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Stock Ideas Investors Daily Edge Three Success Tips on Trading Options
Stock Ideas Investors Daily Edge Three Success Tips on Trading Options 
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| Three Success Tips on Trading Options |
| Saturday, 28 June 2008 | ||||||||
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Let’s talk about cocktails today. We’ll be careful to use both halves of the word. George Carlin died; boy I’ll miss his humor. I’m not much of a swearer myself. But I’m not my grandmother either, so if you swear around me, though not at me, I’ll just overlook it. (Andy is an artist when inspired.) It’s hard to scare a woman who majored in English then Linguistics with four-letter words. Shout one out, and I’ll give you the etymology. Then I’ll treat you to a historic tour of euphemisms, such as Victorian maidens referring to their extremities as “limbs,” because the word “leg” was too indelicate for human appendages. How animal! But what’s with the maiden thing, anyway? Didn’t it ever strike you as weird that prudish people actually categorized other people according to whether they’d “done it” or not? Do you suppose they asked? Maybe they had bumper stickers, too. Swearing happens. And if there’s one area where it’s especially likely to happen, options are it. T.T. wants to know the path, to options, that is. “What are the criteria, in descending order, that are most important to consider before making a trade in options?” he asks. “Perhaps you may trigger me starting on options in the near future.” That’s a smart question for someone who called himself a “rank greenhorn.” Doing a good job at choosing an option is an involved process. Swearing is certainly not necessary, but I would not stand in your way if it helps you find equilibrium. There is an order of importance, though. Doing things in willy-nilly order is a huge waste of your time. But skipping the most important steps—and I suspect most people do skip the two most vital steps—will really cost you. The order of work: I will start this where I start a trade… Step 1: I determine if the stock is trending or ranging…
This may seem simple, but it counts for a lot. It colors three things: 1. What your potential target might be, 2. Whether that’s a long shot or very likely, and 3. Which tools are best for analyzing the pattern It is much easier to set up a trade on a stock in a good trend. If the stock is stuck in a range, then you are faced with a choice between betting on a breakout or trying to make a profit on a movement within its usual range. The first choice is risky, and not a good idea for beginners. The second limits your potential. Look at Fossil (FOSL): Last year, Fossil was on a trend, but since January, all it has been able to do is go back and forth between $29 and $38. Fortunately for Fossil traders, this range is wide. So you could plan a good trade when the stock is low, anticipating a rise to its old highs at $38. Or when it’s high and getting weaker, you might do a bearish trade expecting it to fall back to $29. But usually a range is so narrow that there’s not much profit to grab after you absorb the cost of the option and the bid-ask spread. You can, of course make a trade on an expected breakout, but that calls for some other reason, a catalyst. It’s usually better to let the breakout happen then follow the trend. Fossil was much easier to trade last year for the big hit when it was in a strong trend: The stock was on a path to double. If you’re wondering how I could have gotten $44 for a target when the stock was still under $20, I used “horizontal count” on a point and figure chart. The bull resistance line led there, too. Figuring targets is a skill you’ll need to learn if you want to trade short term, and especially if you’re considering options. There are many ways.  The second reason you want to know whether a stock is trending or not is that it determines which technical tools are most helpful.  For instance, if you look for relative strength when making a trade, you should know that that indicator is much better with ranging stocks. It tends to go wrong in the extremes with trending stocks. An oversold stock in a strong trend can keep falling quite easily. On the other hand, MACD works better with trending stocks. Step 2 is applying your technical tools and deciding whether the trade is strongly supported or ambiguous. For instance, eager new traders are apt to anticipate signals. If they are using MACD crossovers, then they’ll spring the trade when it’s getting close and almost there. Alas, “almost” signals fail quite frequently. Step 3 is analyzing your potential risk and reward. How far up or down is the stock likely to go? Options can change value simply because the calendar turned pages, or the volatility premium changed, or demand was skewed. So I calculate risk and reward based on the stock itself. Back at the end of 2006, Fossil would have been a lovely trade. With the stock around $20 and an upside target of $44, there was lots of reward potential. And the risk was modest. You could have used the September 2007 low as your exit point, and given it a little room. That still would have pulled you out of the trade when the stock was at $17. That comes out to a $24 upside and a $3 downside risk, or an 8:1 reward to risk. It’s actually quite rare to find a case that good, but I always look for at least a 2:1 ratio and prefer to get 3:1 or better. From this point, Step 4 would be to start looking at the options chain to choose the best contract. To do this, I calculate implied volatility and potential payouts under different scenarios. What if the stock went up $5 in 30 days? What if it went up $2 in a week? Down $4? If the volatility fell? I would do that for a couple of options choices, or more. Sometimes you will find a pricing anomaly in your favor. But the main point is to be sure you buy enough time for the trade to work and that the expected movement in the stock would actually result in a profit. It’s possible to be right about what will happen and still lose money. I use a Black-Scholes model for these conjectures, which does the trick. Those are the basic steps, T.T., and you will notice that I haven’t said much at all about interpreting the stock’s potential. There are hundreds of technical tools and ways to use them. Plus news. Plus fundamentals. It is best to start with one or two technical tools or systems use them over and over until they become almost intuitive to you. Some good possibilities are quite simple. For years, I used point and figure charts with little else except trend lines. Even after all these years, I still only use a handful of all the possible tools, and that is true for nearly all seasoned traders. A friend of mine just traded volume spikes quite successfully for many years. I do have two “suites” of indicators I use now—one for trending stocks, one for ranging stocks, but I built that system very slowly. That’s the order of work because each step gives you the information to proceed. As for the descending order of importance, I’d rate them this way: 1. Risk to reward potential. Absolutely critical. If there’s too much risk, it’s a bad trade even if you’re “sure” the stock is going your way. 2. Confidence in your target. It is better to trade a few high-probability situations—they’ll disappoint you often enough to keep you humble-- rather than running headlong with everything that triggers something in your system. 3. The price of the option. While crucial, this ranks below the other two because waiting a day or taking a different contract in the chain can often improve it. But if it costs you $4.50 to buy a 60-strike call on a stock that’s almost there and you only expect it to go to $65, that’s a bad trade. Good luck. Lynn Carpenter P.S. 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