Part 1

I almost hate to tell this story, but in the end there is some Bad News and some Good News.  First the Bad News.

I used to feel like I had a pretty good, well, “feel” for the financial markets.  Oh, I am not saying that I could “pick tops and bottoms with uncanny accuracy” (although just for the record, it is fun to say – go ahead, try it once and you’ll see what I mean).  

But I have always been reasonably good at discerning a trend and figuring out a way to latch on.  In the past if someone were to ask me if I thought the stock market was going to be higher or lower 6 or 12 months from now, I could always at the very least muster up an opinion and back it up with some reasonably reasonable sounding, well, reason.

But not now.

At the moment, I must admit I don’t have the slightest idea whether the stock market will be higher or lower a year from now.  While the trend as I see it is presently “up” (hint: that is important information), there are so many “scary” things lurking out there that it’s tough to be wildly optimistic.  On the other hand, maybe all of those scary things just amount to the “wall of worry” that the stock market is always said to climb.

Dare I even say that maybe, just maybe, “things are different” this time.  Oops.  I said it.  Still, I mean we’ve never been $16 trillion in debt before.  How much bigger will that get before it reverses course – if ever?  And how high can it go before something really bad happens “economy wise”?    

Where will tax rates be a year from now?  Will Obamacare survive or be repealed?  And what are the implications either way?  If it survives, what is in the other 2,750 pages that no one has yet found the time to read?  Maybe you’ve heard, but there is a Presidential election coming up soon.  Maybe your guy will win, maybe he won’t.  Regardless of who is in the Oval Office late next January, will he be able to “right the ship?”

I’m sorry, but that’s a lot of Bad News.

The Good News is that a trader or investor with a plan can still enjoy great success.

Jay’s Trading Maxim’s #1, 2, 3

So when in doubt, back to your “roots.”  So here are mine:

Jay’s Trading Maxim #1: Your absolute #1 priority as a trader is to be able to come back and be a trader again tomorrow.

Sounds so obvious, doesn’t it?  But you would be surprised how many people violate this maxim.  And it’s a hideous thing when it happens.

Jay’s Trading Maxim #2a: There are two keys to trading success; the first is to develop a method that has a realistic probability of generating profits in real-time trading (i.e., you must have a plan).  The second key is that you must have the emotional and financial wherewithal to follow the plan. 

Jay’s Trading Maxim #2b: Without strict adherence to both parts of Maxim #2a, eventually something bad happens and one day you suddenly realize that you’ve violated Trading Maxim #1 and that you are not a trader anymore.

Jay’s Trading Maxim #3: The volatility of the fluctuations of the equity in your account will have a greater impact on your success or failure as a trader than any other factor. 

Swing too little and you never quite make enough on the “ups” to offset the “downs”; swing too much and eventually (and Murphy’s Law being what it is, at exactly the wrong time) you cry “Uncle” and one day you find that you are not a trader anymore.

There I feel better.  Sort of.

On Having a Method

This week’s piece is fairly lengthy (at least by my average weekly standards) and is basically broken into three Parts.  If you are an Optionetics student – for a short or long period of time – looking to develop a trading method and/or expand your knowledge of buying and selling options, I suggest you hunker down and slog through to the end.  If you have an interest in developing a trading method you might want to get through at least Part II. 

Now I hate to say this, but if you have no interest in trading methods nor option trading then – in  all candor - you should probably consider stopping reading right here.  Thank you for your time and I appreciate your reading this far.  Have a nice day.

Alright, now that they’re gone we can kind of “roll up our sleeves” and talk some specifics.  A couple of caveats to note:

I have talked often about the importance of having some sort of objective “method”, or “system” or “rules” or “guidelines” or whatever.  In other words, something that essentially forces you to ignore “the news” and focus on taking action that has the potential to generate a profit, even if you have your doubts at the moment due to “outside noise”.

You should think of the method that I will describe as more of a “template” than as a “system.”  There are plenty of places to do things differently, and quite possibly, better.

The method we will consider is designed to find opportunities to buy call options for (hopefully) a relatively short-term gain.

The Basic Steps

Step 1. Identify a “catalyst”: First we need some reason to look for call buying opportunities.

Step 2. Identify a handful of candidates using an intuitively logical screening process.  For our purposes we will use a handful of tools to identify stocks that have had a pullback within a strong uptrend.  Also, because we will ultimately be looking to trade options we want stocks whose options trade with relatively tight bid/ask spreads.

Step 3. Identify a specific trade or trades among those candidates.

Kaeppel’s Corner: Developing a Trading Method - Part 2

Picking up where we left off in Part 1:

Step 1: Identify a catalyst

In reality, this could be just about anything.  For my purposes, I am operating under the “a rising market lifts all boats” theory, so for a catalyst I want to look for some reason to think that overall market may bounce higher in the near term.  So here is one possibility:

-Look for call buying opportunities when ticker SPY closes above its 200-day moving averages and the 2-day RSI drops below 20 and ticks higher for one day.  The theory here is that the overall market (ticker SPY is an ETF that tracks the S&P 500) has experienced a pullback (identified by action of the 2-day RSI) in an uptrend (i.e., close is above the long-term moving average).  See Figure 1

Figure 1 –Potential “Bull Catalysts” using ticker SPY

As you can see in Figure 1, if nothing else this method generates a lot of possible opportunities.  Now let’s go to Step 2.

Step 2. Identify a handful of candidates using a screening process.

For this process we will use Optionetics Platinum software.

Screen #1: Channels / Up Channel

-From the Platinum Site Map, select Stocks / Channel / Channel Finder

-Under “Channel Finder Wizard Setting” click “Best Up Channel”

-Under “Number of stocks displayed in Output Table” select “500”

-Then scroll down and click “Run”

-When the output appears, click “Replace” to save the Top 500 to My Stock List

Screen #2: Close > 200-day MA

-From the Platinum Site Map, select Stocks / Performance / Moving Averages

-Choose the setting as highlighted in Figure 2

-Click Run

-When the output appears, find the column titled “Short-Long MA (%)” (see Figure 3).

-Scroll down until a negative number appears in this column.  Note the number on the far left of the last positive value (See Figure 4).

-Scroll back up and enter this value Under “Step 3” (See Figure 5).

-Click “Replace”.

Figure 2 - Looking for Stocks above 200-day moving average

Figure 3 - Consider only stocks above 200-day moving average (Short-Long MA (%) > 0)

Figure 4 - Find cutoff between stocks above/below 200-day moving average (Short-Long MA (%) > 0)

Figure 5 - Save only stocks trading above 200-day moving average

Screen #3: Technical / RSI3 <=35

-From the Platinum Site Map, select Stocks / Technicals / RSI

-Enter the settings shown in Figure 6

-Click “Run”

Figure 6 - Finding stocks with 3-day RSI under 35 in lasst 5 trading days

After the output appears, click “Replace”

Screen #4: Tight Option Bid/Ask Spreads

-From the Platinum Site Map, select Tools / List / Stock List Filter

-in the Stock List Filter Wiards box click on "2% Highly Liquid Options and Merge Filtered"  (See Figure 7)

-When the output appears click “Replace”

Figure 7 - Stock List Filter

At this point we now have a list of “candidate” stocks.  In Part 3 we will actually look for an option trade.

Kaeppel’s Corner: Developing a Trading Method - Part 3

From Parts 1 and 2 we now have a list of candidates. Now let’s look at one way to find a long call position. We will look at the “catalyst” signal date of 7/13/12 (See Part 1).  After going through the steps laid out in Part 2 we have a list of the following 6 tickers: DE ALL ALGN POT GLL SNDK

One note is that I suggest removing any “Leveraged”, “Inverse” or “Inverse Leveraged” ETFs that show up in the list (they have a tendency to move in unexpected ways).  Upon further review we find that ticker GLL is a Profunds Ultrashort Gold so we will remove that from our list.

-From Platinum Site Map select Find Trades / Finders / Find Trades II

-The “Selected Stock List” should read “My Stock List”.  If not, select that list from the choice of lists.

-Under “Select Option Strategies”, select “Buy Call” in the upper left hand box of strategies (See Figure 1)

-Scroll down and fill in the settings as they appear in Figure 2 (remember, you don’t actually have to use these exact settings, but these inputs serve as a useful template).

-Then click “Search” to get a list of trades listed by Lowest to Highest % to double.

Figure 8 – Trade Finder Input Screen

Figure 9 – Trade Finder Input Screen

Selecting a Trade

From here there are choices.  The most obvious choice is to buy the option listed at the top of the list, i.e., the one with the lowest percent to double (in other words, this is how far the stock must rise in order for the call option listed to double in value).  This is not a bad choice.

My preferred idea is to click on “Gamma” and list the candidate trades by high to low gamma.  In this example the top trade based on these criteria is to buy October ALL 35 call option for $0.84 (or $84 per contract).  See Figure 3.

Figure 10 – Trade Output Screen after sorting for highest gamma

A trader could buy 25 Oct ALL 35 calls for $2,100. From here we need an exit plan.  The possibilities are virtually limitless, so please consider the following simply as “one possibility”.

Trade Management Plan

1) If option loses 60% of its value, exit entire position (i.e., place a stop-loss at $0.34).

2) If 2-day RSI exceeds 90, sell 20% of original position (i.e., sell 5 contracts)

3) If price closes above upper Bollinger Band, sell 40% of original position (i.e., sell 10 contracts).

Between #’s 2 and 3 only one action per day (either sell 5 or 10 but not 15 contracts on a given day).

So here is the chronology of this example trade:

7/13/12 – Buy 25 ALL October 35 calls @ $0.84

7/19/12 – 2-day RSI > 90; Sell 5 @ $1.03 ($95 profit)

7/27/12 – 2-day RSI > 90; Sell 5 @ $1.02 ($90 profit)

8/1/12 – Close > Upper Bollinger Band; Sell 10 @ $2.07 ($1,230 profit)

8/2/12 – 2-day RSI > 90; sell 5 @ $2.11 ($635 profit)

Gross profit = $2,050 in 20 days.

Figure 11 – ALL Buys and Sells

Summary

Certainly not every trade will work out as well as this example and no one should assume that the method I’ve described is guaranteed to generate profits.  But the real point of all of this is to give you some food for thought in terms of laying out an objective option trading strategy of your own, whether it involves simply buying calls and puts are using more flexible spread strategies. There is lots of room for changes and/or improvements to the example method I have laid out here.  

But the key is to understand the process (a catalyst, a set of steps to find candidates, a set of steps to find a trade, and a trade management plan for once the trade is entered) if not the actual steps. 

Jay Kaeppel

Staff Writer and Trading Strategist

Optionetics.com ~ Your Options Education Site