Showing posts with label advanced-options-trading-course. Show all posts
Showing posts with label advanced-options-trading-course. Show all posts

THE OPTIONS COURSE- Mastering the Market

THE OPTIONS COURSE


Mastering the Market

Rising interest rates, comments from the Federal Reserve, and economic reports can all cause changes in the economic outlook, which can cause stock prices to move sharply higher or lower. When one examines the economic outlook in order to make investment decisions, it is known as a top-down approach to investing. Some traders prefer to take a bottom-up approach. In this case, you are more concerned about the individual investment. For example, you might start by studying an individual company and understand its detailsbefore making a decision.

We want to help you identify the fundamentals of profitable investment. You will have to decide, probably by trial and error, which of the many analytical techniques and market-forecasting methods work well for you. I find many investment tactics to be irrelevant to profit making, preferring to use strategies that are non directional in nature. However, there are a few basic guidelines that will enhance your ability to increase your account size consistently by making good investment selections.

DESIRABLE INVESTMENT CHARACTERISTICS

Finding promising trades is perhaps the most difficult issue to address when first starting out in the investment arena. While there are no absolutes, there are a few guidelines that will enhance your ability to identify profit-making opportunities. A desirable investment has the following characteristics:

• Involves low risk.
• Has a favorable risk profile.
• Offers high potential return.
• Meets your time requirements.
• Meets your risk tolerance level.
• Can be understood by you, the trader.
• Meets your investment criteria.
• Meets your investment capital constraints.

Involves Low Risk

First and foremost, a good investment must have low risk. What does low risk really mean? The term’s significance may vary with each person. You may be able to accept a risk level of $5,000 per trade based on the capital you have available. However, an elderly person on a fixed income may find $100 to be too much to risk. Acceptable risk is based on your available investment capital as well as your tolerance for uncertainty. You should trade only with money you can afford to lose, as there is risk of loss in all forms of trading.

Has a Favorable Risk Profile

Every time you contemplate placing a trade, you need to create a corresponding risk profile. Whether you trade shares or commodities, invest in real estate, or put your money in the bank, every investment has a certain potential risk/reward profile. Some are more favorable than others. Studying a risk profile can show you the potential increasing or decreasing profit and loss of a trade relative to the underlying asset’s price over a specific period of time. As the variables change, the risk curve changes accordingly.

In order to find the best investment, you have to look for trades that offer optimal risk-to-reward ratios. For example, which of the following investment choices has the better risk-to-reward ratio?

• Trade A: potential risk of $1,000; potential reward of $1,000.
• Trade B: potential risk of $1,000; potential reward of $5,000.

Anyone would rather make $5,000 than $1,000. However, to actually make a good decision, you must also have enough knowledge to discern which trade has the greater probability of working out. Another key ingredient is time frame—the time it takes to make the money. If trade A can make me $1,000 in one month with a 75 percent chance of winning, and trade B takes a year to make $5,000 with a 75 percent chance of winning, I would rather go with trade A. In one year, I could potentially make $9,000 [(12 × 1,000) × .75] repeating trade A, and only $3,750 ($5,000 × .75) using trade B. This is referred to as an expected value calculation.

The risk/reward profile of any investment must take into account the following elements:

• Potential risk.
• Potential reward.
• Probability of success.
• How long the investment takes to make a return.

Offers High Potential Return

Risk comes hand-in-hand with reward. A trader cannot be expected to take a risk unless reward is also in the equation. Believe it or not, I have seen countless investors make foolish investments where the risk out-weighs the reward many times over. Why would they do such a thing? Usually because they simply haven’t taken the time to verify the potential risk and reward of the trade or they are taking advice from someone who doesn’t know any better.

The best investments have an opportunity for high reward with acceptable risk. In addition, the good trades have a high probability of winning on a consistent basis. I consider 75 percent an acceptable winning percentage. This means I win three out of four times I place a trade. A baseball player who could do this would have a .750 batting average— which is unprecedented in baseball history.

Meets Your Time Requirements

The process of locating and monitoring your investments must meet your time constraints if you are to be successful. In other words, if you do not have the time to sit in front of a computer day in and day out, then your best investments will not be day trades (entering and exiting a position in the same day). If you don’t even have the time or inclination to look at your investments over a one-week period, then you have to take this into consideration. The time you have available for making investment decisions and monitoring those investments will affect the types of investments you should make. If you don’t have enough time to pay attention to a trade that needs to be closely monitored, chances are you’ll lose money on it. The best investments will match your time availability.

Meets Your Risk Tolerance Level

Your risk tolerance level is directly proportional to your available investment capital. Risking more than you can afford to lose creates stress that impairs your ability to make clear decisions. Some people have the ability to handle uncertainty better than others. It is important to accurately assess your own risk tolerance levels and stay within those boundaries as you progress up your own trading learning curve. As experience in the markets naturally develops your confidence level, your risk tolerance level will increase.

Can Be Understood by You, the Trader

One of my most basic investment rules is as follows: If you don’t know how hot the fire is, don’t stick your hand into it. This rule is broken on a consistent basis by many beginning and intermediate traders. In addition, many seasoned traders singe their fingers as well. Basically, if you don’t understand the exact characteristics of a trade, it is better to walk away from it. It is imperative that you familiarize yourself with the trades you place. Each trade has a unique personality. Your personality and your trade’s personality have to match for you to be successful over the long run.

Meets Your Investment Criteria

Your personal investment criteria can come in many shapes and sizes. Each individual has personal goals, expectations, and objectives when making investments. When I ask my students what they want out of their investments, the typical response is to make money. However, there are a number of related issues that also must be evaluated, including:

1. Capital gains (stocks—medium- to high-risk securities). What are the tax implications of your investing and trading practices?
2. Interest income (fixed income securities—medium-risk bonds and lowest-risk U.S. government securities). Is your objective to earn interest income?
3. Security (government securities—lowest-risk securities). Do you want to invest in only low-interest, low-return investments such as U.S. government securities (e.g., Treasury bonds)?

Meets Your Investment Capital Constraints

Do the investment requirements match your capital available for investment? Just as your investment strategy must meet your personality and time constraints, the capital you have available will have a major impact on what you invest in, how often you invest, and the number of contracts you can afford to trade. For example, if you have a small account (less than $10,000), you will invest very differently from someone with $1 million. In addition, if you’re trading commodities with a small account, you should trade in markets that have low margin requirements and good return potential. 

You should stay away from the high-margin markets such as the S&P 500 stock index futures. No matter how much money you have to invest, start small. I have taught a variety of people over the years with a very wide range of capital available for investment. I advise them all to start by trading small until they figure out what they’re doing. Whether you have $1,000 or $1 million, you have to learn to walk before you can run. In the beginning, I recommend risking only 5 percent of your account on any one trade. In this way, you can afford to learn from your mistakes as a novice trader.

Often, having too much money as a beginner can be detrimental. The more money you have, the greater the chance of overinvesting and making costly mistakes. I find that the best long-term investors are very cautious early on. However, they systematically increase the size of their trades based on the steady increase in capital in their accounts. For example, you may begin with $5,000 and choose to invest 100 shares at a time, then not increase to 200 shares until such time as your account has doubled to $10,000.

IMPORTANCE OF TARGETED EXIT POINTS

One of the most important decisions a trader must make when entering a position is determining when to sell or close out the trade. It is imperative to set a target exit point for each trade. A target exit point is an option price that would result in a substantial, yet attainable, profit. By setting your profit objectives in advance and determining your target exit point before you trade or at the time you make your option purchase, you avoid the consequences of one of the major stumbling blocks to achieving trading profits: greed. It is very hard for most investors to set reasonable profit goals once an option has jumped substantially in price. 

That extra point becomes a moving target with each advance in the option’s price. Therefore, it is not surprising that a reasonable profit is not achieved when the investor is forced to bail out because of tumbling prices. Although setting profit goals in advance may be simplistic and not the most flexible approach to option trading, the target exit point approach to taking profits is a necessary compromise. This is especially true for the options trader who has neither the savvy nor the emotional control to know when to hold and when to fold in the heat of battle, and who is also unable to stay tuned to the markets throughout the trading day.

Note also that the profit objective should be substantial, meaning at least 100 percent, or double your initial investment, so you will not be walking away with small profits by using this approach. With this approach, you will miss out on those 1,000 percent gains that are the options equivalent of hitting the jackpot; but much more important, you will minimize the instances of solid profits becoming painful losses and you will regularly be taking respectable gains off the table. Once you have entered the heat of battle, the tendency will be to base your decisions upon emotion, and therefore your decisions will tend to be incorrect. To avoid this pitfall, set a closeout date based on the amount of time you expect the option needs to reach its target exit point. 

If that profit level has not been reached by the closeout date, exit the position on that date. Closeout dates should be set so that there is still enough time until expiration to salvage some time value from the option if the underlying stock has failed to move. Resist the temptation to sell at a small loss prior to your closeout date. You will be yielding to fear, robbing yourself of some potential gains. Also, resist the temptation to raise your profit objective as the price of the option nears your target exit point. You will then be yielding to greed, and your profits will slip away. Another important question that needs to be addressed is when should you not sell? You should not sell a position the instant it moves against you. 

There is never a need to engage in panic selling if it is assumed that your original conditions for opening the position still hold true (e.g., your market outlook and your outlook for the stock on which you own options have not changed); also, that you are not committing an excess amount of trading capital and you are still operating within your own risk tolerance. As option traders we create option positions for their huge profit potential, which can be fully realized only by allowing positions to remain open for a reasonable period of time. Setting predefined exit points goes a long way to facilitate this task.

TIPS FOR SPOTTING AN EMERGING BULL MARKET

Although no two bulls or bears are exactly alike, and sometimes their signals may be a bit obscure, eventually the indicators will pile up and a trend will become evident. As you analyze the stock market for signs of shifting trends, be cautious. Each market is different from its previous cousins, so not all the warning signs will be present each time. If you notice only one or two of the telltale clues, some fleeting business or economic event temporarily may be tilting the market. However, if you detect four, five, or more of these signs appearing all at once, you’ve probably discovered a major new market phase.

Before the bull begins to charge ahead, you will find six major signs that the bear has retreated into hibernation. Most of these signs apply to stocks, but often they readily relate to other investment markets as well. One of the signs is that the market has undergone a mature decline. Naturally, if you want to determine whether a new market is on its way up, one of the first things you’ll do is determine what activity has come before. If the market has undergone a mature decline then a bull may not be far off. Second, look for a market that is dull and boring. 

Historically, bear markets generally storm onto the market scene, but they depart extremely quietly. This kind of lackluster activity is one of the most common signs that a bear market is losing strength. Such sluggishness may go on for weeks or even months, but stock prices do not necessarily tumble along with trading volumes. When this scenario occurs, professional investors might say the market has been seized by a complacent attitude. The next possible sign is when the market resists bad news. Generally, financial and even some sociopolitical news has a marked effect on the markets. When the markets refuse to budge, despite significant developments, you definitely should take notice. 

Another sign is when the gloom is so deep that even the top-quality investments are sold. As a severe bear market grinds on for what seems like forever, stock investors, for example, often sell their blue-chip securities in one last brief selling period. These probably are the last stocks to go, as investors will have unloaded their lower-quality holdings at the start of the bear. When the market has fallen to an uncomfortable degree, and investors believe hope for a quick recovery is gone, blue chips hit the market with a sudden decline. Not surprisingly, that tends to reinforce the bleak market mood, as investors begin to think that if even the best stocks are acting this way, then something really must be wrong with the market.

Next, as a bear market begins to fade, stocks that once sold at price-earnings ratios of, say, 18 to 20 times earnings often are selling at unusually low P/Es, perhaps less than half their former figures. When those stocks once regarded as must-have securities lose all their appeal, the change from the normal situation should cause investors to take notice. Those who have a chance to purchase bargain stocks before the next bull market should swing into gear. Finally, high dividend yields offer a key signal. Like low price-earnings ratios, the often high-dividend yields to be found at the tail end of a bear market represent a market reversal in market psychology. 

Although yields in a bear market typically are higher than those for the same stock at the peak of a bull market, you can look for this phenomenon to alert you that a bear market has run its course. What does it mean when you can identify several of these indicators? Obviously, the bear market has begun to fade and the bull market slowly is taking shape. More and more trading occurs daily, and the number of advances, the upward movements in the prices of the individual investments, outpace the declines. The volume of trading and the number of advances and declines indicates the market breadth. To summarize, be aware of the following key signals that a bear market is approaching a bottom. 

First, market prices have been declining for more than 12 months. Second, the volume of trading declines and you start to observe a very boring market. Third, bad news makes no impression on the markets. Fourth, investors start unloading top-quality investments by heavily selling many of the blue chips. Fifth, investments that once were stars are now on the skids, selling at undervalued prices. With stocks, price-earnings ratios are unusually low. And finally, sixth, stock dividend yields rise abruptly. The bottom line is if you observe most or all of these signs, the bear market is probably coming to an end and a new bull may not be far behind.

TAKE A LOOK BEHIND THE ANALYST CURTAIN

How many times have you placed a trade that you thought was perfectly set up only to have an unforeseen or unexpected event cause the trade to go bad? The technicals all looked good; maybe even the fundamentals were all in place. To all intents and purposes, the trade looked like a winner. Then all of a sudden out of nowhere comes a comment from one of the “guru goons” (my term for analysts), the company announces an acquisition that the Street doesn’t like, or maybe even a bizarre incident like an earthquake in Taiwan! The underlying then reverses and the trade moves against you. Let’s look behind the scenes of how analysts and institutions really work.

It’s amazing how many individual investors and traders still live and die by analysts’ recommendations. Many people actually still think that analysts make recommendations for the good of investors. Think about it, who do the analysts work for? They work for the institutions. Why do analysts continue to rate a stock a “strong buy” while the underlying is bleeding a slow death? Why do the same analysts raise a stock’s rating that has clearly been in an extended uptrend? Institutions build inventories in stocks that they then allocate to their brokers to sell to investors. In some cases, it is nothing more than a quota that the broker is expected to sell. The analyst from the institution will then focus on some piece of positive data regarding the stock and raise the ratings on the same. 

This causes a short-term buying interest in the stock by retail investors and usually a bump up in the price as well. Who are the retail investors buying from? Their institution! The institution has been accumulating inventory in a stock, so then it manufactures a buying spurt and depletes its inventory at a higher price. Many times this occurs as the stock is showing signs of topping out. The institution makes money, and who is left holding the “bag” or stock? Institutions are in the business to make money, and that consists of more than just broker commissions. If the investors make money, then that’s okay, too, but it’s not the priority. In fact, in some cases your own institution will actually take a position against your trade! It goes even deeper. 

If an institution is dumping an inventory and you have purchased the stock and later decide that you want to sell, the institution won’t buy your stock back! It will execute your trade only after it finds some other patsy to take it off your hands. Have you ever wondered why analysts always seem to be a step behind? When a company announces something negative, if it’s a stock that the institutions are interested in, the analysts all jump on the bandwagon with downgrades. As retail investors are dumping the stock based on the downgrades, the institutions are sitting back and waiting for the downdraft to subside and then they begin to start accumulating again. The whole process starts all over again. How about raising a stock to a “strong buy” once it appears ready to break out of a long-term consolidation or basing pattern? Wouldn’t that be a novel idea? That would mean that analysts were really employed to help investors, however. 

Then there are all of the amazing abuses of investors by analysts regarding initial public offerings (IPOs). How many investors own Internet stocks that were priced at ridiculous price multiples due to continued upgrades by analysts as the stock prices went into the stratosphere? How many investors still own those stocks today under $10 a share? Do you think the institutions feel bad that they sold investors those stocks at ridiculous multiples? Believe me, they will only feel bad until they look at their bottom lines. Some of these longtime abuses are finally beginning to surface in the media, both on the television networks as well as in the print media. Some investors have even sued the analysts. 

Okay, so what’s my point in all this? We are on our own out here and have only ourselves to hold accountable when investing our hard-earned money. Optionetics exists because no matter how much research we do, no matter how good a trade looks when we place it, things happen that are out of our control and can cause trades to go against us. Hedging all trades is crucial. When an unforeseen event does happen, we can employ a creative options strategy to take advantage of it. Even in our worst-case scenarios, our losses are minimal and we live to fight another day. Option strategies are designed not only to aid your research, but also to help hedge the trades you make, regardless of existing market conditions or directional bias.

COMPUTERIZED TRADING SYSTEMS

Trading systems facilitate trader discipline. Computerized systems offer additional advantages. The speed and efficiency with which a computer identifies patterns and generates signals is one obvious advantage. Computers can quickly achieve the number crunching necessary to recognize trading signals. However, it is possible for a trader to calculate these signals manually (in the time required), and the trader’s ability to evaluate a complete rule-based system is limited as well. Computer systems offer direction and suggestions about what to do in a given market and help limit the range of choices. This makes the trader’s task less overwhelming, because the possibilities and opportunities become more clearly defined.

Trading systems approach the market consistently and objectively. Programs are designed logically. Rules are uniformly applied to defined market conditions. Trading systems are effective since rules are not the victims of trader judgment. The whimsical nature of a trader is diminished by a system. The emotional aspect of trading can be significantly reduced as well since systems are void of emotion and judgment. Unfortunately, the emotional tendency of a trader is to outguess the system, even when it’s producing profitable trades. If a trader can discipline himself or herself to follow a system with rigor, emotions will not rule the decision-making process. Trading systems are designed to think, not to feel. 

Another positive feature of trading systems is that they generally include money management rules that help to facilitate trading discipline. One of the more common arguments against trading systems is that they can become popular enough to influence the underlying price. This concern has been voiced both by the market federal regulatory agencies and by individual traders. The concern is that the similarity of computer-based systems used to manage large positions may cause large traders to respond in the same way at the same time, thereby causing distortion in the markets. While it is not guaranteed that past price patterns guarantee future price patterns, it is also not true that markets are random. 

Another argument against the use of trading systems is they define market behavior in limited ways when the market can, in fact, behave in an infinite number of ways. It is believed that because systems are mathematically or mechanically defined, this reduces relationships of events to percentage odds of what could happen next. While the criticism is valid in that systems do capture a very limited number of possibilities, this characteristic is also what makes systems useful. The ability to reduce information to observable patterns gives the trader some semblance of order and direction. Without this, many traders feel overwhelmed and directionless.

One of the more controversial techniques to develop from computerized trading is the concept of optimization. Optimization is a process by which data is repeatedly tested to find the best results. The best moving average size, point and figure method, or other parameters are made to fit the raw data. It is important to understand the methods of optimization and to provide proper precautions regarding optimized trading systems. Performed properly, extensive testing can reveal a great deal. However, excessive optimizing can be misleading, deceptive, and costly. Trading systems give the trader a way to interpret, quantify, and classify market behavior. 

Since trading systems define potential opportunity and provide specific trading signals, following these signals can facilitate the development of profit-making trading skills as well as strong exit and entrance discipline. Computerized trading systems have vastly expanded the scope of information available to today’s traders. Systems can now be thoroughly back-tested and perfected using the computer to test many if-then scenarios. Trading systems offer a way to define and categorize market behavior by reducing information to patterns that generate trading signals. While systems are without emotion, traders are not and often try to outguess a system. Misuse and lack of discipline are major causes of losses in trading systems.

CONCLUSION

The investment elements are designed to guide you on the road to trading success. Trading can be a humbling experience. It can also be highly profitable. Perhaps it is human nature to get a little overconfident and cocky when the money starts rolling in. But that’s the time when you need to fight against your own bravado. Remember, it takes only one big mistake to send you back to ground zero. Start small and let your account grow consistently. There’s always more to be learned and a better trade down the road.

In addition, there a number of things you can do to protect your account. Use the following six guidelines to safeguard your share of market profits:

1. Do your own research before you invest. Don’t invest in companies that minimize or avoid disclosure of their financial condition. Always read the fine print in your information sources and avoid hot tips.
2. Deal with major brokerage firms and reputable brokers. Know your brokerage firm’s financial condition and who owns the firm. Be sure you know what your agreement specifies.
3. Keep a written record of all trades. Write your orders in advance. When you receive trading confirmations, make sure to compare them with your written records.
4. Put your broker to work. If trading confirmations are slow in coming, complain to your broker. Balance all monthly statements. Ask your broker to explain any discrepancies. If trouble persists, go to a supervisor. If it continues, change firms.
5. Change brokers who talk about sure winners. Resist all sales manipulation emphasizing double-digit rates of return, shares that will double, hot stocks, and guaranteed profits.
6. Never put greed before safety. Sometimes you have to protect yourself against yourself, and that can be the most difficult job of all. Remember the market will be here tomorrow—but to use it, you need investment capital.

Hopefully, this information will help you avoid or deal effectively with many of the issues that you might experience. Investors who know how to choose a good broker, how to analyze information, how to order skillfully, and how to protect themselves are investors who know how to make money.

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THE OPTIONS COURSE- Basic Trading Strategies

THE OPTIONS COURSE


Basic Trading Strategies

Trading is a diverse activity that encompasses a wide variety of analysis techniques and innovative approaches. The optimal approach for you requires an assessment of both your time availability and your risk tolerance. Once these factors are determined, you’re ready to specialize in those techniques that fit your parameters. There are three fundamental approaches on which all trading strategies are based: strategic trades, long-term trades, and delta neutral trades. Each has its own set of conditions and rules that foster a unique trading style.

Strategic trades are typically short-term trading opportunities geared especially for day traders and short-term traders who have the opportunity to monitor the markets very closely each day. Strategic trades are specific to certain markets and may be driven by economic data or events. Many strategic traders use the Standard & Poor’s 500 as the key index on which they focus their attention when trading market-related instruments. The Dow Jones Industrial Average (the Dow) is also watched closely to tip off certain bond and currency trades. 

As a trader, you need to develop your own personal trading style based on the patterns you encounter in the markets. Consistently applying the use of a strategic trading approach fosters success. Long-term trading methodologies differ greatly from strategic trades. Long-term traders do not look at trades from a second-to-second perspective. Instead, they approach trades from the perspective of a couple of days to a few months, or even into the next year. These trades are based more on market trends and seasonal factors. 

They take a while to blossom and bear fruit, which gives the long-term trader more time to develop the art of patience. Delta neutral trades make up the third kind of trades, and probably the most complex. These strategies create hedged trades in which the overall position delta equals zero. As the market rises and falls, the overall position delta moves away from zero. Adjustments can then be made by purchasing or selling instruments in such a way as to bring the overall position delta back to zero. Each adjustment has profit-making potential.

Most delta neutral trades can be structured in such a way that your total cost and risk are minimized. Delta neutral trading strategies and longer-term trading opportunities are better suited for traders who are not able to sit in front of their computers all day watching the markets move. Successful delta neutral traders create a trading system with a time frame they feel comfortable working in. You can create trades that are three months out, two months out, one month out, or even only one day out. 

If you are the type of person who does not want to think about your trading every single day, simply take a longer-term approach. Delta neutral strategies can be applied to any market. It can be advantageous to learn to trade both stocks and futures. Even if you think you want to trade just futures, you can make just as much money trading stocks if you use delta neutral strategies. In either case, the options strategies outlined in this book can be applied using stocks or futures. As you read about them, think about the ones that make the most sense to you and then specialize in those strategies.

RISK PROFILES

Before launching into our discussion of specific strategies, let’s discuss one of the most important tools for viewing the profit and loss potential of any options strategy: the risk profile. Understanding and managing risk is the critical task of all traders. Very experienced traders and the mathematically adept may be able to intuitively understand what risk is being assumed by a given trade, but the rest of us work best with a visual picture of the risk we are taking. For that reason, the drawing and understanding of risk curves is an essential part of daily trading activities.

A risk profile is a graphic representation of the profit/loss of a position in relation to price changes in the underlying asset. The horizontal numbers at the bottom of the graph—from left to right—show the underlying stock prices. The vertical numbers from top to bottom show a trade’s potential profit and loss. The sloping graph line indicates the theoretical profit and loss of the position at expiration as it corresponds to the price of the underlying shares. The zero line on the chart shows the trade’s breakeven. By looking at any given market price, you can determine its corresponding profit or loss. 

Risk profiles enable traders to get a feel for the trade’s probability for making a profit. In order to get a better handle on what a risk curve is, let’s use a hypothetical example. The first thing to understand is that the risk graph depicts the value an option or an options position in relation to changes in the underlying asset’s price. As an example, let’s consider call options on Wal-Mart Stores (WMT). Here, WMT is the underlying asset. Assume shares of Wal-Mart are trading for $60 each and one January 70 call can be purchased for $2.50 (or $250 per contract). Therefore, the underlying as-set is Wal-Mart Stores and the option is the WMT January 70 call.

Table shows the risk and reward of holding the WMT January 70 call. The prices are hypothetical prices that might exist at expiration on the third Friday in January. Notice that if the stock doesn’t rise above $70 a share, the position loses $250 because the option expires worthless at or below $70 a share and yields no profit. If the stock climbs to $75, the options are worth $5 and the profit totals $250: [(75 – 70) – 2.50] × 100. At $80 a share, the profit equals $7.50 ($10 – $2.50). Notice that the position breaks even at $72.50 because $2.50 was the initial cost of the call when purchased.

Rather than creating a table for the risk/reward profile of the WMT January 70 call, we can create a risk graph. It plots the profit from the option (on the vertical axis) along with the price of the stock (along the horizontal axis). The potential profit from the call is plotted along the vertical axis. The lowest of the four lines on the graph considers the potential profit and loss of the WMT January 70 call at expiration and contains the same information as the table. Just as we saw on the table, the profits begin to accrue when WMT hits $72.50 a share.

TABLE  Risk/Reward Profile of WMT January 70 Call 


FIGURE  Standard Risk Graph for 1 Long WMT January 70 Call @ 2.50

The breakeven point (at expiration) occurs where the straight black diagonal line intersects with the zero profit line. The other lines reflect the risk/reward with a specific number of days (as shown in the upper left-hand corner) remaining before expiration. The position of the profit/loss lines at various time intervals is based on the model’s assumption that implied volatility remains constant. While this assumption doesn’t reflect reality, it must still be made in order to produce the chart.

You can also use other options pricing software or compute the graph manually. To actually draw the risk curve, your tools can be anything from a pencil and piece of graph paper to a computerized spreadsheet program such as Lotus 123 or Microsoft Excel. The steps will be the same. Drawing a risk curve for any trade, regardless of its complexity, consists of five basic steps:

1. Determine the stock prices for which you will have to calculate values of your trade at expiration.
2. Calculate the profit (or loss) at each of those points, and determine the breakeven level.
3. Sketch the two axes of your risk curve—the vertical axis will delineate the profit (or loss) of the trade, while the horizontal axis will depict the price of the underlying for which you have determined a profit or loss.
4. Actually plot the points that you calculated in step 2 onto the graph set up in step 3.
5. Draw lines connecting each point plotted in step 4.

This simple five-step process will permit you to calculate a risk curve (even without a computer), detailing the actual profit or loss that can be expected at any stock price upon expiration. Granted, you cannot estimate potential profit or loss prior to expiration, but a basic rule of thumb is that the profits will not be as high, nor the losses as great, at any time prior to expiration. If you don’t have a sophisticated risk-graphing program available, this process will give you the basic outline of what your trade will look like. 

As you gain experience and your trading becomes more refined, you will find yourself needing the power of the packaged programs. However, for the beginning trader, a simple risk curve at expiration like this one will help explain where profits can be made or lost. If you graph out the risk curve on every trade you are contemplating, the visual recognition of the risk will soon improve your trading in countless ways.

FIGURE  Wal-Mart January 70 Call Risk Curve 

FIGURE  Risk Graph Framework for 1 Long WMT 70 Call @ 2.50

Skill Builder

Now it’s your turn. Follow the five steps to see if you can manually create a risk graph for 1 Long WMT 70 Call @ 2.50. The complete risk graph can be found if you want to check your work.

           Breakeven                                   72.50
           Maximum loss                    –$250
           Price at maximum loss             70
           Profit @ 75                             $250
           Profit @ 80                            $750

LONG STOCK

While the term going long might have you envisioning a football player going deep for a pass, in the financial markets going long is one of the most common investing techniques. It consists of buying stock, futures, or options in anticipation of a rise in the market price (or, in the case of a long put, a drop in the price). An increase in the price of the stock obviously adds value to a stock holding. To close this long position, a trader would sell the stock at the current price. A profit is derived from the difference between the initial investment and the closing price. A long stock position is completely at the mercy of market direction to make a profit.

Long Stock Mechanics

In this example, the trader is long 100 shares of XYZ (currently trading at $50). Remember, shares of stock do not have premium or time decay. Long stock has a one-to-one risk/reward ratio. This means that for every point higher the shares move, you will make $100. Conversely, for every point the shares fall below the purchase price, you will lose $100.

Figure shows the risk profile of this long stock example. As you can see, when the share price rises, you make money; when it falls, you lose money. Notice how the profit/loss line for the stock position shows a 1-to-1 movement in price versus risk and reward. This means that the stock trade has an unlimited profit potential and limited risk as the price of the stock can fall only as far as zero.

FIGURE  Long 100 Shares XYZ @ 50

Exiting the Position

When you purchase a stock, the only way to exit the position (without exercising options) is to simply sell the shares at the current market price. If the price of the stock rises, the trader makes a profit; if the price falls, then a loss is incurred. Thus, if XYZ rises to 60, 100 shares will yield a profit of $1,000: (60 – 50) × 100 = $1,000. If XYZ declines to 40, 100 shares create a loss of $1,000: (50 – 40) × 100 = $1,000.

Long Stock Case Study

Buying, or going long, stock is the easiest and most straightforward trading strategy available. However, this doesn’t mean it is the best strategy to use. Going long stock consists of buying shares of a company outright and holding onto them as they (hopefully) gain in value. The positives to this strategy are that it is easy and figuring your profits and losses is straight forward. The stock can also be held forever, as long as the company remains a valid corporation and does not declare bankruptcy. 

However, the costs can be expensive, making it difficult to diversify. There are many different ideas on how to pick a good stock, depending on your time frame. Technical analysis is often used for short-term trading decisions, while fundamental analysis is the main discipline for buying stocks over the long term. As with any trading strategy, it still is a good idea to have exit points set up in advance so that you aren’t swayed by emotion.

A risk graph for a long stock trade is very easy to create, even by hand. It is a straight line, which shows that for every dollar gained in the security, you profit a dollar per share. The same holds true to the downside. It shows the dollar-for-dollar profit/loss that comes with this basic strategy. Let’s say we saw the Nasdaq 100 Trust (QQQ) break above resistance on May 1, 2004, and decided to buy 100 shares at $27.69.

This trade proved to be a good investment decision, with the Qs moving higher right into 2004. We might have held onto this trade until the Qs started a downtrend in early 2004. Let’s assume we got out at 36, when the Qs made a lower high and a lower low. By getting out at 36, we would have made $8.31 per share, or $831 overall. Not bad, but we had to invest $2,769 (or half this amount if we used margin)—a 30 percent return on investment. Of course, if the Qs had lost ground, we would have lost a dollar per share for each point the Qs fell.

FIGURE  Risk Graph of Long 100 Shares of Stock on QQQ

SHORT STOCK

Traders can take advantage of a falling market by selling, or shorting, shares of stock. Initially, this process can be quite confusing. After all, most investors want to buy a stock at a lower price and sell it for a profit at a higher price. Short selling reverses this process. With short sales, the trader actually sells the stock first and hopes that it will decline in value, so that it can be bought back at a lower price. The difference between the selling price and the purchase price represents the profit or loss.

In order to sell a stock short, traders must first borrow the shares from their broker. This is not always going to be possible and will depend on the specific stock and the brokerage firm. In some cases, it might not be possible to find the stock. This is especially true of less liquid or actively traded shares. Generally, a broker will look in one of four places for the shares to lend to the short seller. The most common source is from other customers who are long the stock in their margin accounts. Alternatively, the firm might look to one of three other places:

1. Its own inventory.
2. Securities borrowed from another brokerage firm.
3. Securities borrowed from institutional investors.

If the firm has exhausted these options and come up empty, the short seller will not be able to borrow and short that particular stock. Once the stock is sold, the trader will profit if the stock moves lower. Keep in mind, however, that if any dividends are paid by the stock, then the lender, not the short seller, is entitled to them. The person holding an open short position must pay the amount of the dividend to the lender. 

In addition, the margin requirements call for a 150 percent deposit of the net proceeds from the short sale. Also, importantly, the lender generally retains the right to demand that the stock be returned to him or her at any time. So, one risk to short selling is that the lender may demand that the shares be returned before the stock has made a move lower. Undoubtedly, short selling stock comes with a variety of risks.

Short Stock Mechanics

An investor believes that the price of XYZ is too high and expects the stock to move southward. It is currently trading for $20 share. So, she instructs her broker to sell short 1,000 shares of XYZ at $20. The brokerage firm then lends the investor the securities and they are sold in the market for $20. The total credit received from the short sale equals $20,000. Now the money is in the account, but the customer owes the brokerage firm the 1,000 shares. If XYZ falls, the trader can book a profit. For example, let’s say XYZ drops to $10 a share and the short seller instructs the broker to buy back 1,000 shares to close the position. 

The stock is purchased for $10 a share and the cost of the trade is $10,000 (plus commissions). She then returns the borrowed shares and closes the trade. The profit is equal to the difference between the purchase price and the selling price, or $10,000 (minus commissions). Suppose, though, XYZ appreciates to $30 a share and the trader decides that it’s time to cut her losses. In this case, she must buy XYZ back for $30 per share, or $30,000, and return the borrowed stock to her brokerage. The loss is equal to the purchase price minus the sale price, or $10,000 (plus commissions).


FIGURE  Short Stock Risk Graph

Exiting the Position

When you sell shares short, the only way to exit the position (without applying options) is to buy back the shares at the current market price. In order to do so, you must instruct your broker to close the trade or to “buy to cover.” Then, once the stock is purchased, the borrowed shares are moved out of the account and returned to the original owner.

Short Stock Case Study

Outside of trading options, there is only one method a trader has to make a profit during a downtrend in stocks: short selling stock. As previously discussed, going short is the process of borrowing shares from your broker and then replacing these shares at a future date when the stock has lost ground. If this occurs, a trader can profit on the decrease in price. However, shorting stock is extremely dangerous and cannot be done on all stocks and at all times. It’s vital to keep in mind that shorting stock requires a large amount of margin. 

This is because the risk is unlimited to the upside. If you borrow a stock from your broker at $50, expecting it to decline, but it instead moves higher, you are at risk the whole way up. If the stock hits $75, you have lost $25 for each share you are short. This means that a margin call would have occurred several times on this move up. A margin call is a Federal Reserve requirement that a customer deposit a specified amount of money or securities to keep a trade open when a sale or purchase is made in a margin account; the amount is expressed as a percentage of the  market value of the securities at the time of purchase. 

The deposit must be made within one payment period. Another negative to shorting stock is that it can only be done on stocks that have large volume. Also, a stock can not be shorted on a downtick. This means that if the market is falling hard and you want to short a stock, it can’t be done until the stock has traded at the same price or higher. Let’s take a look at the risk, which depicts going short 100 shares of the Nasdaq 100 Trust (QQQ) at $82.44 on November 6, 2000. 

The short sale of 100 shares produces a credit of $8,244. As you can see, the risk graph for a short stock is the exact opposite of a risk graph for a long stock. Although the trade profits dollar-for-dollar as the stock moves lower, it is also at risk dollar-for-dollar if the stock price increases. Keep in mind that your broker will require a rather large sum of capital to cover the margin requirement with the firm—usually 150 percent.

FIGURE  Risk Graph of Short 100 Shares of Nasdaq 100 Trust (QQQ) @ 82.44

Luckily, this trade proved to be a good investment decision, with the Qs moving lower and then sharply lower. If a trader had stayed short until the 200-day moving average was broken near 40, he or she would have made a significant profit. The Qs fell that year from 82.44 to 40 in about a 12-month period, which would have created a healthy profit for the savvy short seller!

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