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Note: Please look for the interview with Jay Kaeppel in the November 2009 issue of Technical Analysis of Stocks and Commodities magazine.

Within the vast ocean of investors and traders it should come as no surprise that there are many different “types” of individuals. Nevertheless, in the broadest stroke possible, we can generally narrow things down to three basic categories – sort of the “Goldilocks” of investing: “too little," “too much” and “just right.” To wit:

• Investor Category #1: Those who think about their investments “too little.”
• Investor Category #2: Those who think about their investments “too much.”
• Investor Category #3: Those who think about their investments “just right.” 

Investor Category #1

The individuals in Category 1 actually had a pretty good run for about 25 years, between 1982 and 2007. Thanks to the “great bull market” these individuals were able to simply dump money into “aggressive growth” mutual funds etc., or stocks recommended by some guy they knew and over time they by and large saw their net worth grow a handsome sum. Yes, all was well right up until the point (round about the fourth quarter of 2008) that roughly 40 to 60% of that growth got wiped out. But it was sure a great ride while it lasted.

Investor Category #2

The twists and turns involved in the experience of those in Category 2 are harder to, well, categorize. The fact is that for those who think about their investment and trading too much, there is a great tendency to lurch from one idea to another. Just as soon as their “latest and greatest” trading method suffers three losing trades in a row, these typically somewhat hyper/impatient individuals (and I think you know who you are) are off looking in some different direction, ready to trade their ‘latest and greatest” for something “newer and better.” And of course, Murphy’s Law being what is, just about the time that these individuals make the switch, their original method once again starts working like a charm. Same as it ever was.

Investor Category #3

Those in Category 3 do the work involved in finding or developing a strategy or strategies that have a high probability of generating profits over time and then work to maintain the emotional and financial wherewithal to stick with it (them) over time. And while they will typically enjoy the benefits of greater profitability than those in Categories 1 and 2, there will invariably be moments of doubt, and periods of time when they will “trail the market averages” (gasp!). How one reacts during such times is what determines whether an individual ultimately resides in the more successful Category 3 or the less successful Category 2.

Those in Categories 1 and 2 do have a certain “advantage," however. Those in Category 1 can maintain a blissful ignorance about 97% of the time, and can then feign outrage the other 3% of the time and claim “there was no way to avoid it” when things come unglued from time to time. Those in Category #2 can always claim that “the markets are out to get them” or that they just “have bad luck.” In any event, adopting a convenient excuse is always easier than doing the hard work involved in doing things “just right.”  Of course, that can be said about most things in life, right?

Ultimately, the point of this discussion is simply to remind you to stop every once in awhile and think about which “Category” you reside in. Now let’s look at some unique approaches to the markets that most people never or rarely ever consider.

Strategy #1: Buying Ten-Day Lows

This method was first introduced to me (and to a lot of other people) by Tom Gentile, co-founder of Optionetics. This is a short-term trading method designed to take advantage of dips in price for a security presently in an uptrend. The rules here are somewhat different than the original rules. The rules we will use here are:

1. The ticker VTI (Vanguard Total Stock Market ETF) closes above its 200-day moving average.
2. The 10-day moving average for ticker VTI (Vanguard Total Stock Market ETF) closes above the 30-day moving for VTI.
3. The security we want to trade is trading above its 200-day moving average.
4. The low today is the lowest low in the last 10 trading days (including today).
5. Buy at tomorrow’s open.
6. Wait for the security to close above its 10-day moving average.
7. Sell at the next open.

Steps 1 and 2 are designed to constitute a filter to indicate when the overall trend of the stock market is in fact bullish. Regarding the entries and exits, most “regular” people are not sitting at their quote screens near the close of trading and are thus unable to trade “market on close.”  So for this method the trade is simply done at the following open. In some cases this will result in better fills at other times worse (definitely an area for a bit more research for someone considering employing this method).

Figure 1 displays two tickers. On the top is VTI. You can see the periods when it traded above its 200-day moving average and when the 10-day moving average is above the 30-day moving average. Those are the only time we want to consider long trades.

In the bottom clip is the ticker EWZ (iShares Brazil). You can see three trades that were signaled (and one that was ignored at the time because the 10-day moving average for VTI was below the 30-day moving average). Trades #1, 2 and 3 gained +0.4%, +5.3% and +8.2%, respectively.

 

Figure 1 – VTI as filter (top clip) and Trading Signals on EWZ (bottom clip)

Utilizing this method requires a bit of focus and dedication and a bit of “pre-trading” thought regarding capital allocation – i.e., how many symbols to follow, which ones, and how much capital to commit to each trade.

Strategy #2: The Double Out-of-the-Money Butterfly

In the past several weeks I have been attempting to highlight the fact that via the use of options there are many possible ways to make money that are not available to the trader or investor who only trades the underlying stock or futures contract. Here is another example that even most active option traders have never considered. Here are the steps:

1. Six weeks prior to option expiration, calculate a one standard deviation move for SPY. This can be done usng the Probability Calculator in Optionetics Platinum software (we will use SPY in this example, but a trader might consider any actively traded stock index such as DIA, DJX, NDX, QQQQ, SPX or RUT).  
2. Establish an out-of-the-money call butterfly as follows:
   • Buy the at-the-money call option (may be slightly in or slightly out of the money)
   • Sell two calls at the strike price closest to one standard deviation higher.
   • Subtract the strike price of call #2 from the strike price of call #1, add that value to the strike price of option #2 and buy one call at that strike price (huh? The example shown below should help clear this up).

At the same time:

• Buy the at-the-money put option (may be slightly in or slightly out of the money)

·        Sell two puts at the strike price closest to one standard deviation lower.

·        Subtract the strike price of call #1 from the strike price of call #2, subtract that value from the strike price of option #2 and buy one put at that strike price.

After the position is established, take a profit if the open profit reaches 20% or more of the maximum risk. (There is nothing magic about 20% – the point really is to look for an opportunity to take a reasonable profit along the way rather than waiting around for expiration. So if you find yourself with an 18% profit and expiration is 10 days or less away, you might consider taking the money and running.) If the open loss on a trade reaches 30% of maximum risk, consider cutting your loss or adjusting the trade.

An example is clearly in order. Let’s look at October options on September 4th (i.e., six weeks prior to October option expiration). As you can see from the Probability Calculator from Platinum in Figure 2, the one standard deviation values as of 9/4/09 – looking ahead to 10/16/09 - are 109.80 and 94.70. As a result we will establish the position shown in Figure 3.

 

Figure 2 – Probability Calculator from Optionetics Platinum


 

Figure 3 – Double OTM Butterfly using options on SPY

To make a long story short, we bought the at the money call (102), sold two calls at a strike price eight points higher (110) and bought one more call another eight point higher (118). Then we did the same using puts and working to the downside, i.e., buying one 102, selling two 94s and buying one 86. Trading a one-lot and simply buying “at the market,” i.e., buying at the ask and selling at the bid for each option, this trade costs $394 to enter (this represents the maximum risk on the trade). As a result, our profit target on a 1-lot is $78 ($394 x 0.2). In other words, if we get an open profit of $78 or more prior to expiration, we will close the entire trade and take the profit.

This trade took a while to work out, but finally by October 9 – as you can see in Figure 4 – our profit target was exceeded, generating a 29% profit in 35 days.

 

Figure 4 – SPY moves up into profit zone

This is clearly not a strategy for people who do not have at least a minimum understanding regarding options. Also, the risk curves should be examined carefully before a trade is entered to make sure that there is some potential for profit prior to expiration. In other words, there may be times when it is better not to take the trade (is this fun, or what?!). Still, in reality, while it seems cumbersome and confusing at first, the truth is that the trade to make can be determined and entered on line in a matter of minutes. Then it is simply a matter of reviewing the trade’s status once a day.

Strategy #3: The Covered Call (without the Stock)

Most individuals who know anything about option trading are familiar with the strategy known as the “covered call." The classic example is this: a trade buys 100 shares of some stock and then writes a call option against that stock position. If the price of the stock exceeds the strike price of the option at option expiration then the stock gets called away and the trader makes a profit equal to (strike price + original option price minus price paid to buy stock). If the price of the stock is below the option strike price then the option expires worthless and the trader keeps the premium and continues to hold the stock.

Interestingly very few traders are aware that it is possible to enter a high probability “covered call” position without actually buying the underlying stock. Here’s how (the following steps utilize a variety of routines available in Optionetics Platinum software): 

1. Five or six weeks prior to option expiration, run List Tools | Stock List Filter. Select “1% Highly Liquid Options” and click Run. Save the results to “My Stock List.”
2. Select Channels, then Channel Finder. Highlight “My Stock List," then select “Best Sideways Channel” and click Run.
3. Scroll down the list of stocks and find all those with a Center Line Slope of 0.0, 0.1 or -0.1. Save that many stocks to “My Stock List” (essentially overwriting the original list). We now have a list of non-trending stocks with tight bid/ask option spreads.
4. From the Main Menu, select List Tools, then Covered Call. Highlight “My Stock List," then under Covered Call Search Wizard Settings, click on “Covered with Call using ROR at Close."
5. Set “Days To Option Expiration of Short Call Option” to a minimum of 21 days.
6. Under Ranking Criteria select “Rate of Return at Stock Close," and under “Use Natural Bid/Ask or Mid Quotes=(Bid+Ask)/2," select “Natural."
7. Click “Run”

See example settings in Figure 5 below.

 

Figure 5 – Covered Call Settings

8. Once you get the list of trades click the heading “Probability of Profit”
9. Find the first trade with more days to “Earnings” than “Days to Expire.” The first trade listed in Figure 6 involves options on GILD – specifically buying the January 40 strike price and selling the October 45 strike price. The option sold expires in 42 days and earnings are in 46 days, so this trade qualifies.
   

Figure 6 – Covered Call trades 

The risk curves for this trade appear in Figure 7.

 

Figure 7 – Risk Curves for GILD covered call

This trade will show a profit as long as GILD is above the breakeven price of 44.15 at October option expiration (although this could change if the implied volatility for the long January option rises are falls significantly).

With just a few days left until October expiration, the outcome of this trade is still in doubt. As you can see in Figure 8, the stock is presently in the profit zone, but has only a little over a point of downside protection. Some might consider taking a profit right now. Still, a slight rise in price from the present level could almost double the current profit. Clearly, this is where a well thought out plan calculated in advance for determining when to cut a loss, take a profit or adjust a trade is most important.

 

Figure 8 – GILD trade with 3 days to expiration

This strategy is clearly not about “hitting home runs.” Rather it is one of those “grind it out and make a few bucks each month” type of strategies. As such it will appeal great to some traders and not at all to others. Here is another case of having to stop and think about whether or not this is a strategy that you can and are willing to pursue.

SUMMARY

Ironically, adopting the posture of “comfortably numb” is in fact one of the choices when it comes to investing. Still, it is hardly recommended. If you want your money to grow it is pretty much required that you:

1. Give it some thought now and again, and;
2. Not change course every time the wind changes direction slightly.

It also doesn’t hurt to look at the markets in ways that most people don’t and to consider strategies that the masses avoid.

Think about it.

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site 

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

NOTES: Please look for the interview with Jay Kaeppel in the upcoming November 2009 issue of Technical Analysis of Stocks and Commodities magazine.

To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.

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