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Profit Forecasting Code Table of Contents

Quick Start Guide ................................................................................................................... Page 1

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Chapter 1: Introduction to Trading ......................................................................................... Page 5 Chapter 2: Psychology of Trading.......................................................................................... Page 9

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Chapter 3: Money Management ........................................................................................... Page 13

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Chapter 4: Technical Indicators............................................................................................ Page 23 Chapter 5: Stock Trading...................................................................................................... Page 65

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Chapter 6: Options As a Trading Instrument........................................................................ Page 69 Chapter 7: Buying Calls & Puts............................................................................................ Page 81

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Chapter 8: Hedged Stock Trades .......................................................................................... Page 93

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Glossary of Terms............................................................................................................... Page 111


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Quick Start Guide Getting Started

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This Quick Start Guide is designed to help you get set up with the tools you will need, so you can start making money in your first 30 days. While everything listed is not necessary for you to become a successful trader, it can help you make thousands of dollars in profits in a few short weeks and also help you avoid many pitfalls that can cost beginning traders a lot of money.

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It is strongly recommended that you have a reliable computer with a reasonably fast Internet connection. DSL or high-speed cable is preferable, but a 56K modem connection would be sufficient.

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The first step is to set up a brokerage account. In order to place buy and sell orders, one must have a brokerage account. There are several types of brokerage accounts. We give a brief explanation of each account type, but recommend an online or direct access broker.

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Types of Brokers

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Full Service

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Full service brokers typically provide specific investment advice and can sometimes give you access to quotes and news that aren't available for free on the Internet. Because they are providing premium services, their commission costs will be higher. While there are some fullservice brokers who know what they are doing when it comes to trading/investing, the majority don’t. In addition, they make money regardless of whether or not you do. The reason you invested into this program was to learn to take control of your own investing/trading, so a full service broker is not recommended.

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Online Broker

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An online broker does not give specific investment advice - he is there to execute trades. His commission costs will be much cheaper because he is not providing additional services. For most traders, an online broker is sufficient unless you can be at a computer most of the trading day, in which case you may want to consider a direct access broker.

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Direct Access Broker

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A direct access broker allows you to trade directly with different market makers. This enables you to get much quicker trade executions at better prices. If you are able to be at a computer throughout most of the trading day, it is strongly recommended to use a direct access broker.

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Types of Accounts

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Once you have decided on a broker, you will need to set up an account. There are several different types of accounts. The type you will be approved for will depend on the amount of capital you are starting with and your trading experience. If you are new to trading and starting with $5,000 or less, then you will probably only be approved for a cash account. If you have $10,000 or more and have some trading experience, then you will likely be approved for a margin account.

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In order to short stock and enter spread trades, you will need a margin account. If you aren’t approved for a margin account you can still trade, but you will be limited on the types of strategies you can use. One word of advice - if you let the broker know you are receiving a structured education on stock, option, and spread trading, then they will often be more lenient when it comes to approving you for a margin account.

Cash Account

Margin Account

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A cash account only allows you to purchase stock.

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A margin account gives you 2-to-1 buying power. In other words, if you have $50,000 in your account, then your broker will match your $50,000 and allow you to trade with as much as $100,000. You will be charged interest on the borrowed money - usually around 7% to 8% per annum. It is necessary to have a margin account in order to utilize all the strategies taught in this course. For example, you can't short a stock or enter a spread unless you have a margin account. Option Account

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An option account allows you to trade equities as well as options. Being able to trade options is necessary if you wish to trade all the strategies taught in the course.

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Pattern Day Trading Account

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A pattern day trading account gives you as much as 4-to-1 buying power for intra-day trades. This type of account is not necessary unless you are day trading. We don’t recommend day trading unless you are a very experienced trader.

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Charting Software

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In order to determine possible trade setups, you will need to be able to analyze a stock chart and plot several different technical indicators on the chart. There are many technical analysis software packages on the market. Some are free and others charge as much as $6,000. Whether the software is free or not, it will require a subscription to a data vendor to provide the market data that the software plots. There are two types of data: real-time and delayed. A realtime data subscription is more expensive than a delayed data subscription.

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The amount of time you can devote to trading will be the biggest factor in determining whether a real-time or delayed subscription is best for you. If you are able to monitor the markets regularly throughout the trading day, a real-time subscription can be very advantageous because it can help you perfect your entries into the trades, thus allowing you to make/save thousands of dollars over the course of a trading year. If you are unable to watch the market throughout the day and are placing most of your trades in the morning/pre-market, then a delayed subscription would probably be better.

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If you would like to start with a free program, there are several on the Internet. However, none of them offer Fibonacci Analysis on their free versions. Free Internet-based technical analysis software.

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http://www.bigcharts.com http://www.clearstation.com http://www.stockcharts.com

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A Newsletter Subscription Subscribing to a good newsletter can be one of your best trading tools. The newsletter you choose should cater to the type of trading you want to do and have a good track record. If a newsletter doesn't post a performance record, it is usually because it isn't very good and should be avoided.

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If you are a full-time trader, maybe you have the time to devote to finding good trade setups. However, most people get into trading because they want to have more free time, not add another 20 hour work load to their already busy schedule. Subscribing to a good newsletter can be a tremendous help in finding good trade setups and saving countless hours of research, whether you are a full-time trader or not.

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If you are new to trading and are just learning how to analyze a stock to find good trade setups, we strongly recommend subscribing to a newsletter. The amount of money you will make and the money you will save in mistakes that many beginning traders make will more than pay for the subscription charge.

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A good newsletter subscription can cost between $99 and $399 per month. We offer a newsletter the includes specific stock and option picks along with market timing updates on most major markets including commodities.

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For additional information please contact Virtual Investing Club toll free at 888-618-7868 www.virtualinvestingclub.com

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Introduction to Trading

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Chapter 1

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Our goal at Virtual Investing Club to educate and empower the individual investor so he can become a responsible trader/investor and consistently take above-average profits out of the market. To do this, we have developed what we believe is the best educational trading product on the market. We have attempted to present the information in the most logical and easy-tounderstand format, and have included an extensive glossary of terms at the back of the course to assist you in understanding much of the trading and investment terminology. We encourage you to take the time to study the materials and learn how to successfully apply the strategies and concepts taught herein. The financial rewards for doing so will be substantial.

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Many would-be traders and investors are often scared away by the perceived risks, complexity, and overwhelming amount of information available on the subject of trading and investing. There are risks involved in trading and investing, however, they can be controlled and reduced through proper education and money management. While there is a vast amount of information available on the subject of trading, one could never, in a lifetime, understand and comprehend all of the investment and trading ideas and methods that make up the investing universe. Nor would one want to, as many trading philosophies and systems of trading often contradict one another.

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In this course you will be presented with many highly specific trading strategies and methods that are proven effective, as well as several technical indicators which we feel are the most beneficial for studying and analyzing the short to intermediate trends of a stock.

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However, the first thing you will learn is proper money management, trade management, and the importance of developing a trading system around a positive mathematical outcome. A trader may do okay for a while trading by the seat of his pants, but if proper money and trade management aren’t present, in the end he will wipe out his entire trading account.

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We understand that money management is not the most exciting part of trading, but it is primary and most important, whereas trading methodology is secondary. So don’t brush over the concepts of good money management and risk-to-reward ratio. They are more vital to your trading success than any technical indicator or trading strategy.

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Trading vs. Investing Many of you have probably had money invested in stocks either through an IRA, 401K or other retirement vehicle. A good majority of you may have even had, or still have, an individual portfolio where you have been actively involved in selecting your own stock candidates. Most of the stocks held in these accounts would fall into the category of investments.

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An investment is usually a longer term endeavor, in which one attempts to buy what he feels is a good solid company that is currently earning a substantial amount of money, or shows a great deal of promise in earning a substantial amount of money in the near future.

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Typically, an investor plans on holding a company for a minimum of six months and upwards of three to five years or longer. If the company does well, the share price should increase, allowing the investor to realize a profit. While investing has had its time and place, the last three years have not been one of those times. In fact, investing has been very cruel to those who have attempted to do so.

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In the end, it is a company’s earnings that drive the share price higher or lower over the long term. Along the way the stock will experience very significant price swings. The difference between trading and investing is that a trader attempts to profit from these price swings. He is not necessarily concerned with where the company’s earnings will be a year from today. He is only concerned with whether the stock is being overbought or oversold right now. If it is, there may be a trading opportunity which will allow him to earn from 12% to 25% on the money he commits to that trading opportunity.

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Another major benefit to trading over investing is that one can play the market both ways. Usually, an investor is only looking to play the stock from the long side (buy the stock), whereas a trader can also play the market from the short side. Playing the market from the short side allows one to make money while the stock price is falling.

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An investor is mostly concerned about the long term prospects of a company showing strong earnings, and a trader is only concerned with shorter term overbought/oversold readings. The method used for determining a good investment opportunity (which is based primarily on the fundamentals of a company), will not work for determining a good trading opportunity. The study of price and volume is a much more accurate way of identifying good trading opportunities. The study of price and volume is known as technical analysis.

Copyright Š 2007 MHI, LLC., All Rights Reserved

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Reproduction in any form without expressed written consent is prohibited.


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Introduction to Technical Analysis

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The main premise of technical analysis is that the market is forward looking and discounts everything that is known about the company. In technical analysis, a stock chart is simply a visual manifestation of all current and future outlooks for the stock. The astute technical analyst is able to profit handsomely by identify key turning points in the stock price, and then trading with the short to intermediate term trend.

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An example will help illustrate this point. Often, ahead of an earnings announcement, a stock will significantly increase in price. After the earnings release the stock will then sell-off, even if earnings are better than expected. This happens because those market players interested in the future earning prospects of a company will start buying well ahead of the announcement on the rumor that earnings are improving. Once the news is released, the “smart” money starts selling because they have made their profit. There may be one last gasp of buying by the “dumb” money, and now there is no more sideline money to propel the stock higher and so it reverses.

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Summary

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In summary, investors are looking to buy and hold a company for a longer time frame, in hopes that the company will gain a substantial market share within its industry and earn a lot of money. An investor is limited to playing the market from the long side. A trader is looking to profit from shorter term price swings as a stock becomes overbought and oversold. A trader can play the market from both the long and short side.

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Now that the basic concepts of trading and technical analysis are understood, let's look at the two approaches to trading the markets. They are: 1. Mechanical 2. Discretionary

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A mechanical system is one that is back-tested for its efficacy, and then programmed on a computer so that all buy/sell signals are given without any human intervention, except to place the trade. Even then, many trading platforms will automatically execute the trade as well. The advantage of this type of system is that it removes all human emotion from the trade. The disadvantages are that many mechanical systems only work in certain market conditions, or work well for a while and then lose their effectiveness.

Copyright © 2007 MHI, LLC., All Rights Reserved Reproduction in any form without expressed written consent is prohibited.

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The second type of trading system is a discretionary system and (like a mechanical system) should be back-tested for its efficacy before any real trades are made. Once the system has proven profitable one can begin trading. A discretionary system leaves the interpretation and trading decisions up to the individual, giving one added flexibility. However, the decision as to when to buy and sell, where to place trailing stop losses, etc. is left up to the individual. This can often be a very difficult task, because one is left to constantly battle the emotions of fear and greed.

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Both systems have their pros and cons. In the daily newsletter we offer, we attempt to combine the two systems of trading. The primary method of analysis we use cannot be programmed into a computer to automatically generate buy/sell signals. Therefore, we use a discretionary system to find trade set ups, decide on entry and exit targets, and set stop loss points. Once we have decided on the above parameters, we strictly adhere to exiting profitable trades at the predetermined targets and the stop loss point remains the same until we have closed the first half of the trade, at which point we raise the stop loss point to assure a winning trade. Using this type of discipline allows us to bring certain aspects of a mechanical system into our discretionary system, offering us the best of both worlds and dramatically improving our trading results. For more information on the newsletter we offer, go to www.virtualinvestingclub.com or call us toll free at 888-618-7868.

Copyright Š 2007 MHI, LLC., All Rights Reserved

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Reproduction in any form without expressed written consent is prohibited.


Psychology of Trading

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Chapter 2

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While the trading instruments that make up the market have no emotion, the individuals that trade those instruments are human beings and are very emotional by nature. Realizing that the human emotions of fear and greed drive price up and down, allows one to begin to understand how to position himself on the right side of the market. Because humans are very emotional, they often make rash decisions that end up being the wrong decision. W.D. Gann said it best in "How to Make Profits in Commodities" :

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“If you will only study the weakness of human nature and see what fools these mortals be, you will find it easy to make profits by understanding the weakness of human nature and going against the public and doing the opposite of what other people do. In other words, you buy near the bottom on knowledge and sell near the top on knowledge, while other people who just guess do the opposite. Time spent in the study of price, time and past market movements, will give you a rich reward. “

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The statement above by W.D. Gann reveals a very plain truth about human psychology as it applies to trading. Simply stated, smart money buys (or sells shorts) into a trend early on, while dumb money buys (sells short) into the trend just as it is about to end.

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Most traders in the market have been led to believe that “the trend is your friend”, or that they should “trade with the trend”. This is true unless the trend is about to end. The problem with trading with the trend, as most traders have learned it, is that once a trend can be identified on a stock chart so one knows which direction to trade in, the trend is about to end.

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In order to make money from a trend, one needs to identify the Trend Reversal Zone (TRZ) early on so he can position himself with the smart money. This allows him to profit from the entire move. In fact, he will most likely be closing his position with a profit at the point where most of the dumb money decides to get involved. It is upon this idea that we will build a case for buying weakness and selling strength (a system that anticipates trend reversals), rather than a system that is trend following in nature.

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Most trading systems are trend-following in nature. In other words, they attempt to buy strength and sell weakness. The problem with these trading systems is they only give a trading signal in the direction of the trend well after the trend has been in place.

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Many times the signal will come just as the trend is about to reverse, or it will come when the current trend is due for a pull-back. If one is using proper trade management and is adhering to his stop loss points, a reversal will stop him out of the trade at a loss. Even if it is just a pull-back

Copyright © 2007 MHI, LLC., All Rights Reserved Reproduction in any form without expressed written consent is prohibited.

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and the trend then resumes, he will more often than not, also be stopped out of the trade at a loss. The end result is a losing trade. This cycle plays havoc with one’s emotions and a trader often finds himself second-guessing his trading decisions, or chasing trades.

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As we make a case for identifying Trend Reversal Zones (TRZ), it should be understood that while we feel strongly that it is superior to a trend following system, it is not a Holy Grail devoid of pitfalls and losing trades.

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When we say that we attempt to buy weakness and sell strength, we are not randomly buying stocks that are in a free fall and appear to be oversold. Nor are we randomly shorting stocks that have had a significant increase in price and appear to be overbought. There are specific methods we use to determine overbought and oversold levels. We will introduce you to our primary method later in this book.

A Market of Emotions

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Every day there is a war being waged in the market. A war between the bulls (buyers) and the bears (sellers). Bears want to get top dollar for their merchandise, while the bulls want to pay as little as possible. In order for a transaction to be completed, one has to give into the other’s terms. If a greedy bull gives into a seller’s terms because he feels he just has to own the XYZ company, the price goes up. If an eager bear (seller) gives into a buyer’s terms, the price goes down. This is nothing new. It is Economics 101, supply and demand.

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Because both buyers and sellers are, more often than not, basing their buying and selling decisions on emotions, eventually these emotions will reach climactic levels and a trend will reverse. For example, when a stock is in an uptrend, there will be a point when the trend becomes apparent to everyone. At this point there will often be one last buying frenzy as greed takes over, because no one wants to miss a good opportunity. It is precisely at this point that the trend will often reverse.

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The same is true of a downtrend. Before a stock hits bottom, there is usually a capitulation-type selling as fear takes over and the weak hands fold. Once all the weak hands have thrown in the towel, the stock is free to rise.

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A stock doesn’t begin to drop because everyone starts selling. A stock begins to drop because everyone stops buying, at which point the price has to come down to entice more buyers. As the price begins to decline, the selling begins to pick up, forcing the price even lower. It isn’t until all the sellers are flushed out of the market that the selling stops. Now the demand for the stock becomes greater, causing price to rise and attracting even more buyers.

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If you have ever looked at a significant market bottom such as the week of the September 11, 2001 terrorist attacks, you will notice that the supply (selling pressure) increased significantly. Once the supply was exhausted, the price stabilized and traders and investors began to buy the market in droves.

Copyright © 2007 MHI, LLC., All Rights Reserved

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Reprinted permission Metastock by Equis Intl.

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A market top occurs in a very similar fashion. Looking at the chart of the QQQ, on December 5, 2001 you will notice a gap on heavy volume. A gap is a space on the chart between the intraday high of the previous trading day and the intra-day low of the current trading day, where no trading took place. Gaps will be explained in greater detail at a later point. The larger volume bar indicates the gap occurred on heavier volume. The next day the price reversed and started what would become a huge trend reversal. Why did this occur? Because on this day everyone who was going to commit capital to this rally had done so and there was no more money to push the price higher. This is that last ‘gasp’ of buying spoken of earlier.

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Selling pressure didn't immediately pick up as price was declining, and it doesn't have to. Price will fall of its own weight once all the sideline money has been committed. However, as it became more apparent that price was beginning to decline, the selling picked up.

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It is not always the case, but often a top or bottom (in a stock or the market in general) will be accompanied by a negative news event of some kind. This aids in committing the remaining sideline money if the news event is positive, or flushing out the remaining sellers if the news is negative.

Copyright Š 2007 MHI, LLC., All Rights Reserved Reproduction in any form without expressed written consent is prohibited.

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Reprinted permission Metastock by Equis Intl.

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Now some will argue that to go back and look at what occurred at a major market turning point is easy because hindsight is 20/20. This is true. These are mere examples to illustrate the psychology behind what occurs at a market top or bottom. Later we will educate you about several indicators for measuring extreme sentiment, such as fear and greed, or complacency.

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The same principle of trend exhaustion can be applied to any time frame, from weekly all the way down to a 1 minute chart. Understanding trend exhaustion for shorter time frames can help with trade entry techniques.

Copyright Š 2007 MHI, LLC., All Rights Reserved

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Reproduction in any form without expressed written consent is prohibited.


Money Management

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Chapter 3

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Money management is the single most important aspect of trading. The methodology is secondary. This isn’t meant to discredit the importance of having a successful method for finding trading opportunities, but without proper money management even the most successful methodology can lose money. In addition, proper money management can eliminate the stress that can otherwise accompany trading.

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Before we can get into specific guidelines for proper money management, one needs to have a fundamental understanding of the different kinds of orders that can be placed, since they can be critical to good money management.

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Order Types Market Order

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A market order is an order to buy or sell a stock or asset at the best available market price. The only advantage to a market order is it will be filled quickly. We don't recommend using market orders since the price at which the trade will be filled can’t be guaranteed. The only time we would use a market order is if we are trying to get out of a losing trade that is quickly moving against us. Under these circumstances, it would be foolish to place a limit order (see next order type) trying to save a few decimal points, since the stock is moving very quickly in the opposite direction, and a limit order price may never be hit, leaving you stuck in the trade losing even more money.

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Limit Order

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A limit order is an order to buy or sell a stock or asset at a specific price, or at a better price. A limit order guarantees the price at which the order is filled, provided the limit price is hit by the security. The only drawback is that the stock may never hit the price specified by the order and the trade will never be filled. This may cause a trader to miss an occasional trading opportunity. However, the advantages of a limit order far outweigh the disadvantages.

Copyright Š 2007 MHI, LLC., All Rights Reserved Reproduction in any form without expressed written consent is prohibited.

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Stop Order

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A stop order is an order to buy or sell the stock at the market price, once it passes through a specified price. A stop order is generally used to close losing trades. For example, if the XYZ company was purchased at $52 and the exit price for a losing trade is $48, a stop loss order could be placed to close the trade once the stock price hits $48. Once $48 is hit, the order becomes a market order to sell the shares at the best available market price.

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One disadvantage to using a physical stop order is that the market makers see the stop order on the books, and will often synthetically force the price down (or up in a short trade) to trigger the stop order. So as the price gets closer to the physical stop order, the chance of getting stopped out increases.

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We prefer to use mental stops initially. Once the price hits the stop, we then look to get out at the best available market price. If you are unable to watch the market throughout the trading day, we recommend that you use a physical stop order. If you are a subscriber to our newsletter, using physical stop losses is less of a concern. We set up the trades in such a way that the stop loss is at least 5% away from the entry price, giving the trade plenty of room. Physical stops should also be used if you are vacationing or traveling and plan on leaving with open positions.

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Stop Limit Order

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A stop limit order works like a stop order, except that once the price moves through the specified price, the order becomes a limit order to get filled at the previously specified stop price. The disadvantage is that it can only get filled at that exact price. The reason a stop order is used in the first place is to exit the trade if the price suddenly moves against the desired direction. If this occurs and the price moves through the stop limit price and isn't filled, it will not get filled unless the stock trades at that price again. This could cause the trade to lose even more money. We strongly recommend not to use stop limit orders.

Order Restrictions

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An order restriction is a qualifier than can be placed on any type of order, assuring that certain conditions will be met. Good-Till-Canceled (GTC)

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A GTC order remains in effect until it is filled, canceled, or until the last day of the month following the month in which the order was placed. For example, if the GTC restriction is placed on May 10th and it is not filled or canceled, it will automatically cancel on June 30th. GTC orders can be used to both enter and exit trades. We especially like GTC orders to exit winning trades since they can be placed immediately after the trade is entered. We also like GTC orders to

Copyright Š 2007 MHI, LLC., All Rights Reserved

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Reproduction in any form without expressed written consent is prohibited.


enter trades where the stock is still trading some distance from the entry price. This way the order can be placed and the trade can still be filled if the move to the entry price is a quick one.

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Day Order

A day order is a limit order that is good only for the trading day on which it is placed. If the order is not filled by the end of the trading day, it will automatically be canceled and the order must be placed again the following trading day.

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All-or-None

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All-or-none is an order restriction that specifies to fill the order only if all shares specified in the order can be filled at that price. In other words, if an order is placed to buy 500 shares at a specific price and only 400 are available, then the order will not be filled. We don't recommend an all-or-none restriction be placed since we would rather participate in a good trade with some money rather than with no money.

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Fill-or-Kill

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Fill-or-kill is an order restriction to either fill the entire order at the limit price or better, or cancel the order. We don't recommend that a fill-or-kill restriction be used.

Stop Losses

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Now that we have discussed the various types of orders and order restrictions, let’s look at several ways that one can determine a stop loss price. A stop loss is a pre-determined price at which a losing trade will be closed. A stop loss can be mental (you are mentally aware to exit a losing trade once it hits a certain price) or physical (a stop loss order that is place after the trade is entered and sits on the books until it is triggered or canceled). Money Stop

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A money stop is based on a pre-determined amount of money that one is willing to lose on each trade. For example, if the most one was willing to lose on each trade was $200, he would need to figure out the price at which he needed to get out so he didn't lose more than $200. Divide the money stop amount by the number of shares ($200 ÷ 100 shares = 2 points, or $200 ÷ 500 shares = $0.40 cents).

Copyright © 2007 MHI, LLC., All Rights Reserved Reproduction in any form without expressed written consent is prohibited.

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Percent Stop

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A percent stop is set by deciding on what percent one is willing to lose. For example, if 100 shares of XYZ stock are purchased at $50, the total investment would be $5,000. If 5% is the most one is comfortable losing, he would exit the trade once he had lost $250. To figure the exit price, divide the risk amount by the number of shares to arrive at how many points the stock can move until the exit price is triggered, then subtract this figure from the purchase price ($250 á 100 shares = 2.50 points, $50 - 2.50 = $47.50).

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Chart Stop

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A chart stop is set by deciding where on the chart to exit the trade. This could be below the low of a prior day (above in the case of a short position), at a moving average, or prior swing low/high etc.

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Time Stop

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A time stop keeps the trade open for a certain amount of time, after which the trade is closed. A time stop helps manage a trade that really isn't going anywhere so those funds can be freed up for other trading opportunities. A time stop is usually used in conjunction with other types of stops. Setting appropriate stop loss points will be discussed in further detail in a subsequent chapter.

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Asset Allocation

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While options can be used to hedge both long and short stock positions and help manage risk, trading options alone or in a spread is a highly speculative trading instrument since they will eventually expire worthless. Because of the risk associated with options and spreads, it is recommended that no more than 20% of one's total trading capital be committed to this type of trading. The other 80% should be committed to either stock trading, or some of the longer-term strategies such as the married put, covered call, or collar trade. Over committing to highlyleveraged trading instruments can wipe out a good portion of one's trading account if a sizable draw down (several consecutive losing trades) occurs.

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How Much Should Be Risked on Each Trade

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When we refer to how much should be risked on each trade, we are referring to the percent of the total account that would be lost if the trade ends up a loser, not the total amount of equity that will be committed to the trade. There are many different ideas on the maximum allowable risk per trade. Some feel no more than 3%, others say 2%, and some say 1%.

Copyright Š 2007 MHI, LLC., All Rights Reserved

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We prefer to never risk more than 1% of our total trading capital on any given trade. Now there are many who may be starting out with only $5,000 to trade with. Applying this approach would mean you can’t risk more than $50 in an effort to make $150. Because commission costs would eat up a significant portion of the gain on each trade, it would be very hard to grow the account. This is especially true when trading options or spreads.

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So what does one do? There are various choices: 1. Trade only stocks, increasing the amount risked on each trade to 3%, for example. This allows you to risk $150 in order to make $450. Once you have built up your account, you could then reduce the amount risked per trade. 2. Another approach would be to simply risk 20% ($1,000) on each trade, which would mean you could only be in 5 positions at one time. 3. If one is wanting to trade only options or spreads, and has only $5,000 to start (we would never recommend this unless it is play money), we would recommend that only $500 be committed per trade. If the trade has been set up with a 3 to 1 risk-to-reward ratio (this will be discussed next), one could potentially make $1,500 on the winners and only lose $500 on the losers (before commissions).

Setting Up Trades With a Maximum Allowable Risk of 1%

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In order to set up a trade with a maximum allowable risk of 1%, one needs to first know the stop loss point so he can do the calculations for the trade. For example, if a 5% stop loss was being used, and the purchase price was $50, 5% of 50 = 2.50 points. This would put the stop loss at 47.50 points. So, if the stock dropped to $47.50 the trade would be closed. Suppose the account size was $100,000. Never risking more than 1% on any given trade would mean that $1,000 was the maximum amount that could be lost and still fall within the 1%. Take the $1,000 (1% of total capital) and divide it by 2.50 (the number of points of allowable risk): $1,000 ÷ 2.50 yields a figure of 400 shares. This means that 400 shares would be purchased at $50, for a total capital commitment of $20,000. If the stock trades down to $47.50, the trade would be closed and the total loss would be $1,000. Using these guidelines, one can easily figure the number of shares to purchase on any given trade. The same method of calculation would apply to a 2% or 3% maximum allowable risk per trade.

-2

Trading Options or Spreads Under the 1% Maximum Allowable Risk Per Trade

06

The easiest way of setting up an option or spread trade under these guidelines, and the method we prefer, is to never commit more than the 1% to any given trade. This would mean if the account size was $100,000, no more than $1,000 would be committed to any given option or spread trade.

20

This method offers various advantages. The trade acts as its own stop loss point, making the trade much easier to manage from day to day. Because the trade is its own stop loss, it can be

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Page 17


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held all the way through expiration (if needed), reducing extra commission costs on losing trades since there would be no need to close a losing trade. Even though this is our preferred method for trading options and spreads, many will find other approaches more appealing. Regardless of which method is used, one should keep the maximum allowable risk to 1% of the total trading capital unless the money is discretionary play money. Then he may choose to trade more aggressively.

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Risk-to-Reward Ratio

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An equally important money management concept is the risk-to-reward ratio. The risk-to-reward ratio is so important because with the right risk-to-reward ratio one can still make significant amounts of money, even if he is only right about the direction of the stock 40% of the time.

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Our entire approach to trading is built around only being right 40% of the time. If we do better, it’s a bonus. For the record, we are currently right about the direction of the stock 65% to 70% of the time. However, because we only plan on being right 40% of the time, we want to make three times as much on the winners as we lose on the losers. In other words we want a risk-to-reward ratio of 3 to 1.

Co

There are some who, upon reading this, will become discouraged with only being right about the direction of the stock 40% of the time. For those individuals, it is important to understand that there are very few traders who are right about the direction of the stock even 50% of the time. In fact, if you are right 50% of the time you are considered a Wall Street guru. If this is the case, doesn't it make more sense to build a trading approach that earns above-average returns even if you are only right 40% of the time, and if you are right more then you will make even more money?

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The following will help illustrate the importance of a good risk-to-reward ratio. If a trader is only right 40% of the time and has a risk-to-reward ratio of 1 to 1 ( meaning for every $1 he is risking he can only make $1), he will eventually lose all of his trading capital. It doesn't take a math genius to see that he will make $4,000 on the 4 winning trades, and lose $6,000 on the 6 losers, for a net loss of -$2,000. Because this mathematical formula has a negative outcome, it is impossible to make money. If one wants to set up trades with a 1 to 1 risk-to-reward ratio, he will need to be right 60% of the time to make money (6 winners =$6,000, 4 losers =-$4,000, net gain =$2,000).

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If the trade has a 2 to 1 risk-to-reward ratio the outcome will be quite different, even being right only 40% of the time. The trader will make $8,000 on 4 winners and lose $6,000 on 6 losers for a net gain of $2,000. This mathematical formula has a positive outcome and will make money every time.

Copyright Š 2007 MHI, LLC., All Rights Reserved

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Reproduction in any form without expressed written consent is prohibited.


LL C

With a 3 to 1 risk-to-reward ratio, there would be a $12,000 profit on the 4 winners and a -$6,000 loss on the 6 losers, for a net gain of $6,000. If a trader can get good at determining the direction of the stock 50% of the time, and maintains a 3 to 1 risk-to-reward ratio, the results are substantially higher. He would make $15,000 on 5 winning trades and only lose -$5,000 on 5 losing trades for a net gain of $10,000.

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Establishing Trades With a 3 to 1 Risk-to-Reward Ratio

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In summary, everyone has losing trades. A losing trade doesn’t mean you are a failure as a trader. If you look at it this way you will have a very hard time making money because you will want to hold on to your losing trades in an attempt to prove to yourself that you are right. In the end you will lose your entire trading account. If you go into it planning on being wrong more than you are right but have the right risk-to-reward ratio, then the losers won’t bother you (as much) and you will consistently be able to make money.

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Setting up a trade with a 3 to 1 risk-to-reward ratio is not as easy as buying the stock, calculating the stop loss point, and then multiplying the risk by 3 and holding it until it hits that price. This would certainly give the trader a 3 to 1 risk-to-reward ratio. However, unless there is good reason to believe the stock will hit the profit objective, a 3 to 1 risk-to-reward ratio does him no good.

Co

While a 3 to 1 risk-to-reward ratio is critical to your trading success, the reason for making the trade needs to be based on sound technical analysis. In other words, there needs to be a compelling reason for making the trade, and believing it has the potential of hitting the profit objective.

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The first thing that needs to be decided on any trade is the price at which the trade will be entered. This could be based on any number of technical indicators such as a trend line, moving average, oscillator, or Fibonacci retracement level. Once the trader has determined the entry price, he can then decide on the most probable profit target, which should be based on support/resistance levels as well. For example, if a trader had determined that a stock was trading in a range between $43 and $50 with a fair amount of support at $43 and resistance at $50, he might decide to buy the stock the next time it trades down near $43, and plan to hold the stock until it trades back up to $50.

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Once the profit objective has been decided, the trader knows how much he can make if the target is reached. He would take this figure - 7 points in this example - and divide it by 3, to arrive at the risk in points (7 ÷ 3 = 2.33 points). He would then subtract this amount from the entry price, so he would place his stop loss 2.33 points below the entry price of $43 which would give him a stop of $40.67. He now has a trade that offers a 3 to 1 risk-to-reward ratio and has a good chance of getting to $50, since the trade was based on sound technical analysis.

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With the risk defined in terms of points, a trader can now take the maximum allowable risk per trade and divide it by the risk, to determine the number of shares to be traded. In this example, if he only wanted to risk 1% of his capital, and had a $100,000 account, he would take $1,000 (1%) and divide it by 2.33 to arrive at the number of shares to be bought ($1,000 á 2.33 = 429 shares).

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When trading an option or spread, one would follow the same process. For example, if he were looking at the same trade and felt support was at $43 with resistance at $50, he could buy a 45 strike call option for 1.30 giving him nearly a 3 to 1 risk-to-reward ratio, if the stock were trading at $50 by expiration. He may also choose to do a 40-50 bullish vertical spread and buy the 40 strike call for $4.30 and sell the 50 strike call for .70 cents for a net debit of 3.60. This would only give him a risk-to-reward ratio of 1.8 to 1. However, because he is buying a lower strike call and selling a higher strike call to help offset the time value decay, the trade has a higher probability of making money than does the 45 higher strike call option. As we look at each strategy, we will discuss both the advantages and disadvantages. Draw Down

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ig ht

Another very important concept of money management is draw down. Draw down is defined as the number of consecutive losing trades before a winner occurs. If one is only risking 1% of his total trading capital on any given trade, he can have 100 consecutive losing trades before he is out of money. Of course, if the percent is being adjusted to remain at 1% all the way down, he would be able to make more than 100 consecutive losing trades before he was out of money.

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If the amount risked per trade is 2%, then he can only have 50 consecutive losing trades before he is out of the game. Risking 3% per trade would only take 33.33 losing trades before he is done. It should be apparent that risking too high of a percent of your trading capital on each trade could quickly wipe out your trading account and leave you broke. The following chart will help illustrate the importance of keeping the draw downs to a minimum.

10% draw down 15% draw down

11% required to recoup losses

17.6% required to recoup losses 25% required to recoup losses

-2

20% draw down

% required to recoup loss from draw down

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% draw down

33.33% required to recoup losses

30% draw down

42.85% required to recoup losses

40% draw down

66.66% required to recoup losses

50% draw down

100% required to recoup losses

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25% draw down

Copyright Š 2007 MHI, LLC., All Rights Reserved

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Reproduction in any form without expressed written consent is prohibited.


Win Percentag e

Probability of seeing at least X consecutive losing trades within a 50-trade period 2

3

4

5

6

7

8

5%

100.0%

100.0%

100.0%

100.0%

100.0%

100.0 %

100.0 %

10%

100.0%

100.0%

100.0%

100.0%

100.0%

100.0 %

100.0 %

15%

100.0%

100.0%

100.0%

100.0%

100.0%

100.0 %

100.0 %

100.0 %

100.0 %

99.9 %

20%

100.0%

100.0%

100.0%

100.0%

100.0%

100.0 %

100.0 %

99.8 %

99.1 %

97.2 %

25%

100.0%

100.0%

100.0%

100.0%

100.0%

99.8 %

98.9 %

96.2 %

90.7 %

82.2 %

30%

100.0%

100.0%

100.0%

100.0%

99.6%

97.7 %

92.2 %

82.3 %

69.1 %

55.0 %

35%

100.0%

100.0%

100.0%

99.7%

97.1%

89.0 %

75.2 %

58.5 %

42.6 %

29.6 %

40%

100.0%

100.0%

45%

100.0%

100.0%

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Probability of seeing at least X consecutive losing trades within a 50 trade period.

50%

100.0%

99.8%

11

100.0 %

100.0 %

100.0 %

100.0 %

100.0 %

100.0 %

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10

97.6%

88.4%

71.3 %

51.7 %

34.6 %

22.0 %

13.5 %

98.9%

90.7%

71.7%

49.1 %

30.3 %

17.6 %

9.9%

5.4%

95.2%

76.8%

50.8%

29.2 %

15.5 %

7.9%

3.9%

1.9%

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99.9%

100.0%

99.0%

86.0%

57.5%

31.3%

15.2 %

7.0%

3.1%

1.4%

0.6%

100.0%

95.8%

70.4%

37.7%

16.9%

7.0%

2.8%

1.1%

0.4%

0.2%

-2

60%

00 8

55%

9

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As you can see, it is very important to keep the draw downs to a minimum due to the larger percentage gains required to recoup the losses.

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Trading Time Frames

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The final topic we will cover in this Chapter is the different time frames within which one can trade. Scalping

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Scalping is trading for very short-time frames, such as a few seconds to a few minutes. This type of trading is very difficult and is not recommended. Day Trading

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This is trading for a few minutes to a few hours. A true day trader will not hold any trades overnight. Day trading is also very difficult to do, and is not recommended unless one is a very skilled trader and can devote a full-time effort. While we don't recommend day trading, as one gets better at trading he will want to consult intra-day charts to perfect his entry techniques. A $0.05 to $0.10 cent difference on each trade can add up to thousands of dollars over the course of a year.

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Swing Trading

This is holding a position from a few hours to a few days. With the right experience, we would encourage some swing trades, provided the trader has the sufficient time to devote to the market.

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Position Trading

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Position trading is holding a position from 3 days to 2 months. This is the time frame we like to operate in for the majority of our trades. There are various advantages to position trading. 1. Because the trade will be held for a longer time frame in an attempt to profit from a larger move in the stock, a less than perfect entry won’t dramatically affect the trade. 2. Position trading doesn’t require one to be in front of a computer all day long, accommodating the part-time trader. 3. Position trading allows one to keep the trading costs from commissions to a minimum.

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Long-Term Position Trading/Investing

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This has a holding time from 3 to 6 months, or longer for investors. Even though our primary holding time is a maximum of 2 months, there are 3 strategies we teach that perform very well for longer time frames. These strategies can be used in an IRA where one plans on doing less trading and more investing.

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Reproduction in any form without expressed written consent is prohibited.


Technical Indicators

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Introduction

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Chapter 4

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The goal of this Chapter is to teach you how to analyze a stock in order to identify potential trading opportunities. After all, any strategy is only as good as one’s analysis of the stock. For example, if one feels a stock is going to go up and plays a bullish strategy but the stock goes down, then the trade will lose money. If one is playing a bidirectional trade (that can profit either way the stock moves) but the stock stagnates, then the trade will lose money. Therefore, one needs to have an understanding of how to analyze a stock in order to identify the trend of the stock, so he can apply the appropriate strategy.

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After discussing several approaches to identifying trading opportunities, various strategies will be presented that allow one to take advantage of each type of market condition. Because not everyone has the same risk tolerance and trading objectives, we will present several conservative strategies as well as several, more speculative strategies.

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Technical Indicators for Selecting the Right Stock

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The technical indicators presented in this Chapter are used for determining the most probable future direction of a stock. You will learn about several technical indicators that are trendfollowing in nature and several that anticipate trend reversals. We prefer to use those indicators that anticipate trend reversals.

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Even though technical analysis is the primary method we use to predict stock price movement, it’s a good idea to be aware of quarterly earnings announcements, new product releases, changes in management, or any other news item that could be announced during the life of the trade. This does not mean that a trade shouldn’t be entered if there is an upcoming announcement, as most known future events will already be priced into the stock.

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Technical Analysis

Technical analysis is the study of price and volume, primarily through the use of charts, for the purpose of forecasting price trends. Technical analysis is built around three key assumptions:

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1. Market action is forward-looking and discounts everything. 2. Prices move in trends. 3. History repeats itself.

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In order to employ technical analysis as a forecasting tool, one must subscribe to the assumption that the market is forward-looking and discounts everything. The technician believes that anything that can affect the price. Whether it is fundamental, economical, political, psychological or anything else, it has already been factored into the price of the stock or market. If this is true, one only needs to analyze price and volume.

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All the technician is really saying is that price action should reflect changes in supply and demand. In other words, if demand is greater than supply, then the price should rise. If supply is greater than demand, then the price should fall. Therefore, anything fundamental that has affected the price of the stock (or could affect the price of the stock as long as it is a known event) will be reflected in the price pattern that prints on the chart.

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The next major presumption of technical analysis is that prices move in trends. One plots price action on a chart in an attempt to identify a trend as it is reversing, or very early on in the trend so he can trade with it.

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The third presumption of technical analysis is that history repeats itself. This is a logical conclusion since a chart pattern is the psychological picture of the emotions of the different market players. Because humans are emotional beings who have a tendency to overreact, charts visually represent how market players have reacted to given circumstances in the past. One could then conclude that given similar circumstances, market players will continue to react the same.

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Before we begin to cover the specific indicators, let’s look at the following daily bar chart, which is the most commonly used chart in technical analysis.

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“TC2000.com chart courtesy of Worden Brothers, Inc., http://www.tc2000.com�

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Trending Versus Trading Ranges

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Each price bar represents the overall picture of the balance between buyers and sellers for that day. The tick mark on the left side represents the opening price. The tick mark on the right represents the closing price. The top and bottom of the bar represent the intra-day high and low.

Co

There is money to be made on stocks that are in a trend, reversing trends, or trading in a range. However, in order to apply the optimal strategy one needs to determine if the stock is in a trend, changing trends, or trading in a range.

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00 8

When a stock is trading in a range, the price will move up to a previous high or down to a previous low, but will not trade outside this range. A trend is not constricted by previous highs or lows. In fact, an uptrend is defined by a series of higher highs and higher lows, and a downtrend is defined by a series of lower lows and lower highs. The following chart shows an uptrend.

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Reprinted permission AIQ Charts

During an uptrend, the best buy signals are generated during oversold periods within a bull market. Each point represents a buy point within the overall bullish trend.

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The following chart shows a downtrend. During a downtrend, the best sell (play bearish strategies) signals are generated during rallies within a bearish trend. Each point represents an optimal entry point for a bearish trade.

20

Reprinted permission AIQ Charts

Copyright Š 2007 MHI, LLC., All Rights Reserved Reproduction in any form without expressed written consent is prohibited.

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When a stock is stuck in a trading range, the direction is more difficult to predict due to random price action in such non-trending situations. The following chart shows a stock channeling (or trading) in a range. One can enter bullish positions when the price hits the bottom support line, and enter bearish positions when the price hits the upper resistance line.

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Reprinted permission AIQ Charts

Magnitude of the Trend

00 8

A trend also has levels of significance. A trend on a weekly chart is more significant than a trend on a daily chart, and a trend on a daily chart is more significant than a trend on a 60 minute chart. The trend used to generate trading signals will depend on the desired holding period for the trade.

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For example, a long-term investor is more interested in the trend on the weekly chart. A position trader is more interested in the trend on the daily chart. A swing trader is more interested in the trend on the 60 minute chart. And a day trader is more interested in the trend on the 5 minute chart.

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Support & Resistance

The higher lows in an uptrend and the lower lows in a downtrend are considered support. The higher highs in an uptrend and the higher lows in a downtrend are considered resistance. In a trading range, the reaction highs are considered resistance and the reaction lows are considered support.

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Support is simply the point at which selling exhausts itself and buyers come back into the market. Resistance is the opposite. It is the point at which buying exhausts itself and selling begins. One very important point about support and resistance is that when a major resistance level is penetrated it usually becomes new support, and when a major support level is broken it usually becomes new resistance.

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Trend Lines

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Now that you understand support and resistance, let’s look at a very important technical tool for spotting and following a trend – the trend line. Although a trend line is very basic, it is very valuable in its many uses.

Drawing a Trend Line

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In order to draw a trend line, one needs at least two points to connect. However, at this point it is only a tentative trend line. The trend line will become valid after the price tests the tentative trend line for a third time and it holds as support/resistance. Once a valid trend line has been identified, it becomes very useful in many ways.

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One of the basic concepts of a trend is that a trend in motion is more likely to continue than reverse. An additional counterpart to this concept is that a trend takes on a certain slope as identified by the trend line, and will usually maintain that same slope. Therefore, a trend line not only helps determine buy and sell points, but is also useful in signaling a changing trend.

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Charts reprinted permission AIQ Charts

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Uptrend – an uptrend line is a straight line drawn upward to the right under successive reaction lows.

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Downtrend – a downtrend line is a straight line drawn downward to the right above successive rally peaks.

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How to Use a Trend Line

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In an uptrend, the corrections will often touch or come very close to touching the uptrend line. Since the intent in an uptrend is to buy dips, the trend line provides a support area under the market where one can buy the stock or market. A downtrend line can be used as a resistance boundary for initiating bearish positions.

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As long as a trend line remains intact, it can be used to determine buying and selling areas. Once a trend line is broken, it is a signal of a change in the trend and all positions in the direction of the previous trend should be closed.

M

If you choose to use a trend line to trade with the prevailing trend, the best policy is to trade in the direction of the overall trend. In other words, during uptrends one would want to buy the dips, but would not want to enter bearish trades on the rallies. Likewise, in downtrends one would want to enter bearish trades on the rallies, but would not want to buy the reaction lows.

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When using trend lines to trade with the trend, it is important to be aware of how long a trend has been in place and when the trend is about to end. At major turning points, the “crowd� is often wrong about the direction. In other words, the masses usually get involved with a trend just as it is about to reverse. Knowing how to identify these trend changes will present some of the most profitable trading opportunities, because when a trend line is broken the stock will usually assert itself strongly in the direction of the break.

Co

What Constitutes the Valid Breaking of a Trend Line?

00 8

As a general rule, the stock needs to close below the trend line to constitute a valid break. Even then, the break should be followed by at least one, if not two, other subsequent closes below the trend line before it can be considered a valid break. The safest entry on a penetration of a trend line is to wait for the price to rise back up (decline back down on an upside break) and test the penetrated trend line from the underside. If the trend line acts as new resistance, it would constitute a high probability trading opportunity. There is not always a re-test of a penetrated trend line, so one could miss potential trading opportunities if waiting for a re-test.

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An additional insight on trend lines is the longer that one has been intact and tested, the stronger the trend line is. Usually a penetration of a significant trend line will lead to a large move in the direction of the break.

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Price Gaps

A price gap is an area on a bar chart where no trading has taken place. For example, in an uptrend a gap is formed when the lowest price of the day is above the highest price of the previous day, leaving a gap (or open space) on the chart that is not filled during the day.

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In a downtrend, a gap is formed when the highest price of the day is below the lowest price of the previous day. Upside gaps can be both a sign of strength and a sign of trend exhaustion. Downside gaps can be both a sign of weakness and a sign of trend exhaustion. There are four types of gaps: breakaway, runaway, exhaustion gaps, and common gaps.

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The Breakaway Gap

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A breakaway gap often signals the beginning of a major market move and usually occurs after the completion of an important price pattern. For example, after a stock or market has completed a constructive base, the breakout above resistance often occurs on a breakaway gap. Likewise when a major support area under a stock is penetrated, it is often accompanied by a breakaway gap.

00 8

The Continuation Gap

Co

Breakaway gaps usually occur on heavy volume. It is very important for upside breakaway gaps to be accompanied by heavier volume, however it is not as important on a downside breakaway gap. Sometimes after a breakaway gap occurs, the price will pull back (rally in the case of a downside gap) and fill part of the gap before resuming the new trend. However, breakaway gaps are usually not completely filled.

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After a significant move has been in place, the price will often spring forward to form a second type of gap (or a series of gaps), known as a continuation gap. Continuation gaps usually occur around the middle of the move, and they act as an excellent measuring tool. One can measure the distance from the original breakout to the runaway gap, add this distance to the continuation gap, and have a pretty good idea as to the extent of the remaining move.

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The Exhaustion Gap

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Eventually, after a major move has occurred, the trend will exhaust itself and reverse. Sometimes this trend exhaustion is accompanied by a gap; however, the gap is quickly filled and the price reverses. This gap is known as an exhaustion gap. Usually an exhaustion gap is also accompanied by a news event that either commits all remaining sideline money to the uptrend so there is nothing left to propel price higher and it reverses, or a negative news event flushes out all the sellers and now the price is free to rise.

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The Common Gap

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Common gaps are quickly filled as the price returns into the gap within a few days. Common gaps occur more often than other types of gaps and they show no follow-through. In other words, after an upside common gap no new highs are reached, or on a downside common gap no new lows are reached.

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In addition, volume shows no real significant increase on the day of the gap, or on the days following. Common gaps usually occur after a sharp reaction move. For example, if the price suddenly gaps-up after a significant decline over a short period of time, it is usually a common gap. Common gaps can also occur during trading ranges.

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Printed permission AIQ Charts

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Moving Averages

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A moving average is one of the most widely used and versatile technical tools. A moving average is simply an average of a certain body of data. For example, if one wants to figure a ten day moving average of the closing price, he would take the last ten days’ closing price, add them together, and then divide by 10. The data that is averaged moves forward with each new trading day.

M

A moving average is a trend-following indicator. In other words, it lags market action and gives trading signals after a trend is already in place. The shorter the average, the closer it hugs the price. The primary purpose of a moving average is to determine when an old trend has ended and a new trend has begun; however, these signals trigger late into the new trend.

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An average is used because it is a smoothing device and makes it much easier to view the underlying trend. A moving average usually calculates the average of the closing price since it is the most important price of the day. There are two basic types of moving averages: simple and exponential.

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Simple Moving Average

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A simple moving average gives an equal weight to each trading day. For example, in a ten day simple moving average an equal weight is given to both the first and last days. This is the main criticism of a simple moving average, because only the period covered by the moving average is taken into consideration.

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Exponential Moving Average

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An exponential moving average addresses this criticism. First, an exponential moving average gives a greater weight to the most recent data. Therefore, it is a weighted moving average. Yet it still gives some weight to the older data, and therefore all the data in the life of the trading instrument is included in the calculation.

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How to Use Moving Averages to Generate Buy And Sell Signals

The most basic way to generate buy and sell signals using a moving average is when the price closes above or below the moving average. If the stock is trading below the moving average and closes above the moving average, it would denote a buy signal. If the stock is trading above the moving average and closes below the average, it would denote a sell signal.

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This method can produce many false signals, especially if a shorter moving average (such as a five or ten day moving average) is being used. One way to avoid many false signals is to not only wait for the price to close above or below the average, but to wait for the average to turn in the direction of the crossover. The moving average should also be suited for the time frame in which one is trading. A position trader would probably not use a three or five day moving average, where a swing trader would.

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The most followed moving averages are the 20, 50 and 200 day moving averages. Therefore, they are the most significant moving averages. If the price is below the 20 day moving average and crosses above the average, it will often continue to advance until it tests the 50 day moving average. If the price then penetrates the 50 day moving average it will often continue until it tests the 200 day moving average. The same holds true if the price is above a moving average and crosses below the average, it will often continue down until it tests the next lower average.

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The challenge with using a single moving average to generate buy and sell signals is that moving averages are lagging indicators. If a longer average is used, one risks missing most of the move; however, the trade is not as vulnerable to false signals. A shorter average will generate a signal sooner; however, false signals will be more prevalent.

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The key is to find an average that is not overly sensitive (generating many false signals), but is sensitive enough to give early signals. One should also consider that while a longer-term moving average performs better as long as the trend remains in motion, when it does reverse it gives back a lot more of the profit before generating a signal in the opposite direction.

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Printed permission AIQ Charts Using Two Moving Averages to Generate Signals

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This technique uses two moving averages: one longer-term and one shorter-term. A buy signal is generated when the shorter-term moving average crosses above the longer-term moving average. A sell signal is generated when the shorter-term moving average crosses below the longer-term moving average. Two popular combinations are the 5-and 20-day moving averages, and the 10-and 50-day moving averages. This technique lags the market more than a short term moving average, but produces fewer whipsaws.

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Printed permission AIQ Charts

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Bollinger Bands

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Bollinger Bands are two bands placed around a moving average, usually a 20 day moving average. The bands are placed two standard deviations above and below the moving average. Using two standard deviations insures that 95% of the price data will fall within the two bands. A standard deviation is a statistical concept that explains how price is dispersed around an average value.

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When the price touches the upper band, the stock is considered overbought and one would expect the price to decline. When it touches the lower band it is considered oversold and one would expect the price to rise. If the price retraces far enough away from the band and crosses the moving average, one would then use the opposite band as a price target.

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Note: During a strong uptrend, the price will usually fluctuate between the upper band and the average. In a strong downtrend the price will usually fluctuate between the lower band and the average. If the average is penetrated, it would warn of a possible trend reversal. Bollinger bands work best on stocks that are in a trading range, rather than stocks that are trending.

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Another very useful application of Bollinger Bands is the when the bands are expanding, the volatility is usually increasing. When the bands are contracting, the volatility is decreasing. Understanding how to identify stocks with a low volatility reading can improve the profitability of certain strategies such as the straddle/strangle, especially if the stock is ready to make a significant directional movement.

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Printed permission AIQ Charts

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Oscillators

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An oscillator measures the movement of the stock’s price relative to the assumed cycle of highs and lows. Most oscillators have a midpoint value of 0, as well as an upper and lower boundary. The range between boundaries is from 0 to 100. When the price reaches the upper boundary, it is considered overbought and is likely to decline. When the price reaches the lower boundary, it is considered oversold and is likely to rise. Oscillators work best in non-trending environments, because during trending markets an oscillator can register an overbought/oversold level for months, giving many false signals along the way.

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Some traders will wait until the indicator has reached an extreme level and then crosses the zero line before initiating a trade. This may reduce many false signals, but the trader will usually miss the majority of the move or may enter a trade just as the trend is about to reverse.

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An oscillator can also be used to identify divergences. A bearish divergence would be when the price makes a new high, yet the oscillator makes a lower high. A bullish divergence would be when the price makes a new low, yet the oscillator makes a higher high. Relative Strength Index

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One of the most popular oscillators is Welles Wilder’s Relative Strength Index (RSI). This index measures overbought/oversold conditions on a scale of 0 to 100 over a defined number of past trading days. Most traders consider a security to be overbought when the price reaches 70 and oversold when it reaches 30 (70 & 30 are the default settings). One should not confuse this indicator with the relative strength of a stock compared to another stock or index. Another popular oscillator for your consideration is Stochastics.

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Printed permission AIQ Charts

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Moving Average Convergence/Divergence (MACD)

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MACD combines many useful features of an oscillator with the many useful features of a moving average crossover system. The indicator has a fast and slow line. Traditionally, the fast line is the difference between a 12 unit and a 26 unit exponential moving average and is known as the MACD line. The slow line is usually a 9 period exponentially-smoothed average of the MACD line and is called the ‘signal line’.

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When the signal line crosses above the MACD line a buy signal is generated. When it crosses below the MACD line a sell signal is generated. MACD also has a middle boundary known as the ‘zero line’. Many traders will not only wait for the signal line to cross above the MACD line to generate a buy signal, but will also wait until the indicator has crossed above the zero line. To generate a bearish signal, one would wait until the indicator has also crossed below the zero line.

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MACD can also be used to identify divergences and convergences with the price. When MACD is above zero and the price makes a new high (yet the indicator fails to make a new high), a bearish divergence exists and warns of a possible price reversal. When MACD is below zero and the price makes a new low (yet the indicator fails to make a new low), a bullish divergence exists and warns of a possible price reversal. If MACD follows the price to a new high or low, then it confirms the strength of the trend.

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Printed permission AIQ Charts

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Relative Strength Versus the Market

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Relative strength analysis is the measure of a particular stock against an underlying index, such as the S&P 500. One would buy stocks that are currently displaying strong relative strength, or when the relative strength begins to turn up. He would short stocks that were underperforming the market and had a down-trending relative strength. One can also use a moving average crossover system of the relative strength to generate buy and sell signals. When the faster moving average crosses above the slower average, a buy signal would be triggered. When the faster moving average crosses below the slower average, a sell signal would be triggered. A very popular combination is the10 and 20 day moving averages of the relative strength.

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“TC2000.com chart courtesy of Worden Brothers, Inc., http://www.tc2000.com�

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On Balance Volume

OBV is a running total of volume which measures the positive and negative flow of volume. It is a leading indicator of the price and often predicts trend reversals. The indicator adds the periods volume if the price closes up and subtracts the periods volume if the price closes down. If the price closes unchanged, OBV stays the same.

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The strength of OBV is that it often rises or falls ahead of the price and gives its strongest signals when it diverges from the price. In other words, if the stock makes a new high yet OBV fails to make a new high, then a bearish divergence exists and warns of a possible trend reversal. If the stock makes a new low yet OBV fails to make a new low, then a bullish divergence exists and warns of a possible trend reversal. If OBV follows the price to a new high or low it confirms the strength of the indicator.

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Reprinted permission QCharts

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Elliott Wave Principle

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The concept I'm going to introduce you to next is one that was discovered by a stock trader in the 1930's named Ralph Nelson Elliott. Today his method of analyzing the markets is known as the Elliott wave principle.

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What R.N. Elliott discovered was that social or crowd behavior trends in identifiable patterns. These patterns are governed by man's social nature and therefore produce repetitive forms that have predictive value.

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In the most basic terms the Elliott wave principle states that the market advances in an impulse wave that can be broken down into 5 sub-waves (1-2-3-4-5). The market then corrects in a corrective wave that can be broken down into 3 sub-waves (a-b-c).

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If this is true then the market could be considered a hierarchal self-fractal. Meaning that the market is always using 5-wave impulse waves and 3-wave corrective waves as building blocks to build larger 5-wave impulse waves and larger 3-wave corrective waves. In addition, going the other direction the market continues to sub-divide into ever smaller impulse waves consisting of 5 subwaves and ever smaller corrective waves consisting of 3 sub-waves.

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Because there are “waves” within “waves” we can identify where a market is at in its current wave count on a long-term yearly chart as well as short-term hourly charts.

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Rules for Wave count

Using the following set of basic rules for wave count, we can determine 'where we are' in terms of the wave count.

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1. Wave 2 should not break below the beginning of Wave 1 2. Wave 3 should not be the shortest wave among Waves 1,3, and 5. In addition, wave 3 should extend beyond the high of Wave 1. 3. Wave 4 should not overlap (close below/above the low/high of Wave 1), of the same degree of trend. 4. Rule of Alternation – Wave 2 and 4 should unfold in two different wave forms. Impulse Wave formations.

An impulse wave can unfold in one of three main ways:

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1.Extended Wave

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In a 5 wave impulse move either sub-wave 1,3, or 5 will extend. A wave extension means it is longer than the other two sub-waves. Extended waves can further be broken down into 4 types of formations: (see figure on next page).

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When a fifth wave forms (provided it doesn't extend) the trend is usually running out of steam and is ready for a 3-wave correction. Therefore a fifth wave can take on two other formations. 2. Fifth Wave Diagonal Triangle

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When the momentum in wave 5 is weak sometimes the 2nd and 4th sub-waves overlap with each other and form a diagonal triangle.

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3. Fifth Wave Failure.

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When the momentum in wave 5 is extremely weak many times it won't surpass the top of wave 3, causing a double top at the end of the trend. This formation is also known as a truncated fifth wave.

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A Corrective Wave is not quite as straightforward as an impulsive wave. There are several fairly complicated corrective wave structures that can be categorized into six major wave formations.

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1.Zig-Zag. This corrective formation is more harmonic than others and is easier to identify. The ab-c pattern consists of a 5-3-5 sub-wave structure. 2.Flat. The a-b-c pattern consists of a 3-3-5 sub-wave structure where b equals a. 3.Irregular. The a-b-c pattern consists of a 3-3-5 sub-wave structure where b is longer than a. 4.Horizontal (symmetrical) triangle. In the case of a triangle the corrective wave pattern is an a-b-cd-e consisting of a 3-3-3-3-3 sub-wave structure. 5.Double Three. A double three pattern consists of any two a-b-c patterns from above linked by an x wave (a-b-c-X-a-b-c). 6.Triple Three. A triple three pattern consists of any three a-b-c patterns from above linked by two x waves (a-b-c-X-a-b-c-X-a-b-c).

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Elliott Wave Summary

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The value of Elliott Wave is there are only three basic impulse wave forms and six corrective wave forms that are conclusive. When we can identify where we are at in the current wave count, we will know which type of wave formation is going to unfold next and begin to predict future market actions.

Patterns Within Elliott Wave Structures

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Many skeptics criticize the wave principle because of its many complexities and feel that it has no real value when it comes to trading the market. It can be difficult to properly label a wave count all of the time, and one may have to continually re-lable a wave count. However, having a knowledge of historical market wave patterns and experience in labeling those wave patterns are of paramount importance, as there is undeniable evidence that market action in all time frames unfolds in 5-wave impulse wave followed by a 3-wave corrective wave.

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The method I’m going to present you with next is based on a pattern within the Elliott Wave principle, and is our preferred method for identifying high probability trading opportunities. To identify these two patterns we use a method of analysis called Fibonacci Analysis.

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By using the Fibonacci number series, we arrive at certain ratios that are then applied to the chart itself in order to identify trend reversal zones. Understanding how to arrive at these ratios isn’t as important as knowing what the ratios are and the governing rules behind applying these ratios to the pattern, but we will still teach you how to arrive at each ratio.

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The Fibonacci Number Series

The Fibonacci number series is named after the famous mathematician, Leonardo Fibonacci, who discovered the following number series: 1, 1, 2, 3, 5, 8,13, 21, 34, 55, 89,144, 233, 377, and so on.

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The unique property behind this particular number series is that each number is equal to the sum of the two preceding numbers. In order to determine support and resistance levels, we use certain ratios derived from this number sequence.

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The first ratio we will use is .618. To arrive at this ratio, simply take any number after the first five numbers and divide it by the next number in the series. For example, if you take 13 / 21 = .618, 21 / 34 = .618, 34 / 55 = .618, and so on. The next ratio is .382. To arrive at this ratio, take any number after the first five numbers and divide it not by the following number, but by the next number in the sequence. For example, if you take 13 / 34 = .382, 21 / 55 = .382, 34 / 89 = .382, and so on.

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The next ratio is .50. To arrive at this ratio simply divide 1 / 2 =.50.

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The next ratio is 1.618. To arrive at this ratio, take any number after the first five numbers and divide it by the preceding number. For example, if you take 34 / 21 = 1.618, 55 / 34 = 1.618, 89 / 55 = 1.618, and so on.

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From these four core ratios we are able to determine the other important ratios we use. The next ratio is derived by taking the square root of .618 = .786 .

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The next ratio is derived by taking the square root of .786 = .886 .

The next ratio is derived by taking the square root of 1.618 = 1.272 .

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The next ratio is derived by taking the square root of .50 = .707 . The next ratio is derived by taking the square root of 2 = 1.414 .

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And the final ratio is 1 or 1.000 .

The ratios we will use to identify these patterns and find major support/resistance levels are as follows:

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.382 , .50 , .618 , .707 , .786 , .886 , 1.000 , 1.272 , 1.414 , and 1.618 .

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To use these ratios in order to identify support/resistance levels, one needs to know the price of an absolute swing high on a chart and an absolute swing low on a chart. A swing high is an intra-day high that is preceded and followed by a lower intra-day high. A swing low is an intra-day low that is preceded and followed by a higher intra-day low.

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This illustration shows a swing low at 33 having ended a previous downtrend, which was followed by an uptrend. The swing high at 50 could possibly end the uptrend and be the beginning of a new downtrend.

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To find possible support levels as the stock declines we take the absolute difference between the low of 33 and the high of 50, which is 17 points, and multiply it by each of the Fibonacci ratios and then subtract the result from the absolute high of 50. This will give us possible support levels.

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17 X .382 = 6.49, then 50 - 6.49 = 43.51. This is the first possible support level. 17 X .50 = 8.5, then 50 - 8.5 = 41.50. This is the second possible support level. 17 X .618 = 10.50, then 50 - 10.50 = 39.50. This is the third possible support level. 17 X .707 = 12.02, then 50 - 12.02 = 37.98. This is the fourth possible support level. 17 X .786 = 13.36, then 50 - 13.36 = 36.64. This is the fifth possible support level. 17 X .886 = 15.06, then 50 - 15.06 = 34.94. This is the sixth possible support level. 17 X 1.000 = 17, then 50 - 17 = 33.00. This is the seventh possible support level. 17 X 1.272 = 21.62, then 50 - 21.62 = 28.38. This is the eighth possible support level. 17 X 1.414 = 24.03, then 50 - 24.03 = 25.97. This is the ninth possible support level. 17 X 1.618 = 27.50, then 50 - 27.50 = 22.50. This is the tenth possible support level.

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This illustration shows the main Fibonacci levels we would be looking for as possible support as the stock declines.

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This illustration shows a swing high at 50 having ended a previous uptrend, which was followed by a downtrend. The swing low at 33 could possibly end the downtrend and be the beginning of a new uptrend.

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To find possible resistance levels as the stock rises we take the absolute difference between the low of 33 and the high of 50, which is 17 points, and multiply it by each of the Fibonacci ratios and then add the result to the absolute low of 33. This will give us possible resistance levels.

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17 X .382 = 6.49, then 33 + 6.49 = 39.49. This is the first possible resistance level. 17 X .50 = 8.50, then 33 8.50 = 41.50. This is the next possible resistance level. 17 X .618 = 10.50, then 33 + 10.50 = 44.00. This is the next possible resistance level.

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We would continue the process to find each possible Fibonacci level to determine possible resistance as the stock rises.

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This illustration shows the main Fibonacci levels we would be looking for as possible resistance as the stock rises.

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Now that you know what the Fibonacci ratios are, how to arrive at the ratios, and how to use them to determine possible support/resistance levels, it’s now time to apply them to a stock chart in order to identify the two specific patterns we like to trade.

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Bullish version of the pattern we like to trade.

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Bullish A-B-C Pattern. At point ‘C’ we would be looking for the stock to make a significant rise in price.

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Bearish version of the pattern we like to trade.

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Bearish A-B-C Pattern. At point ‘C’ we would be looking for the stock to make a significant decline in price.

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Now that you understand the basic shape of pattern we like to trade let’s look at the context in which you should trade this pattern (see illustration next page)

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This is a bullish A-B-C pattern where one would look to buy at point C. The A-B-C pattern should occur after an impulsive wave up (1-A) which should occur after an impulse wave down (5). Trading this pattern one is attempting to take advantage of an impulsive wave 3 or C.

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Here are some additional rules that will help you perfect your entry at point C (2-B).

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1. Point ‘5’ should be a swing high or swing low that is followed by a significant impulsive move ( 1-A ).

2. From point 5, point ‘1-A’ will be the next significant swing high or low. Once you have identified point ‘1-A’ you can begin to look for point ‘A’. Point A should go to the .382, .50, or .618 of the ‘5 - [1-A]’ move.

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3. Point ‘B’ should then make at least a .382 retracement of the ‘[1-A] - A’ move, but could go all the way to the .886.

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4. Once we know where point A occurred at, we can then determine the most probable price for point ‘C’ to occur at. This is the trend reversal price and the price at which we would want to enter a trade. If point A only goes to the .382 or .50 of ‘5 - [1-A]’ and then point B occurs, we would look for point C to occur at the .886 of the ‘5 - [1-A]’ move. If point A goes all the way to the .618 before point B occurs, then we would look for point C to occur at the .786 of the ‘5 - [1-A]’ move.

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5. The ‘B-C’ move should at least equal the ‘[1-A] - A’ move in distance but many times will extend so that the ‘B-C’ move equals 1.272 or 1.618 of the ‘[1-A] - A’ move. This means we would take the price difference between point ‘[1-A] and A and multiply it by 1.00, 1.272, and 1.618. We would then take these results and add it to point B if we are looking for a bearish reversal, or subtract it from point B if we are looking for a bullish reversal. If we are looking for point C to occur at the .786, we would need a ‘[1-A] - A’ = ‘B-C’ move to coincide with the .786 of the ‘5 - [1-A]’ move. If we are looking for point C to occur at the .886 of the ‘5 - [1-A]’ move, then we would still need at least a ‘[1-A] - A’ = ‘B-C’ move to coincide with this level, but when looking for the pattern completion to occur at the .886 it will often coincide with a ‘B-C’ =1.272 or 1.618 of ‘[1-A] - A’.

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6. The last Fibonacci level we can look at is how far point C is extended above or below the ‘A-B’ move. We are looking for a 1.272, 1.618, or sometimes an even greater extension of the ‘A-B’ move, such as 2.00, 2.24, or 2.618. We would take the difference between point A and point B and multiply it by 1.272 and 1.618, and then add it to point B if we were looking for a bearish reversal, or subtract it from point B if we are looking for a bullish reversal. We are looking for confluence at the .786 or .886 of the ‘5 - [1-A]’, along with confluence at the ‘[1-A] - A’ = ‘B-C’ or ‘B-C’ =1.272 or 1.618 of ‘[1-A] - A’ price points. There doesn’t need to be confluence for the trade to work - it just offers a stronger trading signal.

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8. The stop loss for this pattern should be placed somewhere above or below point 5. This gives the pattern the room it needs to work without stopping you out of the trade. The reason we like to place the stop above or below point 5 is that sometimes the price can extend all the way to point 5 and then reverse. You don’t want to be stopped-out of an otherwise good trade.

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9. The minimum profit objective for the pattern is the 1.00 projection of the ‘5 - [1-A]’ move.

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The following charts illustrate this pattern for both bullish and bearish trend reversals.

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This pattern often leads to a bullish trend reversal.

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This pattern often leads to a bearish trend reversal.

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When trading these patterns the most important thing to remember is look for clusters of Fibonacci support/resistance levels near the .786 or .886 of the ‘5 - [1-A]’ move and this will most likely be the trend reversal price.

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Sentimental Analysis

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The final type of analysis we will discuss is known as sentimental analysis. It has already been mentioned that the crowd is often wrong at key trend turning points. If this is the case, one would want to measure the crowd’s expectation at potential turning points to identify extreme bullish/bearish readings.

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Sentimental analysis does just that. It measures the emotions of the investing crowd in an attempt to identify extreme bullish or bearish readings. Once an extreme level has been identified, a trader can use this information from a contrarian viewpoint either to confirm other trading indicators or as a stand alone indicator.

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If an extreme bearish sentiment exists, a contrarian would interpret this as a bullish indicator. If an extreme bullish sentiment exists, a contrarian would interpret this as a bearish indicator.

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While an extreme sentimental reading can be used as a stand alone indicator to identify possible counter-trend moves, we feel it is best used as a supplemental indicator.

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The following example will demonstrate how sentimental indicators can help confirm other trading indicators. Suppose a stock has had a nice run up and is now approaching a significant resistance level, the stock is upgraded by a major brokerage firm, and gaps up near the resistance level on heavier than usual volume. Because the stock has been upgraded, the crowd is now going to feel very optimistic and bullish about the stock, which is why it gapped up on heavier volume.

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The reality is that this final gasp of buying by the “Johnny come lately’s” has now most likely committed the remaining sideline money to the stock and there is nothing left to propel the stock higher. The over-optimistic public at a major resistance level is an excellent contrarian indicator to confirm the original trading signal.

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In addition to extreme sentiment which can be easy to spot, one also needs to know that complacency in the market and media also give a contrarian signal that investors’ expectations are still too high despite the low price, and that a weak stock, sector, or market has still not found a bottom. At a true bottom, investor fear should have reached an extreme level as the crowd finally becomes convinced there is still more disaster ahead.

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Sentiment Indicators

Put/Call Ratios

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The put/call ratio is a ratio of the trading volume in puts to the trading volume in calls. From a contrarian’s viewpoint, a low reading indicates a high level of bullishness and that the market or stock may be ready for a correction or consolidation within the bull trend. Conversely, a high reading indicates a high level of bearishness and that the market may be ready for a rally.

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Implied Volatility

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Implied volatility is the option market's assessment of the expected future volatility of the underlying stock. For example, if the options have an implied volatility of 40%, then standard deviation suggests that the shares have a two-thirds chance of trading within 40% of the current stock price over the next year.

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The higher the implied volatility, the more expensive the options. The implied volatility usually spikes as a stock is plunging in price because fearful investors are rushing to buy puts as protection. Conversely, at market tops the implied volatility tends to reach low levels due to investor complacency, which to a contrarian would suggest a possible pullback since the crowd is fully invested and there is very little sideline money to propel the stock higher.

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In summary, the implied volatility will spike as a stock or market is plunging, but won’t spike as a stock or market rallies to a new high. Instead, it reaches an extremely low level as investors tell themselves all is well. This exists because fear and greed aren’t equally balanced emotions.

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The following chart is a comparison of the S&P 500 and the VIX (CBOE’s measure of implied volatility of the OEX options). Notice when the VIX (lower line) reaches an extremely low level, it coincides with the market top. Conversely, when this indicator reaches extremely high levels, it coincides with a market bottom.

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“TC2000.com chart courtesy of Worden Brothers, Inc., http://www.tc2000.com”

Option Volume and Open Interest

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An option’s volume and open interest can be very helpful in predicting the short term price movements of a stock. Open interest is a more accurate measure of the cumulative demand for an option than volume. Open interest is defined as the number of outstanding contracts on a particular option class or series. Volume is the number of option contracts that trade on a particular day or within the chosen time period.

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Tracking option activity and spotting unusual activity can help to identify profitable trading opportunities, especially for short-term trades. When tracking option activity, one is either trying to uncover the actions of inexperienced option traders so he can trade against them, or he is trying to uncover the actions of institutions so he can trade with them.

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For instance, the small speculators who purchase a few cheap front month (next month) out-of-themoney options trying to get the greatest amount of leverage, tend to be wrong the majority of the time. They have usually received their stock tip from a friend or seen a widely publicized news story. When something becomes “obvious”, it is usually time to trade against the crowd. Excessive option speculation on one side of the market often occurs around major turning points.

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Tracking Advisory Opinion for Overall Market Sentiment

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When the term “investing crowd” is used, we are not only referring to the general public, but also to investment advisors as a group. We certainly don’t mean to imply that all traders, investors, and investment advisors are wrong at key turning points. There are some very smart individuals that fall into each of these categories. However, when viewed as a group they are no better than the ‘average Joe’.

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By surveying the bullishness/ bearishness of investments, advisors can give very strong clues as to which way one should trade the market. Investment advisors are most bullish at market tops (when they should be bearish), and bearish at market bottoms (when they should be bullish). Understanding this allows one to take a contrarian viewpoint and trade against them.

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A composite percentage of bulls above 55 percent is usually a sign that the market is near a shortterm top, whereas a composite reading of bulls below 35 percent is a sign that the market is near the bottom. The composite reading of bullish investment advisors versus bearish investment advisors can be found each day in Investors Business Daily.

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The technical and sentimental analysis methods that have been discussed in this chapter can be applied to any strategy. For example, once a buy signal has been triggered a trader could choose to buy the stock, buy the stock and hedge it with an option, buy a call option, or trade a bullish spread. The strategy chosen should offer the desired risk-to-reward ratio, meet the money management and asset allocation guidelines, and agree with the outlook for the stock.

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Stock Trading

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Chapter 5

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In this chapter we will first teach the basics of stock trading from both the long and short side, since stock trading of some kind (whether directional or hedged) will account for the majority of one’s trading activity. We will then introduce options as a trading instrument. Finally, we will look at hedged stock trades.

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Directional Stock Trades

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There are times when a short-term (two weeks to two months) directional stock trade is the best strategy since it might not make sense to pay the extra premium in order to hedge the trade with an option. In our opinion, a hedged stock trade is a longer-term trade/investment. We will usually only hedge a stock trade if we plan to hold it for three to nine months, or longer. Hedged stock trades will be covered in a later Chapter.

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Before we enter a short-term (two weeks to two months) directional stock trade, we have done our homework to determine a potential overbought/oversold level and a high probability of a trend reversal. Therefore, the risk of holding the stock can be controlled primarily through proper money management and position size.

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Advantages and Disadvantages of Trading Stock

Advantages:

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1. The commission costs for trading stocks are much lower than those for trading options. 2. The bid ask spread is much less than that of trading options. 3. It is much easier to get more capital working for you in fewer positions, thus making it much easier to manage.

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Disadvantages:

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1. Each position requires more capital to establish. 2. Even though you can use a stop loss to help control losses, the entire capital is still at risk to large gaps and other quick moves against the trade which may cause one to lose more than the intended maximum risk amount.

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Buying Stocks

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Buying a stock is the easiest strategy to learn and is already very familiar to most people. When one buys a stock, he is considered to “long� the stock and is hoping the stock price will increase from where he bought it, thus allowing him to realize a profit. The leverage factor for trading stocks is 1-to-1. In other words, if the stock is trading at $50, in order to buy 100 shares it will cost $5,000.

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There is one way to increase the leverage factor to 2-to-1, and that is by trading on margin. When one trades on margin, he is borrowing one time over the value of his account from his broker, therefore giving him twice the buying power. If he had a $50,000 account he can trade with up to $100,000, but he will be charged interest on the borrowed money (usually around 7% to 8% per year). To many people trading on margin sounds risky, and it can be if one does not use proper money management. However, with the right money management and a good trading method, we encourage trading on margin.

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When trading stocks by themselves, we usually don’t hold a position longer than two to four months, and we always set up the trade so the stop loss gets us out at a 1% loss on the entire account. In addition, we prefer to buy weakness and sell strength, therefore the stocks are usually at an extremely overbought/oversold level and the risk of a strong gap is much less. Therefore, we are comfortable trading a directional stock position with no hedge under these circumstances, and will cut our loss quickly if the stock reaches the stop loss point. Remember we are trading stocks, not investing, so don't ever turn a losing trade into an "investment" by holding it beyond the stop loss point.

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Shorting Stocks

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The concept of shorting stock can be a little more difficult to understand for new traders. Shorting stock simply means one is selling a stock he didn't previously own. If the stock drops in value, then he can buy it back at a cheaper price than he sold it for and realize a profit. If the stock goes up he will also have to buy back the stock, only at a higher price than he sold it for and realize a loss.

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The part that is confusing for new traders is the idea of selling something he didn't previously own. A more detailed description should help to clear up the confusion. When you short a stock, you are actually borrowing the shares from your broker and selling them. You have now sold something that didn't belong to you and will eventually have to buy it back and return it to the owner (broker). If you can buy it back at a lower price than you borrowed and sold it for, then you get to keep the difference. If you have to buy it back at a higher price than you borrowed and sold it for, then you will have to pay the difference. In summary, if you short a stock, then it needs to go down in order for you to realize a profit. If the stock rises, then you will realize a loss.

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Chapter 6

Options As a Trading Instrument

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An option is a legally binding contract between a buyer and seller that gives the option (contract) owner the right to buy a certain number of shares in the underlying stock on which the option (contract) is listed. If the contract is exercised, these shares can be bought at a specific price on or before a specific date.

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Not all stocks have listed options, although there are thousands of stocks that do. Options are listed on an exchange and can be traded by the general public. The option market is a very liquid market made up of trading firms that employ a floor trader to trade the firm’s money, making it very easy to both buy and sell options. The competition between trading firms and floor traders keeps options priced at a fair value. There are some option contracts that are more actively traded and more competitively priced than others.

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If one is interested in buying an option contract, he pays the current ‘ask price’. If he wishes to sell an option contract, he sells at the current ‘bid price’. The difference between the bid and ask price is known as the bid/ask spread and is much greater than the bid/ask spread for stocks. For example, you might look at a quote for Microsoft stock and see that it can be purchased for 49.87 ask and sold for 49.86 bid. The .01 cent difference is the bid/ask spread. A particular option on Microsoft might be priced at 3.50 ask by 3.35 bid. The .15 cent difference is the bid/ask spread for the option and is much more significant than the .01 cent difference in the stock price. In fact, it represents almost 4.3% of the value of the option. Because one starts at an immediate 3% to 6% loss on an option trade, it is critical to use proper money management and to allow for enough movement in the stock to make up for this loss. This loss is known as ‘slippage’.

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Components of an Option Contract

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1. Type 2. Contract value 3. Expiration date 4. Strike price

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1. Type

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An option contract has several components. In order to trade options effectively, one needs to have a basic understanding of each component. The first component is the type of option. There are two types of stock options, a call and a put.

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A call option gives the option buyer the right to buy a certain number of shares at a specific price on or before a specific date. If a call buyer decides to exercise his right, the call seller (also known as an option writer) is legally obligated to sell him the shares.

A Closer Look at a Call and Put Option

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Call Option

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A put option gives the option buyer the right to sell a certain number of shares at a specific price on or before a specific date. If the put buyer decides to exercise his right, the put seller is legally obligated to buy the shares from him.

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A call option is a contract between two persons that gives the buyer the right to buy a certain number of shares in the underlying stock at a specific price on or anytime before a certain date in the future, after which, if he hasn't purchased the shares in the underlying stock, the contract becomes worthless. The call owner would only exercise his right to buy the shares if the stock price rises, because now his contract allows him to purchase the shares for less than the current market value. Therefore buying a call option is a bullish strategy.

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An example many of you may be more familiar with is a lease option on a home. Let's suppose that you are selling your home valued at $200,000. I am interested in buying your home in the future, so I might offer to pay you $5,000 for the right - but not the obligation - to buy your home at $200,000 within the next twelve months. If the real estate market were booming over the next twelve months and the home appreciated to $220,000, I could then exercise my contract to buy the home at $200,000 and turn around and sell it for $220,000, thus realizing a $15,000 net profit ($220,000 - $200,000 = $20,000 - $5,000 paid for the lease option = $15,000 net profit). You as the homeowner also made money (the $5,000 premium I paid you), but you gave up some of the profits by selling me the right to buy the home for a cheaper price than what it is now worth.

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If over the next twelve months the home hadn't appreciated and was still worth $200,000, I wouldn't need to exercise my option to buy the home since it can be purchased on the open market for the same price my contract specifies. The lease option contract would expire worthless and you would keep your home and the $5,000 premium I paid you as a profit for guaranteeing me the right to purchase the home for $200,000 over the twelve month period.

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A call option works much the same way as a lease option. One can purchase a call option which gives him the right to buy the stock at a specific price anytime between the opening of the contract and the expiration date, should he choose to do so. The option seller on the other hand (much like the homeowner only now he doesn't have to own the stock [home] in order to sell a call option) is obligated for a certain period of time to sell the option owner a certain number of shares in the underlying stock, if the option owner decides to exercise his contract.

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If the stock rises and the call owner decides to exercise his rights, the option writer (seller) is obligated to sell him the shares in the underlying stock. If he doesn't already own them, he would have to purchase them on the open market at a higher price than where he is obligated to sell it for, thus resulting in a loss. The call buyer doesn’t have to exercise the option to realize a profit. He can also trade out of the option by selling it back on the open market for its current value.

Put Option

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If the stock doesn't rise or actually falls, the call buyer will lose his premium and the option writer will realize the same premium as a profit.

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A put option is a contract between two persons that gives the put buyer the right to sell so many shares of the underlying stock at a specific price on or anytime before a certain date in the future, after which, if he hasn't sold the shares in the underlying stock, the contract then becomes worthless.

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The put owner would only exercise his right to sell the shares if the stock price declines, because now his contract allows him to sell the shares at a higher price than the current market value. Therefore, buying a put option is a bearish strategy.

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Let's look at another example to better understand a put option. When one buys insurance on an automobile, he is paying a premium for the right to have the insurance company fix his car if he gets into an accident. Let’s suppose that his car is worth $30,000. By paying his insurance premium, he is buying the right to "sell" (fix or replace) his car to the insurance company for full value. If the cars value declines (due to an accident), he can exercise his right (put option in

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the financial markets) to recover the full value. If his car is never damaged, he will lose the premiums he paid.

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A put option works very much the same way. One can purchase a put option which gives him the right to sell the stock at a certain price. If the stocks value declines, he can exercise his right and sell the stock. If he owned the stock, he will recover the loss in the stock minus the premium he paid for the put and any difference between the strike price he owned and where he originally bought the stock. This is known as hedging a long stock position and is the first multiple position trade you will learn.

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If he didn't own the stock, he can buy the stock at the current market value (less than his put strike price) before exercising his put option, and then exercise the option by selling the stock at the strike price. He could also sell the stock at the strike price without first owning it and would then be short the stock at the strike price. One can also trade out of the option by selling it back on the open market for its current value.

Writing Calls and Puts

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The examples above focus primarily on the option buyer, rather than the option writer. Although we don't teach any strategies involving "naked" options (written options with no hedge options), understanding "naked" option positions is important.

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In the example above, the homeowner who sold a lease option on his home was covered (or protected) by the home. If he hadn't owned the home and the lease option buyer decided to exercise his right to purchase the home, then the lease option writer (seller) would have had to purchase the home for its current market value and then sell it for the lease contract price, resulting in a loss.

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In the financial markets, the naked option writer could buy back the written option at the current market value if he were concerned the option buyer might exercise his rights, and this way he would avoid assignment. However, the trade could still result in a loss depending on the price he pays to buy back the option. If the stock’s value remains at or below the written strike price of the call option, the option writer gets to keep the entire premium as his profit for the risk he took in writing the contract.

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In the car insurance example, the insurance underwriter is much like the put writer. He is writing the contract and guaranteeing the value of the stock. In exchange for the risk, he receives a premium. If the stock’s value remains equal to or greater than the strike price of the put, he will keep the entire premium as his profit. If the stock’s value declines, the put writer can choose to buy back the naked put position by paying the current market value, or he can let the option be assigned and have to buy the stock at the strike price.

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2. Contract Value

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The next component is the number of shares each option contract represents. Each contract represents 100 shares in the underlying stock on which the option is listed. One contract is the minimum amount that can be traded. For each option contract purchased, the option buyer is actually controlling 100 shares of the underlying stock. This is true for both calls and puts. The only way the number of shares will change is if there is a stock split, merger, or some other event that affects the value of the stock. Even though the number of shares is affected, the overall value of the position will remain the same. Under these situations, it is a good idea to discuss with your broker how the shares will be affected.

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3. Expiration Date

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Every option contract has a date after which it expires worthless. This date is known as the expiration date. All option contracts expire the third Saturday of the month for which the contract is written (sold). Even though options expire the third Saturday, the last trading day of the week is Friday. Therefore, all positions need to be closed or exercised on the third Friday of the month for which it was written. If the third Friday happens to be a holiday, then the last day an option contract can be traded is the last trading day before the third Friday.

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There will always be listed options that expire in the current month and the following month. For example, if it is January then there will be options available for trading that expire in January and February. After these two months the months available for trading will be determined by one of three option expiration cycles. They are:

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January, April, July, October February, May, August, November March, June, September, December

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In addition to these listed months, there may also be LEAPS. LEAPS stands for Long Term Equity Anticipation Security. The only difference between a standard listed option and a LEAPS option is that a LEAPS option has an expiration date that is at least 9 months out. All LEAPS options have January expiration dates and are usually available for the next two years. Once a LEAPS has less than 9 months until expiration, it converts into a standard listed option.

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4. Strike Price

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The strike price is the specified price in the contract at which the stock will be purchased or sold, assuming the option owner decides to exercise his right to do so. Strike prices advance in set increments, so the price at which one can buy the right to purchase or sell the stock is not a random value.

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An example will aid in understanding strike prices. When a stock is trading at a value less than $5.00, there usually won’t be listed options. Once the stock price reaches between $5.00 and $25.00, the strike prices will occur every $2.50. This will give one the ability to buy or sell the right to buy or sell the stock at $5.00, $7.50, $10.00, $12.50 ... all the way up to $25.00. If a stock were trading at $6.00, one would have to decide between the $5.00 or $7.50 strike price.

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Once a stock is trading between $25.00 and $100.00, the strike prices advance in $5.00 increments. If the stock is trading between $100.00 and $200.00, the strike prices advance in $10.00 increments. Beyond $200.00, the strike prices advance in $20.00 increments.

Intrinsic Value

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Intrinsic and Extrinsic Value

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The two values that make up an options premium are known as intrinsic and extrinsic value. Intrinsic value is determined by where the stock is trading in relation to the strike price. For example, if one purchases a $25.00 strike call option and the stock is trading at $30.00, then there is $5.00 of intrinsic value since the option owner could exercise his right to buy the stock at $25.00 (the strike price he owns) and then sell it on the open market for $30.00, realizing $5.00 of cash value. Therefore, intrinsic value is the cash value that would be realized if the option were exercised. A put option will have intrinsic value if the stock price is trading below the strike price.

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Extrinsic value

The strike price of an option The time remaining until expiration The volatility of the underlying stock Any cash dividend to be paid during the life of the option The current risk-free interest rate

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1. 2. 3. 4. 5.

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Any remaining value beyond the intrinsic value is known as extrinsic value. Extrinsic value represents what buyers are willing to pay and sellers are willing to accept in anticipation of the underlying stock rising or falling within the time remaining until expiration. Extrinsic value decays with each passing day and will eventually evaporate completely. The factors that make up the extrinsic value are:

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The Strike Price of an Option

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We will only discuss the first three factors since they have the greatest impact on the value of an option.

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Where the stock is trading in relation to the strike price not only has the greatest impact on the extrinsic portion of the options value, but it also has the greatest impact on the entire value of an option, including the intrinsic portion. When a stock is trading at or near the strike price, the strike price is considered to be at-the-money (ATM). When a stock is trading below the strike price of a call option or above the strike price of a put option, the strike is considered to be outof-the-money (OTM). When a stock is trading above the strike price of a call option or below the strike price of a put option, the strike is considered to be in-the-money (ITM).

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When a strike is exactly ATM or OTM, the entire value is extrinsic because there is no cash value. Those strikes which are ATM have the greatest amount of extrinsic value because they are the closest to the current stock price and have a higher probability of moving ITM. As the strike price moves ITM, the value of the option premium increases significantly due to the intrinsic (cash) value; however, the amount of extrinsic value decreases. As the strike price moves further OTM, the extrinsic value also decreases significantly even though its entire value is still extrinsic.

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The Time Remaining Until Expiration

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The amount of time remaining until expiration makes up the majority of the extrinsic value of an option. The more time left, the more extrinsic value an option will have. As the expiration date draws closer, the rate at which the time value decays begins to accelerate. This is especially true in the final 45 days of an option’s life.

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The Volatility of the Underlying Stock

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The volatility of the underlying stock will also have a significant impact on an option’s extrinsic value, especially over the short term. The more volatile the stock is, the more expensive the option premiums will be. The increase in premium is caused by the additional extrinsic value being priced into the option on account of a greater volatility and likelihood of the stock making a significant move within the time remaining until expiration, further causing a particular option strike to finish in-the-money.

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There are two measurements of an option’s volatility: historic and implied. Historic volatility is a value derived from the past or historical fluctuations of a stock and does not imply movement in a specific direction. For example, one might look at two stock charts - one that starts at $50 and six months later is at $70, and another that starts at $50 and six months later is trading at $55. At first one might be inclined to think the stock at $70 is more volatile. However, a closer look at what occurred over the last six months will prove otherwise. The first stock has climbed very steadily from $50 to $70, while the second stock has risen as high as $80 and fallen as low as $30 but finished near where it started. Even though the second stock has had very little net change in price, it is clearly more volatile than the first.

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Implied volatility is a value derived from the current market sentiment of the anticipated future fluctuations of the stock. In other words, the option price is increasing based on the speculation of significant fluctuations in the stock price, not actual fluctuations in the stock price.

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Implied volatility is driven by the human emotions of fear and greed. For example, prior to a major announcement such as an earnings report, the emotions of those who are actively trading the stock are heightened by the possible outcome of the event. As speculation mounts, uncertainty increases, causing the implied volatility to spike.

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Exiting an Option Position

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There are several ways one can exit or close an option position. The first (and easiest) way is to sell back the option position on the open market, provided the option still has some value. If the option has no value it will expire worthless and there is no need to exit the position. Selling back a long option position works much like selling back a long stock position. It is sold at the best available bid price.

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The other way a long option position can be closed is by exercising the option. Exercising an option is the right of the option buyer, not the option writer. One would only want to exercise an option if there was intrinsic value and the majority of the time value had decayed. Exercising an option with time value decay would mean the option owner is forfeiting this additional premium when he could realize it as additional profit if he were to sell back the option position on the open market.

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One would only exercise a call option if the stock price was above the strike price he owns. When he exercises the option, he forces the option writer (seller) to sell him the said number of shares in the underlying stock at the strike price. If the option writer doesn't own these shares, he will have to purchase them on the open market at the current ask price and then deliver them to the option owner at the strike price. If the difference between the purchase price and the delivery price (strike price) is greater than the premium he received for writing the option, he will realize a loss.

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One would only exercise a put option if the stock price is below the strike price he owns. When he exercises the option, he forces the option writer to purchase from him the said number of shares in the underlying stock at the strike price. If the option owner doesn't own the shares in the underlying stock, he could either purchase them on the open market below where he owns the right to sell them and then exercise his option, or he could exercise his put option and sell the shares to the option writer and end up short the said number of shares at the strike price.

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An option will usually only be exercised on or near expiration due to the extrinsic value still left in the option premium. If the option owner exercises early, he forfeits the additional premium. Even though options are generally only exercised near expiration date, the possibility of early exercise always exists. If one is short an option, he would need to be aware of what action to take if assigned the position.

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Early Assignment

There are several reasons why an option might be exercised and assigned early. Assignment is the term used for when an option writer is forced to fulfill the terms of the contract because the option owner has exercised his position.

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The first reason is that the option is deep in-the-money and there is very little or no extrinsic value. The second reason is that the stock is ready to pay a cash dividend. Because an option owner is only controlling the stock and has no ownership in the stock, he is not entitled to receive the cash dividend. In order to receive the cash dividend he would need to own the stock before the ex-date (the last day one can own the stock by and still qualify to receive the dividend). Therefore, he may choose to exercise his option to buy the stock so that he will qualify to receive the dividend. The third reason is that the option is not trading at parity. When an option is trading at parity, it is trading for the full intrinsic or cash value. There may be times when the option is actually trading 1/8 or 1/4 point less than full cash value. When this is the case, the option is said to be trading at less than parity. The only way for the option owner to realize the full cash value would be to exercise the option.

py r

Option Greeks

00 8

Co

There are four Greeks that measure how an options premium is affected in relation to changes in the stock price, time until expiration, and the implied volatility. An understanding of these four Greeks will aid in helping one know how a trade will be affected under different market conditions.

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06

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1. Vega - measures the rate of change in an options premium due to changes in the implied volatility. For example, if Vega has a reading of .40, then for each percentage point of change in the implied volatility the option premium will increase by .40 cents. Vega has a greater impact on those strikes which are at-the-money, because any significant movement in the underlying stock (in either direction) will cause either the call or put to move in-the-money. Vega is also affected by how much time is left until expiration. The more time that is left, the greater the Vega. As time passes, Vega decreases until the expiration day when there is no more Vega.

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2. Theta - measures how much value an option premium will lose within a given unit of time. The value lost per unit of time will increase the closer expiration day gets. Understanding when an option premium loses most of its value can assist in limiting and reducing losses due to time value decay, or in realizing a profit from writing option premiums.

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3. Delta - measures the degree of change in an options premium in relation to changes in the underlying stock. Delta is expressed as a value from .00 to 1.00. As an option strike moves further in-the-money, the Delta increases until it reaches its maximum value of 1.00, at which point the option premium will increase in value $1.00 for every $1.00 increase in the underlying stock.

ig ht

The amount of time left until expiration will also affect the Delta. The Delta of those strikes that are deep in-the-money and have very little time until expiration will be at their maximum, whereas the Delta of those strike prices that are at-the-money or out-of-the-money will actually have a higher delta the more time left until expiration.

Co

py r

In theory, Delta says that any call and put option with the same strike price will have an absolute Delta of 1.00. For example, the Delta of an ATM put might be .47 and the Delta of an ATM call might be .53, but the sum of the two is 1.00. Because the Delta can only increase to an absolute value of 1.00 or decrease to an absolute value of .00, the deep ITM strikes and far OTM strikes have already experienced the greatest change in Delta. Therefore, the Delta of the ATM strikes (for both calls and puts) will be the most affected by changes in the underlying stock price.

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-2

00 8

4. Gamma - measures changes in the Delta in relation to changes in the underlying stock. For example, if a particular option has a Delta of .50 and a Gamma of .05, the Delta would change from .50 to .55 if the underlying stock were to rise by $1.00. The Gamma is the greatest for ATM strike prices.

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Buying Calls & Puts

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Chapter 7

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Buying a call or put option by itself is a directional trade and should be used for very bullish or bearish market conditions, or if one is trying to take advantage of a very quick, short-term movement in the underlying stock. The amount of money one commits to directional option trades should fit within the money management guidelines outlined earlier.

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Buying Calls

Trade Synopsis

00 8

Trade Structure

Co

py r

Buying calls is a bullish strategy that allows one to profit if the underlying stock or asset rises. If the stock declines the call option will lose value; however, the total risk is limited to the amount paid for the option. In addition, the long call is subject to losses caused by time value decay, and therefore a call option should only be purchased when one feels the stock or asset is going to assert itself in a fairly significant upward move within the time remaining until expiration.

20

06

-2

Whether one buys an in-the-money, at-the-money, or out-of-the-money strike price will depend on his outlook for the stock. Out-of-the-money calls are cheaper and offer a higher potential return if the stock moves significantly; however, the probability of making a profit is much lower because the stock has to move much further for the strike to move into the money. Many beginning option traders buy out-of-the-money calls because they are the cheapest. This is a mistake. One should not buy a call option just because it appears cheap. It is cheap for a reason.

Buying in-the-money calls is generally a more conservative approach but will require more

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Page 81


capital because one is paying for intrinsic value. The potential percentage returns are also lower because of the higher cost. However, the trade will perform better if the stock rises only moderately.

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Buying at-the-money calls offers a moderately-priced option which still has a significant amount of leverage; however, at-the-money options are the richest in time value premium.

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Example

M

Assume a stock is trading at 89.25 . In the example a 90 strike call is purchased at $4.50 per share.

Long Call

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15

5 0 -5 -10 85

90 95 Stock Price

Co

80

100

105

20

06

-2

00 8

-15

py r

Profit/Loss

10

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Calculations

Cost per share / maximum risk

The cost per share is equal to the ask price for the call option.

Break-Even Point

To calculate the break-even point: 1. Take the strike price. 2. Add to the strike price the cost per share.

Max Reward

The maximum reward in this position is unlimited once the stock surpasses the break even point.

Calculate Profit

To calculate the profit: 1. Take the current stock price and subtract from it the strike price. 2. Then subtract from that result the cost per share. Let’s assume on expiration the stock is trading at $105.

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Definition

90 (strike price) +4.5 (cost per share) = 94.5 (break-even point)

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Risks & Rewards

py r

ig ht

M

105 (current stock price) -90 (strike price) = 15 -4.5 (cost per share) = 10.5 (profit per share)

Co

Note: All calculations are based upon expiration and are figured on a per share basis. To figure the totals of any of the per share calculations, simply multiply by the total number of shares.

3 Key Components in Determining the Trade’s Profit/loss

00 8

The three key components in determining any trades profit/loss are:

-2

1. Changes in the stock price 2. Time value decay 3. Changes in the implied volatility

Changes in the Stock Price

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06

In order for a long call to become profitable by expiration, the stock needs to be trading above the strike price purchased by more than the cost of the option. Therefore, a reasonable increase in stock price is critical to the trade becoming profitable.

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Page 83


Time Value Decay

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Because one is paying extrinsic value in addition to the intrinsic value, time decay works against a call buyer. A call option will experience value loss in the final 45 days of its life the majority of the time. Changes in the Implied Volatility

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The higher the implied volatility, the more expensive the call option will be. The lower the implied volatility, the less expensive it will be. If after purchasing a call option the implied volatility picks up, the value of the call will increase. Conversely, if the implied volatility is high when the call is purchased and then bleeds-off, then the position will lose value.

ig ht

Strategy Applications

py r

When buying calls, the most important factor in determining the profitability of the trade is the upward movement of the underlying stock or asset. Therefore, it is best to buy calls when one expects a strong upward move in the stock.

00 8

Co

In addition to identifying good buying opportunities, one should also determine a time frame for the trade. For example, the closest expiration month (front month) in-the-money strikes will most closely follow the price movement of the stock. Therefore, it has a greater reward potential than the longer-term in-the-money calls which have more extrinsic value. The time frame chosen should match one’s estimation of how long it will take for the stock to reach the price target.

20

06

-2

Our preferred method of trading long calls is when we expect a trend reversal to the upside, but want to limit the total amount of capital at risk. This can either be because we feel there may be a little more downside before the stock actually reverses, or it is just a higher risk trade. When we buy a long call, we prefer to only commit the amount of money we are willing to risk on any given trade and let the trade act as its own stop loss. This makes managing the trade easier and reduces commission costs on losing trades.

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Helpful Hints

1. If one is only looking to take advantage of a quick, short-term movement in the stock (swing trade), then a front month in-the-money option is probably the best choice since it will be the most sensitive to the stock’s movement.

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2. The deeper in-the-money the call option is, the less extrinsic value it holds. Therefore, it more closely resembles owning the stock itself and the position is mostly subject to cash value or intrinsic losses, rather than time decay losses.

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Follow-up Action

py r

Because we only commit what we are willing to lose in a long call play, we let the trade act as its own stop loss so there is no need for follow up action. However, because others may prefer to trade options differently, we have included several methods for adjusting the trade.

Stock Drops

Co

If the stock drops, one can sell the call for its current market value and cut his losses. This is probably the best choice when a stock has broken a technical support area.

00 8

The second choice is to "roll down" the trade into a bull spread. To do this, one would sell back his original long position and sell short another call option at this strike price. He simultaneously buys a lower strike call option with the money received for selling the two higher strike call options. By “rolling down”, one lowers the break even point moving it closer to the current stock price.

-2

Stock Rallies

20

06

If the stock rallies, then one can sell his call for a profit or sell half the position and continue to hold the other half for further profits. One can also "roll up" the trade. To roll up the trade one sells back his current position and uses some of the profits to buy a higher strike call option. This should only be done when one feels the stock still has significant upside potential.

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The third option is to create a risk-free bull call spread by selling a higher strike call against the lower strike call. This can eliminate all or most of the risk in the trade, while still maintaining a tremendous profit potential.

Stock Stagnates

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If the stock stagnates, one should exit before the loss from time value decay becomes too large, unless he is only risking the maximum allowable risk per trade, then he can continue to hold the trade if he chooses.

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Buying Puts

Trade Synopsis

Co

py r

Buying puts is a bearish strategy that profits if a stock declines in value. Many traders will buy puts in place of shorting stocks because the maximum risk is limited to what was paid for the put option. A put will lose value if the stock rises and is also subject to losses due to time value decay.

Trade Structure

00 8

Whether one buys an in-the-money, at-the-money, or out-of-the-money strike price will depend on his outlook for the stock. Out-of-the-money puts are cheaper and offer a higher potential return if the stock moves significantly; however, the probability of making a profit is much lower because the stock has to move much further for the strike to move into the money.

06

-2

Buying in-the-money puts is generally a more conservative approach but will require more capital because one is paying for intrinsic value. The potential percentage returns are also lower because of the higher cost. However, the trade will perform better if the stock declines only moderately.

20

Buying at-the-money puts offers a moderately priced option which still has a significant amount of leverage; however, at-the-money options are the richest in time value premium.

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Example

ig ht

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Suppose the ABC company’s stock is trading at $200 a share and the 200-strike put is trading for 9.75 bid and 10 ask. The 200-strike put is purchased for the ask price of $10 per share.

Long Put 20 15

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Profit Loss

10 5 0 -5

Co

-10 -15

170

180

190

200 210 Stock Price

220

230

20

06

-2

00 8

-20

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Page 87


Definition

Calculations

Cost / maximum risk per share

The cost per share is equal to the ask price of the put option.

Max reward per share

Technically, because a stock can’t fall below zero there is a limit to the maximum reward. The maximum reward is, however, very significant once the stock drops below the break-even point.

Break-Even Point

To calculate the break-even point: 1. Take the strike price. 2. Subtract from that figure the cost per share.

200 (strike price) -10 (cost per share) = 190 (break-even point)

Calculate Profit

To calculate the profit: 1. Take the strike price and subtract from it the current stock price. 2. Subtract from this result the cost per share. Let’s assume on expiration the stock is trading at $170.

200 (strike price) -170 (current stock price) = 30 -10 (cost per share) = 20 (net profit per share)

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Risks & Rewards

Co

Note: All calculations are based upon expiration and are figured on a per share basis. To figure the totals of any of the per share calculations, simply multiply by the total number of shares.

00 8

3 Key Components in Determining the Trades Profit/loss

The three key components in determining any trades profit/loss are:

20

06

-2

1. Changes in the stock price 2. Time value decay 3. Changes in the implied volatility

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Page 88


Changes in the Stock Price

LL C

In order for a long put to become profitable by expiration, the stock needs to be trading below the strike price purchased by more than the cost of the option. Therefore, it will require a reasonable downward move in the underlying stock.

HI ,

Time Value Decay

Changes in the Implied Volatility

ig ht

M

Because one is paying extrinsic value in addition to the intrinsic value, time decay works against a put buyer. A put option will experience value loss in the final 45 days of its life the majority of the time.

py r

The higher the implied volatility, the more expensive the put option will be. The lower the implied volatility, the less expensive it will be. If after purchasing a put option the implied volatility picks up, then the value of the put will increase. Conversely, if the implied volatility is high when the put is purchased and then bleeds-off, the position will lose value.

Co

Strategy Applications

00 8

When buying puts, the most important factor in determining the profitability of the trade is the downward movement of the underlying stock or asset. Therefore it is best to buy puts when one expects a strong downward move in the stock.

20

06

-2

In addition to identifying good buying opportunities, one should also determine a time frame for the trade. For example, the closest expiration month (front month) in-the-money strikes will most closely follow the price movement of the stock. Therefore, it has a greater reward potential than the longer-term in-the-money puts which have more extrinsic value. The time frame chosen should match one’s estimation of how long it will take for the stock to reach the price target.

Copyright Š 2007 MHI, LLC., All Rights Reserved Reproduction in any form without expressed written consent is prohibited.

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Our preferred method of trading long puts is when we expect a trend reversal to the downside, but want to limit the total amount of capital at risk. This can either be because we feel there may be a little more upside before the stock actually reverses, or it is just a higher risk trade. When we buy a long put, we prefer to only commit the amount of money we are willing to risk on any given trade and let the trade act as its own stop loss. This makes managing the trade easier and reduces commission costs on losing trades.

HI ,

Helpful Hints

M

1. If one is only looking to take advantage of a quick, short-term movement in the stock (swing trade), then a front month in-the-money option is probably the best choice since it will be the most sensitive to the stock’s movement.

ig ht

2. The deeper in-the-money the put option is, the less extrinsic value it holds. Therefore, it more closely resembles shorting the stock itself and the position is mostly subject to cash value or intrinsic losses, rather than time decay losses.

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3. The extrinsic value of an in-the-money put disappears more quickly than the extrinsic value of an in-the-money call option. Therefore, if you have written an option it is at risk of assignment, regardless of how much time is remaining until expiration.

Co

Follow-up Action

-2

Stock Drops

00 8

Because we only commit what we are willing to lose in a long put play, we let the trade act as its own stop loss so there is no need for follow-up action. However, because others may prefer to trade options differently, we have included several methods for adjusting the trade.

06

If the stock drops in value, one can sell the put for a profit or sell half the position and continue to hold the other half for further profits.

20

One can also "roll down" the trade by selling back the original long put position and buy a lower strike long put with some of the profits. This should only be done if one feels that the stock still has the potential to continue to decline.

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The third adjustment is to create a risk-free bear spread by selling a lower strike put against the original long put position. This allows one to eliminate all or most of the risk and continue to hold the trade and realize a profit as long as the stock finishes below the break-even point.

Stock Rallies

HI ,

If the stock rises in value, one can sell back the long put for its current market value and cut his losses. This is probably the best choice if the stock has penetrated a technical resistance level.

ig ht

M

The other choice is to "roll up" the trade into a bear put spread. To roll up the trade one would sell back the original long put position and sell short another put position at this strike price. One would then take the proceeds from this transaction and buy an even higher strike long put. The final position is a bear put spread. Rolling up the trade moves the break even point closer to the current stock price.

Stock Stagnates

20

06

-2

00 8

Co

py r

If the stock stagnates, one should exit before the loss from time value decay becomes too large - unless he is only risking the maximum allowable risk per trade, in which case he can continue to hold the trade if he chooses.

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LL C HI , M ig ht py r Co 00 8 -2 06 20 Copyright Š 2007 MHI, LLC., All Rights Reserved Reproduction in any form without expressed written consent is prohibited.

Page 92


Hedged Stock Trades

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Chapter 8

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Now that you understand both buying and shorting stock as well as buying calls and puts, we will now look at how to hedge stock positions using options. These strategies are designed to protect long-term stock holdings from significant losses and or create monthly cash flow from existing stock positions.

Protective & Married Put

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Trade Synopsis

py r

Buying put options in conjunction with stock ownership is a way to insure stock holdings. It's like buying insurance on a home or an automobile. If the stock declines in value beyond a certain point, the put option will begin to earn one dollar for every dollar the stock loses. This offsetting profit in the put option provides a hedge against the losing long stock position.

00 8

Co

A premium must be paid for this protection just like an insurance premium. The premium will cut into the upside profit potential of the stock somewhat over just buying the stock; however, it is minimal - especially when compared to the downside protection a put offers. This will be demonstrated during the section on calculations. A put option can be purchased simultaneously with the stock and is called a married put. If one buys put options as protection or to lock in profits after the stock has been purchased, it is called a protective put. Using a married put allows one to trade on margin without the risk of receiving a margin call.

-2

Trade Structure

20

06

A protective/married put consists of buying the stock and buying a put to protect that stock. One put contract per 100 shares in the underlying stock needs to be purchased, otherwise some of the shares will be unprotected. Usually a slightly out-of-the-money put is purchased since it will be cheaper, however there is not as much protection as an at-the-money put. Regardless of the strike purchased, the protection only lasts for the life of the put option. A long call can be purchased to hedge a short stock trade in much the same way. However, we will only cover hedging a long stock trade.

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Example

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Buy 100 shares of stock at $80 per share. At the same time buy one contract of the 75 strike put which is trading at $3.50 bid, $3.75 ask.

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M

Risk graph of a Protective Put

4 month 75 strike protective put

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15

5

Co

Net profit/loss

10

0

00 8

-5

65

70

75

80 85 Stock price

90

95

20

06

-2

-10

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Page 94


Definition

Calculations

Total cost per share

To calculate the cost per share: 1. Take the cost of the stock per share and add to that cost the cost per share for the put.

80 (stock price) +3.75 (put price per share) = $83.75 (cost per share) or ½ if on margin

Max reward per share

The maximum reward for this trade is unlimited once the stock passes the break-even point.

Max risk per share

To calculate the maximum risk: 1. Take the initial stock price per share and subtract from it the strike price of the put. 2. Add to that result the cost of the put per share.

Break even point

To calculate the break-even point, take the initial stock price per share and add to it the cost of the put per share.

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Risks & Rewards

ig ht

M

80 (initial stock price) -75 (put strike) =5 + 3.75 (cost of put per share) = 8.75 (max risk per share)

py r

80 (initial stock price) +3.75 (put price per share) = 83.75 (break-even point)

Co

Note: All calculations are based upon expiration and are figured on a per share basis. To figure the totals of any of the per share calculations, simply multiply the per share result by the total number of shares.

00 8

3 Key Components in Determining the Trade’s Profit/loss

The three key components in determining the trade’s profit/loss are:

20

06

-2

1. Changes in the stock price 2. Time value decay 3. Changes in the implied volatility

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Changes in the Stock Price

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In order for a protective/married put to become profitable, the stock must move up beyond a certain point because an extra premium was paid for the insurance. If the stock declines, a loss will be realized. However, the loss is limited to a pre-defined amount that is much smaller than what would have been lost had the stock declined beyond a certain point without the hedge.

Time Value Decay

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M

Time value decay will affect the put option but not the stock. Because a premium has been paid for the put option, it will eat into some of the profits that could have been realized had the put not been purchased.

Changes in the Implied Volatility

Co

py r

Changes in the implied volatility will directly affect the price of the put option but will have no direct affect on the stock price. Therefore, it has very little affect on the profitability of the trade. However, if the implied volatility increases it indicates that the market feels the stock is more likely to make a significant move, which makes hedging the position even more important.

Strategy Applications

00 8

The married/protective put should be used for a fairly bullish outlook since there is a minimum movement required in the underlying stock in order to break-even and cover the extra insurance costs. Because the profit is derived from an upward movement in the stock, the strategy is generally an intermediate to longer-term trade, usually three to six months or longer.

20

06

-2

A protective/married put can really be applied to any popular stock buying strategy, whether it is buying breakouts or bottom fishing. Regardless of the buying signal one uses, the strategy is generally a longer-term trade/investment where one plans on holding the position for a longer time frame in an attempt to catch a larger move in the stock. Having the put in place allows one to enter the trade/investment without requiring him to constantly be watching the position. A protective put also allows one to protect and lock-in profits on any long stock positions he may already have.

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Helpful Hints

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Buying at-the-money puts will be more expensive than out-of-the-money puts because they have the greatest amount of extrinsic value. The more expensive premiums will also eat into the profits more than out-of-the-money puts; however, the protection will be greater than buying out-of-the-money puts. The further out-of-the-money one buys, the more it becomes a “disaster only” type of protection. In addition, one is at greater risk of receiving a margin call if he is trading on margin and the puts are far out-of-the-money.

M

Follow-up Action

20

06

-2

00 8

Co

py r

ig ht

If the stock rises significantly early on in the trade, then the put option will still hold some extrinsic value. If the stock appears as though it will continue to rise, the put option could be sold to recover some of the premium that was paid. If one wants to continue to protect the stock, he could sell back the initial put and with that premium buy a higher strike put for either the same time frame or for a shorter time frame. This would lock in some of the profits. One would want to make sure the cost for the new put position doesn't exceed the profit in the stock or it will only increase the cost basis in the trade.

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Covered Call

Trade Synopsis

M

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Writing covered calls is a strategy where a stock owner either sells calls against an alreadyexisting stock position or establishes the covered call simultaneously as a multiple position trade. A covered call can offer both downside protection on the stock as well as upside profit potential. One should have a neutral to mildly-bullish outlook when establishing the trade. A covered call limits the upside profit potential; therefore, if one is fairly bullish on a particular stock or asset, then a covered call would not be the ideal strategy.

py r

ig ht

There are basically two types of covered calls: an in-the-money covered call and an out-of-themoney covered call. Deciding which one to use depends upon the outlook for the stock, and whether one wants more upside profit potential with less downside protection, or more downside protection and less upside profit potential. We will discuss both types of covered calls.

Trade Structure

00 8

Co

The trade consists of shorting one call contract for every 100 shares owned in the underlying stock. Shorting calls as a single position strategy has unlimited risk if the stock rises. However, shorting calls against stock that is owned has no risk if the stock rises. In fact, many times having the stock called away (the stock rises above the strike price of the short call and the position is assigned) is more profitable. The covered call does, however, have significant risks if the stock declines. The risk is equal to the entire value of the stock minus the premium received for selling short the call contract.

20

06

-2

The covered call strategy is looked at by the investing community as a fairly conservative strategy. However, the covered call has the same risk profile as selling naked puts, which is looked at as a very high risk strategy. The difference is that in a covered call the trader has actually put up the capital to purchase the stock; whereas, if he is selling naked puts he has probably only put up the minimum collateral requirement. This is not meant to discourage covered call writing, otherwise the strategy wouldn’t be covered. It is meant to inform traders about the risks involved in writing covered calls.

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Example

The first example is of an in-the-money covered call. Let’s assume that XYZ Company is currently trading at $55, the XYZ October 60 call is selling for $1.75, and the XYZ October 50 call is selling for $9.25. Let’s look at an example for 5 contracts of each covered call.

ig ht

M

HI ,

Risk graph of an In-the-Money Covered Call

ITM Covered Call

Buy stock at $55, short 50 strike call

py r

5 0

Co

Net Profit/Loss

10

-5

00 8

-10

45

55 50 Stock Price

60

65

20

06

-2

40

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Page 99


Definition

Calculations

Cost per share

To calculate the net cost per share: 1. Take the current stock price. 2. Subtract from that figure the credit per share for selling the 50 strike short call.

55 (current stock price) -9.25 (bid price of 50 strike call) = $45.75 (net cost per share)

Maximum gain per share

To calculate the maximum gain per share: 1. Take the current stock price and subtract from it the strike price of the in-the-money short call. 2. Subtract this result from the premium received for selling the in-themoney short call.

55 (current stock price) -50 (ITM short call) =5

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M

9.25 (premium from short call) -5 =4.25 (max gain per share)

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To figure the break-even point: 1. Take the current stock price. 2. Subtract from this figure the credit received for selling the in-the-money short call.

55 (current stock price) -9.25 (credit short call) = $45.75 (break-even point)

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Break even point

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Risks & Rewards

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Note: All calculations are based on expiration and are figured on a per share basis. To figure the totals of any of the per share calculations, simply multiply the per share result by the total number of shares.

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OTM Covered Call Buy stock at $55, short 60 strike call

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Stock Price

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Net Profit/Loss

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Risk graph of an Out-of-the-Money Covered Call

Definition

Cost per share

To calculate the net cost per share: 1. Take the current stock price. 2. Subtract from that value the credit per share for selling the 60 strike short call.

55 (current stock price) -1.75 (bid price of 60 strike call) = $53.25 (net cost per share)

To calculate the maximum gain per share: 1. With a OTM covered call, take the OTM strike price sold. 2. Subtract from it the cost per share.

60 (higher OTM short call) -53.25 (net cost per share) = 6.75 (max gain per share)

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Risks & Rewards

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Maximum gain per share

Calculation

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Page 101


To calculate the break-even point: 1. Take the current stock price. 2. Subtract from that value the credit received for selling the out-of the-money short call.

55 (current stock price) -1.75 (credit short call) = $53.25 (break-even point)

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Break-even point

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3 Key Components in Determining the Trade’s Profit/loss

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Note: All calculations are based upon expiration and are figured on a per share basis. To figure the totals of any of the per share calculations, simply multiply the per share result by the total number of shares.

1. Changes in the stock price 2. Time value decay 3. Changes in the implied volatility

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Changes in the Stock Price

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The three key components in determining the trade’s profit/loss are:

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If the stock increases, it will affect the profitability of an OTM covered call but will have very little affect on an ATM or ITM covered call since the profit in both is derived from the short call. A downward movement in the underlying stock will have a negative impact on the profit/loss of any covered call.

Time Value Decay

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All or part of the trade’s profit is derived from the short call expiring worthless; therefore, time value decay is critical to the trade’s profitability.

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Changes in the Implied Volatility

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A covered call is best employed when the implied volatility is trading at higher than normal levels. This allows more expensive call option premiums to be sold allowing for greater profits.

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If a covered call is written and the implied volatility increases, it won’t directly affect the profitability of the trade unless one wants to maintain ownership of the stock and has to buy back the written call at a higher price because of the increase in the implied volatility. The other negative aspect of an increase in the implied volatility is that the market is assessing a greater likelihood of a significant move one way or another, which could hurt the trade if that move was down.

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If the implied volatility decreased after the position is established, it would benefit the trade in two ways. First, it indicates the market is assessing a lower likelihood of the stock making a significant move in either direction. Second, it would make maintaining ownership of the stock easier, since the short call position could be bought back at a cheaper price than what it was sold for.

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Strategy Applications

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In theory, a covered call strategy can be used as a hedge, much the same way a put is used. On a down-trending stock, one could month after month sell an at-the-money or slightly in-themoney call option to recoup most of the loss caused by the declining stock. Even though this works in theory, it is not recommend to use the strategy in this way.

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The strategy can be used in many ways. It can help recover losses on long-term stock positions. When selling calls against stock positions that one wants to retain, the trades always need to be monitored so the short position can be bought back if it looks as though the stock will be called away. The short position can usually be bought back at a discount to what it was originally sold for since time decay should have significantly eroded the option’s premium.

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Another way to use the strategy is to simply create cash flow on already existing stock positions. Calls can be written against any stock that has options traded on it. If the options expire worthless and the stock is never called away, one could continue to take in monthly cash flow in the way of option premiums on stocks they were going to continue to hold anyway. This lowers the cost basis in the stock and further reduces the risk exposure.

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Helpful Hints

1. The more volatile the stock, the higher the potential returns are; however there may be more risk involved since a more volatile stock is more likely to fall in price. One needs to balance potential returns with potential risk.

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2. The deeper in-the-money the short call is, the more downside protection the trade offers; however the upside potential is less than an out-of-the-money covered call.

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3. One should own 100 shares in the underlying stock for each option contract sold short, otherwise some of the short call positions will be naked.

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4. The more shares purchased in a covered call, the greater the overall percent return will be because commission costs on a per share basis will be less, the larger the position.

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5. If writing covered calls on margined stock, it is important to understand that even though the broker is putting up half the money, the entire risk belongs to the trader. If using margin, a collar trade (which will be covered later) may be a better alternative.

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Follow-up Action

Stock Drops

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Option 1. If the stock drops in price, one can close the position by selling back the stock and buying back the short call. This is the best follow-up action to take should the stock break through a technical support level.

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Option 2. The second follow up action is to "roll down" the trade. To do this, one would buy back the original short call position, usually at a profit since it is cheaper than when it was originally sold. One then sells a call option with a lower strike price. Rolling down offers more downside protection against further declines in the stock price and can even produce additional profits if the stock stabilizes. If a reversal to the upside is expected, rolling down would not be the best option since it would limit the upside profit potential.

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Stock Rises

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Option 1. The simplest thing to do if the stock rises in value is to just let the stock be called away (option buyer exercises their rights and assigns you the option). This way, the covered call writer would realize the entire profit potential of the trade.

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Option 2. The second option is to "roll up" the trade. In “rolling up” the trade, the covered call writer buys back the original short call position and sell a higher strike call position. This significantly increases the upside profit potential. The trade-off is that it requires additional cash be deposited into the position, raises the break-even point by the new debit amount, and reduces the downside protection. In order to reduce the new debit amount one can “roll out” the expiration date, selling more time premium, in addition to “rolling up” the trade.

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Stock Stagnates

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If the stock stagnates, or rises slightly and the original short call expiration is near, one could let the short call expire worthless and then sell the stock, or choose to "roll forward" by selling short another call option with more time until expiration.

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If the original short call is slightly in-the-money and one wants to maintain stock ownership, he would need to buy back the original short position. The best time to close the original short call position is when there is no time value left in the option. One could simultaneously roll forward and establish a new longer-term short call position. This would further reduce his cost basis in the trade and lower the break-even point.

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Collar Trade

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Trade Synopsis

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A collar trade is the combination of a protective put and covered call strategy. Given the right market conditions and provided the trade is set up correctly, the collar trade can be a no-risk trade, and sometimes even have a guaranteed return. The collar trade allows one to trade on margin without the risk of receiving a margin call.

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In a collar trade the maximum profit is realized if the stock rises enough and is then called away. In the event that the stock stagnates or declines, a small profit can still be realized if the trade has been structured properly. Because the trade reduces or eliminates the risk of holding the stock, some of the upside potential will be sacrificed. However, given the right market conditions a collar trade can still offer annual returns of 10% to 20%, depending on whether margin is being used.

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Trade Structure

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A collar trade consists of owning the underlying stock, selling an out-of-the-money call option (usually a LEAPS option), and at the same time buying an at-the-money or slightly out-of-themoney put option (usually a LEAPS).

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Because the call option sold is more expensive than the put option purchased, this part of the transaction will create a credit. The overall trade is still a debit trade because the stock is also purchased and requires more capital.

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For our purposes in explaining this strategy we will only cover how to establish the trade so there is virtually no risk. However, the trade can be established with a maximum risk and a maximum reward. In fact, the trade profile of such a position is identical to a bullish vertical spread.

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Why and When to Use the Strategy

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The market conditions will dictate whether opportunities are available to place collar trades that offer good upside potential and still allow the trade to be structured with virtually no risk. In order to have a risk-free trade, the call option needs to be priced substantially higher than its put option counterpart. This is especially true since the call option being sold is further out-of-themoney than the put option being purchased. It is usually easier to find higher priced call options during higher interest rate markets.

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During strong bull markets, many investors like to buy the market leaders. The challenge in doing so is determining whether the market leaders are currently overextended and ready to make a significant correction, or if they are going to keep on rising. The collar trade allows a trader/investor to buy the market leaders and participate in the profits if they do continue to rise, but without the risk if they suddenly drop.

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Example

80-90 collar trade, stock at $82.50

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Net profit/loss

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Buy 100 shares of stock at $82.50; buy 1 contract 80 strike put $5.25 bid, $5.50 ask; sell short 1 contract 90 strike call $8.50 bid, $8.75 ask.

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Definition

Cost of trade per share

To calculate the cost/credit per share: 1. Take the bid price for selling the OTM call and subtract from it the ask price for buying the ATM or OTM put. 2. If the result of step 1 is a positive number, subtract it from the cost of the stock per share. If the result of step 1 is a negative number, add it to the cost of the stock per share.

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Calculation 8.50 (credit for OTM call) -5.50 (debit for ATM put) = 3.00 (credit per share) $82.50 (cost of stock) -$3.00 (credit per shares) = $79.50 (cost of trade per share)

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Risks & Rewards

95

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Page 108


Definition

Calculation

Maximum risk/ minimum reward per share

To calculate the maximum risk or minimum reward: 1. Take the credit for selling the call and subtract from it the debit or cost for buying the put. 2. Subtract from this result the initial stock price. 3. Add the strike price of the put to that result. If the resulting value is a positive number, the trade offers a minimum reward. If the resulting value is a negative number, the trade has a maximum risk.

8.50 (credit for OTM call) -5.50 (debit for ATM put) = 3.00 (net credit per share)

Maximum gain per share

To calculate the maximum gain per share: 1. Take the strike price of the call and subtract from it the strike price of the put. 2. Add to this result the minimum reward per share if it is a positive value or subtract the maximum risk per share if it is a negative value.

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Risks & Rewards

90 (call strike price) -80 (put strike price) = 10 10 +.50 (min reward per share) = 10.50 (max gain per share)

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3.00 -82.50 (initial stock price) = -79.50 +80 (put strike price) = .50 (min reward per share)

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Note: All calculations are based upon expiration and are figured on a per share basis. To figure the totals of any of the per share calculations, simply multiply the per share result by the total number of shares.

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Strategy Applications

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This strategy can be used anytime a no-risk trade can be structured, provided the outlook for the stock is bullish. Otherwise, the trade will tie up capital that could be invested elsewhere. In order to create a no/low risk trade, one needs to identify out-of-the-money call options that are either trading for more or at least equal to the at-the-money or slightly out-of-the-money put options. It is easier to find these types of trades on longer-term time frames using LEAPS. The maximum profit potential is realized when the stock rises beyond the short call position and the stock is called away.

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Helpful Hints

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1. The put strike price purchased and call strike price sold will impact the maximum and minimum rewards possible in the trade. Buying at-the-money puts and selling at the money calls limits the risk and locks in a greater minimum reward if the stock stagnates or moves up only slightly, but lowers the maximum reward potential. Buying out-of-the-money puts and selling out-of-the-money calls increases the risk as well as the maximum reward potential if the stock rises, but lowers the minimum reward potential if the stock stagnates.

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Follow-up Action

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If the stock declines in price, on expiration day the put contract can be exercised forcing the put writer to buy the said number of shares at the strike price of the put option. This helps recover the loss in the stock. Any net credit left over from the call and put transaction is a profit.

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Another option is to sell back the put option for its intrinsic value which will recover most (if not all) of the loss in the stock. He can then continue to hold the stock for a rebound. The out-ofthe-money call option would expire worthless. This should only be done if one feels strongly that the stock has found a bottom.

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If the stock is trading somewhere between the call and put strike prices, both option positions will expire worthless and the net credit received from the call and put transaction is a profit. There may also be additional profit if the stock is trading above the initial purchase price.

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Glossary of Terms

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All or none. A requirement placed on an order that it must be completely filled or not at all filled. Asked price. The lowest price a seller is willing to accept for a stock, option, or other asset.

Bear. Someone who likes to play a declining market.

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Bearish. An outlook of lower prices in the underlying asset.

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At-the-money. When an asset is trading at the same price as the exercise price (strike price) of an option, it is said to be at-the-money.

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Bear call spread. A strategy that involves the purchase of a higher strike call option and the sell of a lower strike call option for the same expiration month. The strategy is designed to produce a profit if the underlying asset declines in price. Bear put spread. A strategy that involves the purchase of a higher strike put option and the sell of a lower strike put option for the same expiration month. The strategy is designed to produce a profit if the underlying asset declines in price.

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Bearish time spread. A strategy that involves the purchase of an out-of-the-money longer term option and the sell of an out-of-the-money shorter term option for the same expiration month. Bid price. The highest price a buyer is willing to pay for a stock, option, or other asset.

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Bid/ask spread. The difference between the bid and ask price for a particular asset. Bollinger Bands. Developed by John Bollinger, this indicator plots bands two standard deviations above and below a 20 period moving average. The upper band often acts as resistance while the lower bands often acts as support.

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Bull. Someone who likes to play a rising market. Bullish. An outlook of higher prices in the underlying asset.

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Bull call spread. A strategy that involves the purchase of a lower strike call option and the sell of a higher strike call option for the same expiration month. The strategy is designed to produce a profit if the underlying asset increases in price.

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Bull put spread. A strategy that involves the purchase of a lower strike put option and the sell of a higher strike put option for the same expiration month. The strategy is designed to produce a profit if the underlying asset increases in price.

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Buy to open. A purchase transaction where one opens a new long position in the underlying asset or listed options.

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Page 111


Buy to close. A purchase transaction where one buys back and closes an existing short position in the underlying asset or listed options.

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Calendar spread (also time spread). A strategy that involves the purchase and sell of an option with the same strike price and different expiration months. The strike price involved is usually at-the-money and can be done with either calls or puts.

Call. An option contract that gives its owner the right to buy 100 shares in the underlying asset at a fixed price (strike price) on or before a specific date (expiration date).

Closing price. The price of an asset at the last transaction of the day.

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Called away. When an option writer is required by the terms of the contract to surrender the underlying asset to the option owner (buyer) at the strike price of the written call.

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Collar trade. A strategy consisting of buying shares in the underlying asset while simultaneously purchasing and equivalent number of put contracts as a hedge and writing an equivalent number of call contracts to offset all or part of the cost of the put contracts.

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Contract. An agreement between an option buyer and option writer guaranteeing the option buyer the right to buy a certain number of shares in the underlying asset on or before a specific date at a specified price in the contract (strike price). If the option buyer exercises his right, the option writer is legally bound by the contract to fulfill the terms. Covered call write. A strategy consisting of writing call option contracts equivalent to the number of shares owned in the underlying asset. The written calls offer a limited hedge against a decline in stock price.

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Credit spread. A strategy whereby one receives a credit into his account upon entry into the spread. Credit trade. A trade whereby one receives a credit into his account upon initiating the trade. Convergence. The point of converging; a meeting place.

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Correction. When the price declines after it has rallied.

Day order. A limit order that is only good for the day it is placed. If it is not executed on that day, the order is automatically canceled.

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Debit spread. A strategy whereby one pays money out of his account upon entry into the spread. Debit trade. A trade whereby one pays money out of his account upon initiating the trade. Delta. Measures the degree of change in an option premium in relation to changes in the underlying asset.

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Diagonal bear spread. A strategy consisting of purchasing a longer term higher strike put option and simultaneously selling a shorter term lower strike put option. The strategy is designed to profit from a decline in the asset’s price.

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Diagonal bull spread. A strategy consisting of purchasing a longer term lower strike call option and simultaneously selling a shorter term higher strike call option. The strategy is designed to profit from a rise in the asset’s price.

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Discount broker. A broker offering basic order fulfillment services for a much lower commission rate. Divergence. The act of diverging. Efficacy. Power or capacity to produce a desired effect, effectiveness. Execution. The completion of a buy and sell order on the exchange floor.

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Exercise. When an option owner (buyer) decides to purchase or sell the said number of shares at the strike price. Exercise price. See strike price.

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Expiration day. The last day on which an option may be exercised. The expiration date is the Saturday following the third Friday of the month for which it is written. However, options cease trading on the third Friday and must be exercised or closed on this day, otherwise they expire worthless.

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Extrinsic value. Any value in an option premium over and above the intrinsic value. Full-service broker. A broker who provides information, investment research, and advice in exchange for a higher commission rate. Fundamental analysis. A valuation of an asset based on earnings, price/earnings ratio, price/book value etc.

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Gamma. Measures changes in the delta in relation to changes in the underlying stock. Good-till-canceled order. A limit order that remains on the books of the exchange trading floor until executed or canceled.

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Historic volatility. A value derived from the past or historic fluctuations of an asset. Implied volatility. A value derived from the current market sentiment of the anticipated future fluctuations of the asset.

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Index option. A listed option on a stock index or industry group index. In-the-money. An option with intrinsic or cash value. A call is in-the-money when the strike price is below the current stock price. A put option is in-the-money when the strike price is above the current stock price. Intrinsic value. The cash value realized if the option is exercised.

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LEAPS. An acronym for Long term Equity Anticipation Securities. LEAPS are call or put options with expiration dates at least 9 months out and as far out as 2 and ½ years. LEAPS contracts also represent 100 shares in the underlying asset and when a LEAPS contract has less than 9 months it converts into a regular listed option.

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Limit order. An order to buy at or below or sell at or above a specified price known as the limit price. Limit orders guarantee the price at which an order is filled provided that price is hit by the underlying asset.

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Limited risk. An investment in which the maximum loss cannot exceed a predetermined amount. Liquidity. The ease with which a buy or sell order can be placed without changing existing market prices.

Listed options. Options traded on an exchange that have an active secondary market and can be traded without exercise.

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Market maker. Those who create the liquidity in the options market by maintaining the best bid and ask price on the floor of an option exchange. Market makers compete with each other to provide the best bid/ask price. Married put. A strategy that consists of buying shares in the underlying asset while simultaneously purchasing an equivalent number of put contracts as a hedge against downward movement.

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Naked writing. When one engages in selling an option without first owning it, owning shares in the underlying asset, or owning another option position on the same asset to hedge the naked position.

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Neutral spread. A spread strategy that is designed to profit from time value decay rather than stock price movement. Offering price. (See also asked price). The lowest price a seller is willing to accept for a stock, option, or other asset. Open interest. The number of outstanding option contracts on a particular option strike price. The greater the open interest the more liquid that strike price is.

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Opportunity cost. The cost one pays to participate in an investment opportunity based on current interest rates. Option. A contract that gives the holder the right to buy or sell a number of shares (usually 100) in the underlying asset at a fixed price (strike price) on or before a specific date (expiration date).

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Options Clearing Corporation, The. The issuer of all option contracts traded on any option exchange. Option exchange. Any market where option contracts are traded, they include: American Stock Exchange, Chicago Board Options Exchange, Pacific Stock Exchange, and Philadelphia Stock Exchange.

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Options pricing model. A method used to determine an options value based on the price of the underlying asset, the strike price, the amount of time until expiration, the volatility of the underlying asset, any dividends to be paid out during the life of the option, and the current risk free interest rate. The model assumes that stock price movement is random. There are several option pricing models based on these factors; the most widely used is the Black Scholes model.

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Option writing. The process whereby one opens a new option contract and receives the option premium in exchange for guaranteeing fulfillment of the terms of the contract should the option owner decide to exercise.

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Order. An instruction to purchase or sell an asset, first sent to a brokerage office and then in turn sent to the exchange floor for execution.

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Oscillators. Indicators that plot the movement of an asset’s price relative to an assumed cycle of highs and lows. Out-of-the-money. An option with a strike price that is above the current asset’s price in the case of a call option or below the current asset’s price in the case of a put. These options have no intrinsic (cash) value and are made up entirely of extrinsic value. Overbought. A condition in which the stock has reached a cycle high and is more likely to decline in price than continue to rise in price.

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Oversold. A condition in which the stock has reached a cycle low and is more likely to rise in price than continue to decline in price.

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Platform. Trading platform - the layout of quotes, charts, and order entry screens that allow one to trade online. Position. The establishment of a new opening transaction in an underlying asset or its listed options.

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Premium. The price paid by a buyer and received by a seller to guarantee fulfillment of the terms of the contract. Premiums are quoted on a per share basis and are usually greater than the intrinsic value due to the time and volatility value. Protective put. A strategy that consists of being long the underlying asset and then purchasing an equivalent number of put contracts to hedge the position from downward movement.

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Put. An option contract that gives its owner the right to sell a certain number of shares (usually 100) at a fixed price (strike price) on or before a specific date (expiration date). Rolling down. The process whereby one closes out an option at a higher strike price and “rolls down” into an option with a lower strike price.

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Rolling out. The process whereby one closes out an option that is near expiration and “rolls out” into a longer term expiration date. Rolling up. The process whereby one closes out an option at a lower strike price and “rolls up” into an option with a higher strike price.

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Sell to open. A sell transaction where one opens a new short position in the underlying asset or listed options. Sell to close. A sell transaction where one sells back and closes an existing short position in the underlying asset or listed options.

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Sentiment. The sum total of all bullish and bearish outlooks on a particular asset.

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Slippage. The cost an investor pays to buy at the ask price and sell at the bid price.

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Page 115


Specialist. Those who create the liquidity in the options market by maintaining the best bid and ask price on the floor of an option exchange. Specialists typically don’t compete with one another, but rather focus on a certain underlying stock’s options. Specialists also keep the book of public orders.

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Spread. The simultaneous purchase and sale of options on the same underlying stock, with different strike prices or expiration dates, or both.

Standard Deviation. A statistic used as a measure of the dispersion or variation in a distribution, equal to the square root of the arithmetic mean of the squares of the deviations from the arithmetic mean.

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Straddle. A strategy consisting of the simultaneous purchase of a call and put option on a 1:1 ratio for the same strike price and expiration date. The strategy is designed to profit from substantial price movements in either direction. Strangle. A strategy consisting of the simultaneous purchase of a call and put option on a 1:1 ratio for the same expiration month but different strike prices.

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Strike price. The fixed price at which a buyer can either buy or sell the stock and the writer is obligated to buy or sell the stock if the option is assigned.

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Technical analysis. The process whereby one determines an outlook for a given asset based on historical price and volume data plotted on a chart using different mathematical formulas. Theta. Measures how much value an option premium will lose within a given unit of time. It is the rate at which time erodes an option’s premium.

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Time decay. The loss of an option’s value over time assuming all other factors are constant. The rate of time decay is not a linear event, but rather accelerates as the expiration date draws near. Time premium. That portion of an option’s value that is based on the time remaining until expiration. The more time left, the more expensive an option will be due to greater the time premium.

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Time spread. See calendar spread.

Underlying asset. The asset that would be purchased or sold were the option exercised. The underlying asset can include stocks, futures, and indexes. Vega. Measures the rate of change in the option’s price due to changes in the implied volatility.

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Volume. For stock, the number of shares that have been traded within a specific unit of time. For options, the number of contracts that have been traded within a specific unit of time. Whipsaws. To cause to move or alternate rapidly in contrasting directions.

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XYZ Company. A fictitious company.

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For additional information please contact Virtual Investing Club Toll Free 888-618-7868 www.virtualinvestingclub.com

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The Profit Forecasting Code