TD % F and TD Dollar-Weighted Options

TD % F AND TD DOLLAR-WEIGHTED OPTIONS

One of the biggest complaints we have with many of the option trading strategies is that they are complicated, mathematically derived formulas designed to sell or write options. Not only does this limit option traders ’rewards but it also leaves them vulnerable to an enormous level of risk. We have always felt that this approach is lopsided, and any technique that would work in favor of the option buyer, containing one’s risk while unleashing one’s reward, would certainly be welcomed in the option-trading community. We believe that the indicators that follow, TD%F and TD Dollar-Weighted Options, are novel trading approaches to buying calls and puts, capable of anticipating not only option price movement, but also movement in the underlying asset. While these option trading indicators are certainly not the antidote to all of the ailments of an option buyer, they are incredibly simple ways to increase the potential for an option day trader’s success.

Economics 101 teaches that price moves higher when demand is greater than supply and price moves lower when supply is greater than demand. This ongoing battle between securities buyers and sellers is constantly being waged every minute and second of the trading day. Collectively, these intraday trading battles make up the overall daily trading war. This interaction can best be described in the context of a motion picture. At the completion of trading, an extensive collection of price frames are combined to create the complete daily trading picture. Rarely does the market close precisely on its high or low. These price extremes are often recorded intraday, lost amidst the flurry of price ticks (trades). Unless one examines each and every price transaction, a trader is oblivious to the time at which the daily high and the daily low are formed. In fact, given the daily reporting practices of the financial media, one can only speculate as to the daily trading sequence of a market, regardless of the proximity of these levels to one another. For example, an opening price near the daily high or the daily low does not necessarily mean the two were recorded approximately the same time of day, just as a closing price near the daily high or the daily low does not necessarily mean the two were recorded at the end of the day. Market volatility prevents one from drawing such conclusions. In any case, a full-time day trader’s awareness to intraday trading nuances and price activity is particularly keen, as is the trader’s sensitivity to other market factors, such as volume, bid and ask spreads, and so forth. Our assumption is that most of you are not provided the luxury of devoting your full time and attention to day trading. Consequently, we have limited our discussion of trading techniques to those which can be applied using the daily data commonly reported in financial papers or on quote machines. Although these techniques can all be programmed, they are sufficiently easy that they can be calculated with only basic math required.

Market expectations play an important role in creating supply and demand. In other words, fear and greed swing the price pendulum in any market. Fundamental information, such as earnings forecasts, new product introductions, crop reports, government policies, money supply, interest rates, and a host of other factors, contribute to expectations and determine price levels. Market sentiment and traders’ perceptions play an important role as well, and are responsible oftentimes for exaggerating and extending price movements beyond realistic levels. The trading opportunities arise whenever these price extremes are exceeded and the traders’ market-timing tools are sufficiently sensitive to identify these pending price reversals.

Various indicators have proven to be helpful in identifying those terminal inflection price levels where traders exhaust their selling campaigns and buyers initiate their buying, and vice versa. Usually, the termination of these price moves are accompanied by volatile price moves over a short period of time. In other words, one last lunge upside or downside occurs. Conventional methods of technical analysis have tried to identify these low-risk trend-reversal opportunity zones. However, these approaches are primarily subjective and oftentimes reflect the interpreter’s emotions rather than a defined methodical process. We have chosen to rely upon objective research to develop a stable of proprietary indicators to identify these potential market turning points which produce exceptional trading opportunities. Throughout the years, these indicators have achieved a high rate of empirical success both within and across several different markets. As with all predictive approaches, however, there are no guarantees. But by installing a rigid and comprehensive series of parameters which have proven to produce reliable results in the past, traders can establish a distinct advantage over the methodology practiced by their trading peers.

It’s amazing to observe the behavior of an apprentice option trader. The pattern of trading such an individual exhibits is reminiscent of our old next-door neighbor. Totally immersed in this trader’s psyche was the belief that his option trading profits would grow faster than he could count. Excited and fantasizing about the imminent wealth he was to acquire, he initially traded with reckless abandon following every “whisper” buyout situation or rumored news event. As time progressed and his losses accrued, our disappointed and disenchanted option-trading neighbor finally abandoned following his emotions and withdrew from trading altogether, cursing his first trade in what he believed to be a “rigged” market. Our hope is to short-circuit your replay of this course of events and protect you from becoming another market fatality statistic like him. By following the list of option trading rules previously described, the risk of having the news and one’s emotions dictate and influence one’s trading style is eliminated. And once indicators TD % Factor (TD % F) and TD Dollar-Weighted Options are introduced, objectivity replaces subjectivity and further enhances the potential of trading profits. Unlike the bulk of the indicators presented in this book, these two are unique in that they are both applied directly to the option’s price activity, as opposed to the activity of the underlying security, which provides insight into market sentiment and enables a trader to trade options without becoming completely dependent upon the activity of the underlying asset.

TD % F

One of the most significant option-related discoveries we made occurred quite by accident and its application has far surpassed the positive results achieved solely by applying the option rules described in the previous chapter. TD % F has added dimensions of precision and objectivity to the option-selection process. Whereas most traders justify the purchase of an option based upon their interpretation of the prospects for the underlying security and then in turn applying this forecast to the Option, TD % F relies entirely upon the price activity of the option itself to measure die attractiveness of the option and totally ignores the price activity of the underlying security. In other words, in this instance, it’s possible that the “tail could wag the dog” and the outlook for an underlying security can be forecast based upon the activity of the option. Not only can this indicator be applied to time the purchase of the option, but also to anticipate price reversals of the underlying stock. In this case, a stock trader could draw conclusions regarding the near-term outlook of a stock by applying TD % F to the option.

We developed TD % F as a result of evaluating a multitude of both profitable and unprofitable option trades throughout the years. The construction and description of TD % F are simple and straightforward. Neither confusing formulas nor complex mathematical models are required to perform the necessary calculations to arrive at trading conclusions. To demonstrate the simplicity and ease of its use, we taught the necessary conditions to the youngest member of our family, 11-year-old Dominic. He was able to master the process within minutes. We are confident that you will likewise be just as proficient as he in as short a period of time.

Like the majority of our market-timing indicators, TD % F is designed to buy into weakness and to sell into strength. However, since the indicator is applied directly to derivative securities, such as options, the timing of entries enables traders to leverage their trades to the maximum. As described earlier, it also provides an indication as to when the underlying security is susceptible to a potential price reversal.

The sum total of all traders’ expectations regarding a security or its derivative securities is reflected in its price activity. Occasionally, these expectations can be skewed, creating price distortions and trading opportunities in the market. But with the application of various trading models designed to take advantage of these dislocations, price quickly reverts back into balance. TD % F operates in a similar manner. It attempts to identify and take advantage of severe short-term price disequilibrium or imbalance. Market psychology is responsible for short-term price moves and a quantifiable method for measuring human nature and price behavior is TD* % F. How do these inefficiencies or trading anomalies become apparent to traders as opportunities? As with most discoveries or inventions, their creation is oftentimes accidental and not premeditated. Most traders review the prospects for an underlying security, research various options to select the one best suited to their trading needs, and then rely upon their expectation of this security’s price activity to formulate their forecasts for the option. Similarly, most often TD Sequential, TD Combo, TD Lines, TD FibRange, TDST, TD Stop, and TD Retracements are applied to the underlying security to identify possible market reversals and trading opportunities, and then, in turn, this information is applied to the option, as are the TD Rules for option trading, all of which are used to time option entry. TD % F works in reverse. If TD % F indicates that the option appears to be vulnerable to a price reversal, then the trading assumption is that the underlying stock should respond in kind. For that reason, TD % F is a meaningful and original contribution to the library of analytical techniques on two trading levels, the option and the underlying security.

The key elements required to calculate and apply TD % F are an option’s daily high, daily low, and daily close, as well as the previous trading day’s close. Whereas other indicators may rely upon the underlying securities’ price activity and interrelationships, TD % F concentrates solely upon the option’s price profile. By multiplying the previous trading day’s call option closing price level by 45 and 52 percent and then by subtracting that value from that same trading day’s call option closing price, a price objective buy range for calls is established for the current trading day (an alternative method which merely requires multiplication and no subtraction is to multiply the previous trading day’s call option closing price level by 48 and 55 percent to arrive at the call buy range zone for today). Conversely, by multiplying the previous trading day’s call option closing price level by 90 and 104 percent and then by adding that value to the previous trading day’s call option closing price, a price objective exit range zone for calls is established for the current day (another method which merely requires multiplication and no addition is to multiply the previous trading day’s call option closing price level by 190 and 204 percent to arrive at the price objective exit range zone for calls for that trading day). In order to purchase the call option,-TD % F requires that the market not open below 55 percent of the prior trading day’s closing price; it must open greater than that level and then trade to that level to permit entry.

An identical exercise for puts can be conducted to arrive at ideal entry and exit price objective levels as well. By multiplying the previous trading day’s put option closing price level by 45 and 52 percent and then by subtracting that value from that same trading day’s put option closing price, a price objective buy range for puts is established for the current trading day (an alternative method which merely requires multiplication and no subtraction is to multiply the previous trading day’s put option closing price level by 48 and 55 percent to arrive at the put buy range zone for today). Conversely, by multiplying the previous trading day’s put option closing price level by 90 and 104 percent and then by adding that value to the previous trading day’s put option closing price, a price objective exit range zone for puts is established for the current day (another method which merely requires multiplication and no addition is to multiply the previous trading day’s put option closing price level by 190 and 204 percent to arrive at the price objective exit range zone for puts for that trading day). In order to purchase the put option, TD % F requires that the market not open below 55 percent of the prior trading day’s closing price; it must open greater than that level and then trade to that level to permit entry.

It is likely that the price objective buy range for calls will often coincide with the price objective exit zone for puts and vice versa since, by definition, if a call declines in price, then the put should rally—the two are inversely related. The calculated buy price range, whether it be for calls or puts, provides a benchmark for downside option price risk for that particular trading day. Typically, TD % F is applied to the most active option contract which is usually the nearby expiration with the closest strike price and the largest volume and open interest. Because some options are inactive and may not trade daily, it is important to make certain that the closing price displayed is in fact the previous trading day’s closing price and not a closing price from any prior trading day.

For the purpose of illustration, we contacted Steve Moore and Nick Colley at Moore Research to request some recent random option data which we in turn applied to TD % F. They provided daily high, low, and close data for the soybean (July ’98) call option contracts with the closest expiration and nearest strike (exercise) to the underlying security price. For analytical purposes, we prefer to focus upon the most active option contracts as measured by daily call (or put) volume and open interest. Typically, the nearest strike price option has the most volume and open interest. In the following table, we identified with an asterisk (*) the day the most-active option strike price changed from 650 to 625 and that trading day coincided with the increase in volume and open interest as well.

*The day the most-active option strike price changed from 650 to 625.

** The open was less than 55 percent (51 percent) of the previous day’s close, therefore no trade.

A quick comparison of closing prices and subsequent trading days’ lows and highs demonstrates how TD % F can be applied successfully. In each instance in which there is a percentage value in parentheses next to a low price in the low column—a total of five occurrences—the option low was contained within a price range defined as 48 to 55 percent of the previous option day’s close. For example, the low for trading day no. 2 is 49.5 percent less than the close of trading day no. 1—in other words, 50.5 percent of trading day no. 1 ’s close. This value is contained within the guidelines of 45 to 52 percent which TD % F requires be multiplied by the prior trading day’s closing price and then subtracted from that same closing value; or, as a mathematical shortcut method, the value is simply calculated by multiplying 48 to 55 percent of the prior trading day’s closing price. The close of trading day no. 11 and the following trading day’s low (trading day no. 12), the close of trading day no. 12 and the following trading day’s low (trading day no. 13), the close of trading day no. 13 and the following trading day’s low (trading day no. 14), and the close of trading day no. 16 and the following trading day’s low (trading day no. 17) are likewise examples in which price held 48 to 55 percent of the previous trading day’s close.

Had a trader bought the call option when the low price was between 48 to 55 percent of day no. 17’s close (no less than 1.03), a stop loss below 48 percent of the prior trading day’s close would have produced a small loss. However, since there is no opening price level reported, it is possible that the market may have opened below the 55 percent low-threshold level and as a result there would have been no call option purchase since TD % F requires that the market not open below 55 percent of the prior trading day’s close which it would have done. Consequently, without the opening price value, it is impossible to conclude whether the call would have been purchased or not. By reviewing the opening price of the underlying July soybean contract chart, one may conclude that the high for the call option occurred after the opening since that is what occurred for the underlying market which opened at 610.00, made a subsequent high at 612.00, and a close at 608.75. Therefore the call option would not have opened above 55 percent of the prior trading day’s close and would not have been purchased.

The reverse of a price decline of 48 to 55 percent in the value of the call option from its prior trading day’s closing price to the current trading day’s low occurred on trading day no. 19. In this instance, the succeeding trading day’s high was much in excess of 100 percent—over 50 times greater. This relationship complements the one described previously since, instead of multiplying 48 to 55 percent of the prior trading day’s close to estimate a support level for low-risk buying, TD % F can be applied in reverse to arrive at potential resistance levels for low-risk exiting or selling since markets often stall and reverse at 100 percent of the previous trading day’s close added to that close or, in other words, 200 percent times the prior trading day’s close. We have found that it is best to avoid purchasing a call or a put option if the low of the current trading day is less than 48 percent of the prior trading day’s close, as additional downside price movement should occur, just as it is best to avoid exiting or selling a call or a put option when price exceeds 208 percent of the prior trading day’s close, as additional upside price movement should be attained that same trading day. Furthermore, because it is not uncommon for call and put markets to complement one another, when a call option records a price move between 190 and 204 percent of the prior trading day’s close, it is important to monitor the put activity to observe how the market behaves once it declines 48 to 55 percent of its prior trading day’s close. Conversely, when a put option records a price move between 190 and 204 percent of the prior trading day’s close, it is important to monitor the call activity to observe how the market behaves once it declines 48 to 55 percent of its prior trading day’s close.

We recall a stock put option trade we identified on September 11, 1995. Micron (MU) had enjoyed a phenomenal price rise from 15J4 on October 4, 1994, to a high of 9454 on September 11,1995, almost one year later. At that time, a daily TD Combo low-risk sell indication was given by inserting open for day no. 13 of countdown instead of close and by ignoring recycling (see TD Combo). The nearby exercise or strike price for the puts was 95 and September 1995 was the nearby expiration. The stock closed at 89% on September 8. At the same time, the closing price of the put on September 8 was 6%. On September 11, the stock recorded its closing high and the put option traded as low as 314. On that same trading day, we placed our purchase orders for the put between 48 and 55 percent of the prior trading day’s close which was at 314 and 314. Price declined to 3% bid and 3% offer but, as so often happens, the market did not decline to the bid; rather, it held the offering price on the downside. The put never once traded below 3%. Within five trading days, the stock declined from 94% to 8814, and within seven additional trading days, the stock further declined to 72%, down almost 22 points from its high a couple of weeks earlier. Had the option been trading at that time, the put position would have been worth at least 22% and that includes no time premium.

Buying puts at the high of a secular (long-term trend) market move would have been avoided by all trend followers. But as price continues to rally, ultimately the peak of a price move grows closer in terms of time and price. We had no idea that TD Combo had identified any top other than possibly an interim price peak for Micron. The fact that TD % F had spoken loud and clear, that purchasing the put options was a low-risk opportunity, was sufficient evidence to us of an imminent trend change. Had we wanted to hold the position or roll it over into another put option expiration series further into the future, we could have participated in the decline to a further degree. However, day trading or holding the position for a few trading days was sufficiently profitable. Also, we could have exited the position daily and bought puts every additional time TD % F indicated the reduction in trading risk to doing so. It all depends upon the outlook a trader prefers to assume.

The concept of TD % F is simple to describe and easy to calculate, but was fairly difficult and costly to conceive. Many years ago when option trading was still in its infancy, we aggressively traded in the options market. On a number of occasions our exposure was greater than we had hoped and, consequently, we needed to place stop losses. Initially, our stops were too tight, which resulted in our exiting our option positions prematurely and just prior to major market moves. We experimented with a number of different stop-loss methods, attempting to remove our subjectivity and replace it with a mechanistic approach. We knew options were a risky market and we were determined not to lose any more than one-half of our investment on any one trade. Therefore, we applied a stop loss based upon a decline of 50 percent from the prior trading day’s close. We were surprised with the results. What occurred most often was that an option’s price would gravitate toward our stop-loss level but would reverse just prior to a 50 percent retracement of the previous trading day’s closing price. Typically, price would decline to a point just prior to our being stopped out of the trade, whereupon the option would then commence its rally. Our arbitrary 50 percent stop-loss level proved to be a prudent decision. In addition, those instances in which we were stopped out of our position, the market price not only continued to decline further that trading day, but it also often times failed to recover to the stop-loss level before the expiration of the option. The price declines that held above the stop-loss levels proved to be exceptional low-risk opportunities to purchase call options and put options.

It became quickly apparent to us that the dynamics of the market were such that once the low for an option approached, but did not exceed, 48 to 50 percent of the prior trading day’s closing price, the option would usually rally. We experimented with a series of percentages between 50 and 60 percent of the prior trading day’s option close and we also tested numerous stop-loss levels. The percentages presented in the preceding soybean example appeared to work the best. At the same time, we realized that once the option price declines below 48 percent of the prior trading day’s close, apparently, the weight of the intraday price breakdown becomes so severe that price is unable to recover that trading day. To express this in another context, the option’s price decline produces an extreme oversold condition which equates with a renewed selling, rather than a buying opportunity, due to its intensity.

Our research and observations indicate that an option price decline can readily tolerate an intraday decline of up to 48 to 55 percent of the option’s previous trading day’s close. However, declines which exceeded this threshold of intraday weakness have a debilitating effect upon the price of the option, as well as the underlying security. One might describe? intraday option price declines from the prior trading day’s close of less than 48 to 55 percent as minor injuries, scrapes, broken bones, all of which are easily recoverable; whereas declines of any greater amount would be something akin to a heart attack or a severed vertebra and consequently, irreparable. It would take a miracle for an individual to walk again after suffering paralysis and similarly it would require the option to record a one-day rally from its previous trading day’s close of over 104 percent to demonstrate its ability to recover.

While we believe that TD % F is a revolutionary method to identify option trading candidates, we are aware it is not infallible, by any stretch of the imagination. Rather, TD % F is another tool an option trader can use to anticipate potential price reversals and changes in market trends. In fact, other percentages may work better than the set we propose here and we invite you to experiment to develop others. The critical consideration is the fact that the concept appears to have validity and is applicable to option trading, particularly on a day trading level, provided the option price declines occur sufficiently early in the trading day to justify entering the trade and capitalizing upon the reversal in trend.

Although it was difficult to acquire reliable option data, the CQG bar charts that follow nicely illustrate TD % F. Figures 5.1, 5.2, and 5.3 plot the price activity of three commodity options, Silver March 1999 575 Call, Japanese Yen March 1999 94.00 Call, and Copper March 1999 72.00 Call, respectively. As you can see, from the prior trading day’s close, any move that is 48 to 55 percent of the previous trading day’s close, downside, is identified on the chart with the intraday low and the prior trading day’s closing price; and any move that is 190 to 204 percent of the previous trading day’s close, upside, is identified on the chart with the intraday high and the prior trading day’s closing price. Note how price has a tendency to reverse at these price levels intraday, if not for a series of trading days. Keep in mind that in order to qualify as a TD % F low risk buy, the opening price level must be above 55 percent of the prior trading day’s close and the subsequent low that same trading day must not decline to 47 percent or less than the prior trading day’s close—at that level, the trade should be stopped out at a small loss. Conversely, on the upside, the opening percentage gain over the prior trading day’s close should not exceed 190 percent of the prior trading day’s close or no exiting or selling of the option should occur.

We prefer reviewing the actual option price bar charts, instead of strictly the data, to develop enhancements to our techniques. TD % F should work equally well with other types of options. Due to the problems in collecting accurate data, we are unable to present any stock option chart examples. Hopefully, chart availability will increase as the ranks of option day traders increase in size. At the time this technique was developed in the mid-1970s, we subscribed to the William O’Neill stock option service which displayed daily option price activity. We were able to confirm our suppositions regarding TD % F and option trading with those charts. Unfortunately, they are no longer available. However, a situation that recently occurred illustrates the application of TD % F to the stock option market nicely.

A few days prior to the completion of this book, a good friend, who coincidentally happened to be a large hedge fund manager, mentioned that he had observed a tendency for the technology stocks to rally the last two days prior to option expiration. He informed us that he had taken advantage of this trading pattern by investing $25,000 in Dell Computer January 80 Call options. After a few minutes, conversation had moved to our involvement with this book. We described to him TD % F and he inquired about his prospects for trading success in applying this indicator to the option market. He indicated the prior trading day’s call option close was PA; we asked where the low had traded that morning and he said it had just occurred, at a price of 54. We quickly calculated the current value at the low to be 45 percent of the prior trading day’s close—a sign that further downward movement was very likely. Upon realizing this, we advised him to get out of the trade immediately. He hung up the phone and proceeded to exit his option position; luckily, he was able to escape

Figure 5.1. This daily price chart applies TD%F to the silver March 1999 575 Call option. In this chart, C represents the closing price and L represents the low price of the following trading day. As you can see, in the two instances which appear where TD%F identified low-risk option buying opportunities, the market’s closing price was followed by a decline of almost 50 percent of the prior day’s close. In each example, the option buying opportunity would have proved profitable.

Figure 5.2. The Japanese Yen march 1999 94.00 Call option daily price chart illustrates the reverse scenario, where a low-risk TD%F option buying opportunity was profitable to a point where the low-risk option exiting opportunity was triggered. In this example, C represented the closing price and H represented the high price of the following trading day. The day after entering the trade following the low-risk option buying opportunity, the market rallied almost 200 percent higher, indicating a low-risk exit opportunity.

Figure 5.3. In this daily price chart of the Copper March 1999 72.00 Call option, three example of TD% F are presented over a period of two weeks. Again, C represents the closing prices and L represents the low price the following trading day. In each example, the option market recorded a daily ow that was 50 percent of the prior day’s closing price, each time presenting a low-risk option buying opportunity. By day trading these option positions and holding each of these trades into the close, a trader would have realized a sizable profit, without ever taking loss.

the trade relatively unscathed, with only a! point loss. The next trading day, while the stock was almost able to rally to 80, his option never traded higher than his exit price level and expired worthless. The following expiration month’s call option, however, held above a 50 percent decline of the prior trading day’s close and the market was able to rally sharply off of its lows. He informed us that he had learned a good but frightening lesson and intended to apply this technique to his future option trades, as well as use it to time his stock purchases.

1.     Identify the most recent trading day’s call or put option closing price

a. Concentrate upon the nearby expiration options

(1)   Apply primarily to those options which have three or fewer weeks until option expiration

(a.) Preferably apply to those options that are within a week of expiration

(b.) Concentrate upon “in the money” or close to “in the money” options

2.   Calculate 48 to 55 percent of the call or put option’s most recent closing price (yesterday’s close) prior to the current trading day’s opening price level to establish low-risk entry level

3.   Install “alert” so that a day trader is notified once price declines intraday 48 to 55 percent of the previous option trading day’s close

4.     If the option declines below 47 percent of the previous trading day’s close, then exit the trade since price should decline further

5.     Do not take a trade if the option opens below 55 percent of the previous trading day’s close

6.   Calculate 190 to 204 percent of the call or put option’s most recent closing price (yesterday’s close) prior to the current trading day’s opening price level

7.      Install “alert” so that one is notified once price rallies intraday 190 to 204 percent of the previous option trading day’s close

8.     Do not exit an option position if the market opens above 190 percent of the previous option trading day’s close

9.     If the option advances above 204 percent of the previous trading day’s close, then expect higher prices

a.          Coordinate this rally into the 190 to 204 percent price zone for a put or call to coincide with the reciprocal event occurring with same exercise price and expiration counterpart call or put

10.  The option’s closing price must be at least 3/4.