Jan

8

Is the Market Always In Your Face?

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“Favored stocks usually underperform and the out-of- favor stocks out- perform the market.”
 
They don’t know squat. Their recommendations are bogus and history proves it-market analysts have a lousy record. In his book, Contrarian Investment Strategies: The Next Generation, David Dreman drags the Wall Street analysts through the mud as he discloses why being a contrarian makes a lot of sense. John Bogle, chairman of the Vanguard Group, trumpets the study that showed that 90% of fund managers underperformed the market in every 10 year period since records began in the 1960s. As further testament to the “false gurus”, all the “smart money” was out of the market in ´87 but the “dumb money” stayed in and reaped the benefits when the market came roaring back.
 
Contrarians postulate that analyst recommendations help set up the overconfidence and emotion that makes it possible to make investments that take advantage of the positive affects of surprise. The basic premise is that the favored stocks usually underperform and the out-of- favor stocks out- perform the market. As a matter of fact, if a contrarian investor sees that 70% of Wall Street experts are bullish-a contrarian investor knows the market is topping out. Conversely, if the experts are 70% bearish, it’s a good time to invest. For those familiar with the technical tool-Relative Strength Index (RSI) – it does basically the same thing in that a buy signal is given when a stock is over-sold and a sell signal is generated when a stock is over- bought.
 
A contrarian investor looks for stocks that are solid but out-of-favor. Being solid can be defined as having a low price-to-earnings ratio, a favorable price-to-cash flow and a favorable price to book value. As option investors look closely at the underlying stock, contrarian fundamental investment strategies can be a very valid strategy.
 
Dreman goes on to list a series of 21 rules and 3 strategies for a contrarian investor to apply to their investing system. The three strategies are:
  1. Look for stocks with a lower than industry price to earnings ratio.
  2. Look for stocks with a lower than industry price to cash flow
  3. Look for stocks with a lower than industry price to book value.
He also recommends that an investor in a contrarian stock should exit when any of the above criteria move back into the normal range.
 
Bottom line, contrarian investing is dedicated to using the consensus opinion of analysts and gurus as a contrarian indicator. Favored stocks and investments are to be avoided. A guru bullish fever is a signal to sell stocks and investments. Excessive Guru bearishness is a time to buy stocks and options. Additionally, according to Dreman, investors should look for “value stocks” which are for some reason off the radar or out of favor. These stocks have the powerful element of surprise which can have an explosive impact on price movement and is a powerful attraction for the mob chasing alpha.
 
As a stock option trader or stock investor, a contrarian point of view can form part of an effective investing strategy. However, a trader must be aware that a stock option with a thin market is something to be concerned about. 

Jan

7

Entrails After the Fact: Even a losing trade can be “money well spent”.

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It was the scene of a crime. There was no blood, but the damage had been done. I had repeated the same error I had done on several past option trades. Like a crime scene investigator, I put back the pieces of what had happened. The “vic”-me-had been overcome by the fear of being wrong but it wouldn’t happen again.
 
“Live and learn”-if your smart enough. Unfortunately most would-be option traders learn mainly after getting hit over the head or slapped in the face; a reduced investing account balance and bruised ego act as a surrogate for a bloody nose and a knee in the groin. For an ill-prepared option trader, lessons can be costly and limited to just a few. Usually the last lesson is when you understand that you are over your head and don’t know what your doing. You put your tail between your legs and head back toward mutual funds and conservative buy-and- hold stocks.
 
Here’s your first lesson about stock options: get educated about stock options before you trade options. Sounds obvious, but only about 10% of stock option traders have taken professionally prepared courses on the subject. An industry cliché is that about 80% of all options expire worthless. Other cliché statements tout that only about 10% of option traders are successful. Is there a correlation here?
 
Learning never stops. Once you understand the theory, your practical trading experience will be a life-long mentor-if you document and analyze each trade. An excellent tool to help keep your eye on the ball and continuously improving is the trading journal.
 
Once a trade has been completed, not only do you analyze the technical aspects of a trade but also your state of mine. What were you thinking? How would you do it differently next time? Make your experience count. But just merely writing it down doesn’t count if you don’t take the time to analyze it.
Trade comments:
date of trade
symbol
# contracts
open price
total $
close price
total $
fees
net profit/loss$
%
 
 
 
 
 
 
 
 
 
 
 

When you take the time to write things out and analyze after each option trade has been closed out, you’ll constantly improve and even a losing trade can be “money well spent”. The act of writing forces you to concentrate on what you are writing. Just thinking is not as effective. In the trade comments, make note of the things that happened and what to do next time you encounter the same or similar trade opportunities. By doing some introspective self-analysis of what you were thinking and feeling at the time, option traders will see how important it is to stay balanced, disciplined and detached. This self –analysis is very important for a trader and don’t skip this step.
On weekends and non-trading days, review your journal and look for patterns in your trading that may be causing losses or successes. Once patterns are identified, you’re really climbing the learning curve.

Most traders evolve and as they do, so does their system. Constant analysis should be a very important part of a traders discipline and the Trader’s Journal should be an integral part of your trading system.

Jan

6

Questions to Ask Yourself as an Options Trader

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“By constantly being introspective and honest, a trader learns how to not only deal with trading but also themselves.”
 
Why are you trading? Is it to get free from your hum-drum job? Is it because you hate office structure? Is it an escape from the reality you’ve created for yourself?
 
Recently, we’ve talked about proper mental preparation for trading options. And we briefly talked about the importance of having a trading plan. Jody Samuels- options and currency trading mentor and owner of Fx Traders Edge™ (www.tradersedge.com)- spends a lot of time with her students helping them develop a trading plan. She feels it’s an absolute necessity for any trader, be it options or other financial trading or investing. The first section in her trader’s planning session is defining what motivates a trader. To do so, she asks a series of questions that must be answered with utmost sincerity. The following represents the type of questions she asks in this one section of her eleven-section plan.
 
·         Why are you trading?
·         What are your trading goals?
·         What do you see as your greatest strengths as a trader?
·         What are your weaknesses as a trader?
·         What strengths do you have as a trader that can be improved and
           how would you improve them?
·         What can you do to improve your trading weaknesses?
·         What do you see as the greatest threat to you being
           a successful trader?
·         How does your trading fit into your personal life?
·         How much time each day can you commit to trading?
·         What are your personal goals for the next 18 months?
·         Where do you want to be in your personal life?
·         Is trading stressful for you?
·         How do you deal with stress?
·         What do you do when you’re burned out from trading?
·         How do you keep a positive attitude when experiencing
           a string of losing trades?
·         Do you have a daily routine for keeping physically and
           emotionally fit?
 
The above questions are just a small part of the trading plan that Jody develops with each one of her students. She and other successful and experienced investment traders understand the critical nature of clarity and truthfulness when trading. If you let your ego keep you away from the truth, it will manifest itself in your trading returns-or lack there of. 
 
Traders need to realize that trading performance is not a measure of how good a trader they are but of how viable their trading system is. That’s why it’s so important to trade mechanically and without emotion. Follow the rules of your trading system and track every trade-particularly the losing trades.
 
A trader needs to constantly be asking questions not only of a technical nature but also introspective questions. “Why did I move my stops? Was it because of my ego telling me that I couldn’t possibly be wrong? Why did I trade that day when I knew I wasn’t feeling very well? When I look at a successful trade, do I feel proud for myself or my system?” The battle with ourselves never stops because traders are human and that may be the biggest obstacle to becoming a successful trader. Keeping emotions and ego away from the trading system is usually the difference between success and failure as a trader. By constantly being introspective and honest, a trader learns how to not only deal with trading but also themselves.

Jan

5

Are You A Stock Option Dabbler?

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“Option trading hobbyists have the longevity of a fruit fly.”
 
“ So, you’re a stock option trader?” she asked. “ Not really, I just dabble a little bit”. “ Then here, just open your wallet and give me your money”, she smiled. It might be more productive than being a dabbler”, she laughed coquettishly.
 
That might be the only luck you’d have being a stock option “dabbler”. If you are a private pilot would you “dabble” when you climb into the cockpit? If so, don’t invite me to go sightseeing with you. No, if you don’t take option trading seriously-no matter how often you trade-you’re probably a masochist looking for someplace to hurt yourself financially. It’s not that trading options is dangerous and ultra risky, it’s just that trading options requires some education beyond a newspaper column or enticing stories of financial conquest. It takes some effort and understanding to trade options and option-trading hobbyists have the longevity of a fruit fly.
 
To learn how to successfully trade stock options requires some time and dedication to the learning process. Options aren’t that difficult to learn, but the subject is a cut above investing in mutual funds or invest and hold strategies. Stock option trading is not for the hobbyist. If you’re an option trading masochist, go see a Hollywood movie or read the Britney Spears autobiography.
 
Stock options are pretty amazing investment tools and offer tremendous flexibility for option traders. But they don’t earn their potential rewards by being easy to understand. If you want to trade options, you need to be serious about them. It takes a business-like attitude to trade stock options.
 
First and foremost, the subject of stock options needs to be studied. Nowadays, with the tremendous advantages of online learning, anybody anywhere can learn about stock options and how to trade them. Would you start a business and invest your money without learning about the business? Of course not.
 
Once you have learned about the basics of trading stock options, it’s time to assess if option strategies will help meet your investment goals. That suggests some sort of investing plan. Have you made an investment plan? Most
people don’t and this is the first sign of hobbyism and its resulting disappointments.
 
What is an investment plan? Consider it like a business plan. First, you decide what your goals are and then how to reach those goals. After that, the devil is in the details. Extensive study has shown that doing a business plan first goes a long way to assuring success. Without a road map, you not only can get lost but you also don’t even know where you’re going.
 
In an investment plan, a trader not only defines goals and ways to measure progress toward those goals, but also operational strategies and procedures  to select the proper option trade, what profit margins to expect, stop-loss parameters and how to exit a trade. Almost as important is the rules for money management and what to do if the option trading system is not producing the results expected.
 
Needless to say, doing an investment plan is a subject in itself. The point is, if you aren’t willing to spend the time to approach options trading with a more than casual level of commitment, your chances of having a positive experience will be nil; only momentary thrills as you toss the dice and cross your fingers. Option traders are not gamblers, they define high probability trades and execute them where they find them. Option traders don’t do things without weighing the odds, and a real option trader would never be a hobbyist. Likewise, a hobbyist will never be a trader.

Jan

4

An Option Trader’s Mind

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“Success is more a matter of proper mental preparation
 than having a good trading system”.
 
Norman Hallett knows. For over twenty years, he was a trader and grew to understand the importance of having the proper trading mentality. As a matter of fact, he realized that proper mind-set is so important for traders that he started up www.directyourmind.com. On his website and course offerings, he teaches traders of all ilk how to “put on a proper trading head”.
 
Some of the pearls of wisdom he promotes are:
 
·         Successful option traders set goals. Trading and investment goals should be specific, realistic, measurable and attainable. Moreover, trading and investment goals should be tracked and evaluated on a regular basis.
 
·         Successful option traders specialize. It’s better for an option trader to know a few things well than to know a little about a lot. Becoming an “expert” on a few companies, commodities or other investment vehicles really helps a trader understand the small innuendos that can help make the difference between a winning or losing option trade. Many option traders develop several trading systems specific to the stock, option, commodity, etc. For the novice option trader, it’s a splendid idea to focus on just a few types of investment products and strategies and learn everything possible about them.
 
·         Successful option traders take losses in stride: Norman is right when he says that nobody likes to lose but option traders need to under-stand that losing is part of winning. If an option trader is disciplined and pulls the trigger when the system calls for it, the trader will be trading with the head and not the heart. Traders understand it’s a game of probabilities and money management. Losses will happen.
 
·         Successful option traders are prepared and stay focused: A successful option trader is like a well conditioned athlete. They need to be rested, eat well and be sharp every trading day. Many option traders pick a specific time to do their trading. They pounce when their targets are hit, set up stop-loss instructions and walk out the door. Before placing an option trade, “vision” the way it should unfold and when reality follows the vision, be ready to act. Come prepared and have your strategy clearly defined before it happens..
 
·         Successful option traders stay detached: An option trader needs to be totally objective and keep emotions out of trading. That’s the purpose of having a clearly defined option trading process. Establish a system and implement it the same way- every trade. No exceptions.
 
·         Successful option traders are independent thinkers: Norman warns that following the advice of brokers or “experts” can be a mistake. Experienced option traders learn to trust their system. If the system isn’t working right, they stop trading and fix the system.
 

Too much emphasis is placed on technical information and analysis. Not enough emphasis is given to having the proper mental preparation. In fact, many experienced traders, such as Norman Hallett, strongly believe that success is much more a matter of proper mental preparation than having a good trading system. Option traders and investors need to give this topic serious study; more-over, learning how to stay detached and objective may very well be one of the most important lessons for success in life.

Jan

3

Why Uncle Sam Likes Index Option Spreads

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“Gains made on these trades are taxed under a 60/40 rule”
As an option trader, if you don’t consider taxation on gains, you probably think you won’t have any profits to tax. In which case, you should be thinking twice about trading. But for those of you, who know that you’re the real thing, listen up.
Brad Griffin, a CPA and a fixture at Index Spread Options Trader (www. indexoptionstrader.com) talked about options, taxation and the unique status held by index option spreads. First of all, Brad explains that short-term gains from most types of stock and option investing are taxed as ordinary income. If you are in the 31% income bracket, you will pay 31% of your profits as short term gains. If you have a great short term trade, you pay 31% of the profits to the Uncle. If you have a losing trade, Uncle feels bad, but you’re on your own, baby. Nice partnership. Uncle rewards a trader’s patience because if a position is help for more than 12 months, it is considered as long-term and any gains on stock and option investments are normally taxed at 15%. Moreover, if your tax bracket is below 25% then long term gains are taxed only 5%. Uncle is a compassionate fellow but probably wants to know why you have enough money to invest at that tax bracket.
Mr. Griffin goes on to explain that there is some good news because the gains from stock index options trades are taxed differently than gains on individual stock options and stocks. According to Brad, gains on stock index spread trades are considered ITC Section 1256 contracts. This means any gains made on these trades are taxed under a 60/40 rule: gains are treated as 60% long-term capital gain income and 40% short-term capital gain income (ordinary income) regardless of how long the investment was held. At the end of his article, Brad reminds us to not trust what he says as the truth so do your own due diligence. Always good advice.
So what is an index spread option?
As you may know, there are many types of spreads, but the classic definition is: The purchase of one option and the simultaneous sale of a related option, but with different strike prices and/or expiration dates. Index options are traded just like other options with the exception of more favorable taxation. An index is a number which tracks a specific market. For example, some of the markets tracked by an index are:
  • NASDQ 100 Index (qqqq)
  • NASDAQ (NDX)
  • Dax Industrial Index (DJX)
  • Dow Jones 30 Index
  • S&P 500 Index (SPX)
An example of buying an SPX spread would be the following.

You think that the price of the SPX will rise within a certain time period. You would purchase an SPX call with a certain strike price and expiration month and simultaneously sell an SPX call for the same expiration date but with a different strike price. By selling (writing) a call, we receive a premium which helps reduce the overall cost of the position versus buying just a straight call. Thus, the spread puts less money at risk when assuming a long position. The same concept works for puts when the market is forecast to go down.

Jan

2

Trading LEAP Options

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A LEAP might just be the thing you’re looking for. It’s a normal option on Viagra-it lasts a lot longer. Most people think of options as a speculative tool to be used for short term, repetitive trading. But options are much more. Most don’t think of options as a long term investing strategy. But a LEAP (Long-term Equity Anticipation) takes the flexibility of options into the realm of longer investing and not just short term trading,
 
A LEAP is an option to exercise the rights of the underlying stock within a certain period- if in-the-money. For a LEAP option, the expiration period can be from one to as much as two and a half years. This gives an investor or trader a method to allow more time for a stock to perform as expected but without having to pay the full stock price of owning the stock. For example, to own 100 shares of a stock priced at $50 would cost $5,000. To own a two year LEAP option contract on the same stock could cost about $1,000; thus, freeing up more investment capital for other uses yet keeping a position in the underlying stock. No matter what the cost of a LEAP option, it will be significantly cheaper than owning the stock outright. Not only that, you can roll a LEAP option forward for an even longer period.
 
An important consideration when buying LEAP options is the breakeven price. To figure this important price, you need to add the LEAP option premium plus any other transaction costs to the strike price. For instance, if the LEAP option cost $3 per share (a contract is for 100 shares) the stock price would have to rise to the strike price plus the $3. If the strike price were $40, then the break-even price would be $43.
 
As with all options, the total risk is the premium paid. If you own the underlying stock, the risk can be the total amount of stock owned. For example, if the stock costs $50 and you have 100 shares, your risk exposure is $5,000. If the option premium for the same stock is $2 per share, your total risk is the $200 premium paid.
 
Returns on LEAPS are much higher than owning the underlying stock.
For example, if 100 shares of a $50 stock appreciate to $60, you will have a gain of $1000 on your investment of $5,000 for a return on investment of 20%. If you had one option contract and it went from the initial premium of $2 to $4 you would have a gain of $200 for the contract. This is a return of 100% on the original premium investment of $2.
 
Options also can be sold (closed out) if they don’t behave as desired. It’s always advisable to use a mental stop-loss just as in all other trades.
 

The key benefits of investing in LEAPS over buying the underlying stock is that the risk are lower, the cost of the investment is much less and the return on investment is much larger.

Jan

1

Rolling out of an OTM Covered Call

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Did you know that you can effectively bypass stock option expiration? Well, maybe that’s a little over the top….but not far. Consider one of the most conservative option strategies: the covered call. It is a strategy that makes money on low volatility. The owner of the underlying stock writes (sells) a call option on the underlying stock. Typically, the option writer writes an out-of the-money call and is hoping that the option will expire worthless and the premium paid for the option can be kept by the writer. This option strategy can be done many times over and over again with the same stock; as long as the call doesn’t go in-the-money and gets called away; it’s like getting high stock dividends on a super regular basis. A refinement on this option strategy is to save transaction costs of constantly writing new calls. It’s called “rolling out” of an OTM convered call.
Let’s say that you have written a covered call option with a stock strike price of $42 on XYZ company with a current stock price of $40. The call option you have written expires in one month. Because of the time decay value of the option premium, the option value is streaking towards zero. You’re happy and you want to write another call option as this one expires. To save transaction costs on writing a new option contract, you decide to “roll out”.
You have several choices:
1). If the stock has remained fairly flat, you can write the new call option for the same $42 strike price to expire at the end of the next month.
2) If the stock price has declined during the existing option call period, you could write a new call option with a lower strike price and try to collect a higher premium for an OTM strike price that is close to being at-the-money (ATM). However, if the underlying stock appears to be continuing in a southerly direction, you might consider getting out of the stock altogether and find another underlying stock. (Most covered call writers look for a stock which is slightly bullish with average to low volatility.)

3) If the stock has moved up closer to the strike price or is at the strike price, you will have made a slight profit on the underlying stock ($2) as well as the option premium collected for writing the call option; however, you don’t want the stock to get called away if it goes into-the-money. In this case, you could buy back the $42 call option and write a new call option for a higher strike price. Or, you could let the stock get called away and you would keep not only the option premium for writing the call but also the appreciation on the underlying stock.

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