than not leaves traders with big losses monetarily and emotionally. Why? First, the market is volatile and never moves linearly. Second, playing options greatly compounds the volatility of the market.

Even on the best of days, any trader not utilizing limit orders is constantly faced with a bevy of questions as the market trudges on: What is going to happen next? How much higher will it go? Should I sell or wait?

As you can tell these are all questions guised at helping the trader react to the market thus putting the trader in a defensive position. Traders should instead be proactive with their exit strategies. To do this they must utilize sound limit orders to lock in profits.

In the past, choosing where to set a limit order could be an arduous process involving considerable time looking at historical prices. Fortunately, with the advent of our performance calculator, those days are officially over. Now, any trader can easily set the parameters in the performance calculator for the position they are considering and quickly find the winning history (historical, statistical probability to achieve the specified gain) for that specific type of play at the exact level of return they are seeking. With this powerful tool, deciding where to set limit orders is merely a function of knowing one’s tolerance for risk.

Next month we will reveal some of the research we have found using this very tool and provide some examples that show traders reasonable limit orders for different levels of risk.

Some Basic Trading Tips

June 6th, 2010 No Comments

There will always be tough months to trade, what should you do?

Do not panic! If you are panicking then you are using money that does not need to be tied up in option trading.
Think about your picks carefully. Why would one stock make three picks go up? Carefully read the commentary to understand what I am trying to convey.
Do not put all your money in at once. Save some so you can add to your position if necessary later. You must remember that most of the time these options gain at least 10%. So, if you buy more at a discounted price your gain could be even higher.
Stop worrying about the stop losses and start thinking about the limit orders. Here is how Options-Intelligence suggests trading: Once the option has crossed the 10% level you can place a stop at breakeven, if it falters you have not lost any money. If it crosses 25% you can move the stop to 10-15%. Keep that separation level of 10-15% every 5% it moves up until 50%. At that time you can sell half and let the rest ride adjusting your stop upward along the way keeping a 10-15% separation.
Before you panic sell for a loss, contact me, so I can look at your position and give you an opinion as to what the outcome could be. Sometimes two heads are better than one. I have seen almost all types of circumstances and am very familiar with how our positions trade.
If you book a profit and the option goes below where you got out, there is nothing wrong with getting back in if the option goes back above your sell point and using a trailing stop to enhance gains.

Market Insight and Psychology

Setting Limits

Limitless options: A common mistake

Some Basic Trading Tips

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