Tools And Techniques

TOOLS AND TECHNIQUES

Following the markets for many years has enabled us to make many trading observations regarding options and securities. One of the most noteworthy is the concept of buying weakness and selling strength. Timing the price zones where this can be performed is the foundation of our work and enables a trader or an investor to anticipate trends rather than strictly follow them. To assist one in identifying these low-risk opportunity zones, we suggest that one also incorporate a series of trading rules we have developed. These rules and observations are especially important when looking to day trade options.

If you are trading as a hobby or on a part-time basis, then pause for a moment and deliberate how difficult your full-time job can be at times and think about the ways in which it can be made simpler. More than likely, others before you have been similarly challenged to create shortcuts, and most if not all quantum leaps in job improvements for your particular field of employment have been developed. Any upgrades in technology are few and far between and your knowledge is probably shared by all others performing similar tasks.

Now who says that trading is any less difficult or complex? The media has projected an image of wealth and luxury with trading. Certainly, there are extremely wealthy traders, but don’t you think if it were as simple as many believe it to be that more traders would be successful? Trading is difficult.

However, whereas most professions are mature and thoroughly researched, trading is a fertile field for objective market-timing indicators. Only within recent years has it become acceptable to research the dynamics of the marketplace. Previously, not only were the technology and the software lacking, but also the legitimacy of pursuing such a research path was questioned by university professors and well-known investors alike. Now the brightest minds in the world are developing code to break the market and, although unsuccessful, are making progress. Prior to the advent of computers, intelligence was not necessarily an advantage or even a factor in trading success since a trader’s emotions tended to interfere with prudent and thoughtful decision making. Technology has removed the element of emotionalism and enabled the process to become more objective and mechanical. We’re not implying we have the Holy Grail by any means, but we have enjoyed a distinct advantage over other analysts by virtue of having observed and researched the markets for close to 35 years, collectively. Consequently, we have had the opportunity to develop a group of original techniques which have proven to be sensitive to identifying significant market reversal points.

BUYING WEAKNESS AND SELLING STRENGTH

As individuals, we are all products of our environment. Our feelings, attitudes, and actions are often influenced by a series of external events and conditions. A rush to buy winter wear typically occurs only after the first freeze or snowstorm arrives, just as the need to purchase umbrellas usually arises once the weather changes to rain. Most often, we are ill-prepared to adapt to the immediate future should it differ from what we are accustomed to. Simply put, we are creatures of habit—we wait for a change to make a change. Traders often react similarly, extrapolating current market trends of strength or weakness well into the future without properly establishing contingencies should an unexpected change in (market) conditions arise. They tend to exaggerate these trends because they possess a biased predisposition to the market due to either overall market sentiment or the fact that they are personally involved in a trade and are subconsciously promoting their own positions.

It is not difficult to understand why a trader might prefer to be a trend follower. Uncertainty in any aspect of life is difficult to deal with. To overcome this uncertainty, most people rely upon experts to explain the likely ramifications of an event or, failing to seek out just such an experienced individual, concede to the will of the masses, finding solace in conformity. There is a decided level of comfort and security in either allowing another to make a decision for us or by acceding to the influence of a group. In each instance, the burden of responsibility for making a mistake is removed from oneself, since the decision was ultimately determined by others. This attitude may be acceptable in life but to practice similarly in the market is financial suicide.

Approval and acceptance are essential to interacting harmoniously with others. To constantly oppose widely held opinions or decisions and to force one’s beliefs upon a group is an invitation to exclusion. In today’s society it is important to be socially correct and not be disruptive—flow with the crowd mentality, if you will. Conducting one’s trading activities similarly may be easy psychologically but the implications to one’s portfolio could prove financially disastrous. There is a common trading adage that states “The trend is a trader’s friend.” Our experience suggests that, for the sake of completeness, this expression should be qualified with an addendum that reads “Unless the trend is about to end,” because that is the single worst time to enter into a trade in the direction of the prevailing trend. However, it is the single best point in time to enter into a trade against the overall trend. The price level just prior to that inflection point where price reverses its trend is the ideal time to enter the option market, for example, because it allows the trader to participate in the inception of a new trend. Unfortunately, this price reversal point is much easier to reference than it is to identify. Not only must traders acquire the expertise and the tools necessary to locate these low-risk opportunities, but they must also possess the courage to defy the dominant psychology of the market at that time, which is to extend the existing trend. Consequently, our goal is to share with you various methods we created to help identify these critical market turning points for securities, as well as their respective derivative products, such as options. Not only do these indicators provide a trader with insight as to how to anticipate price reversal points but also with a detailed list of conditions that generally exist at those turning points, all of which enable a trader to make this difficult process more objective and less emotional.

Market highs and lows differ in frequency and duration, depending upon the time frame one applies. For the most part, short-term highs and lows may not have much of an impact upon the overall market picture or trend. Obviously, at major turning points, short-term price bottoms and tops will coincide with and evolve into long-term price bottoms and tops, since longer-period market price moves are comprised of a series of shorter-period market price moves. Personally, our trading efforts are most often devoted to these short time frames. This enables us to participate in many short-lived price moves, and, at the same time, market conditions justifying, also allows us to extend our holding period for a longer period of time. Since any market turning point could extend into a significant bottom or top, we encourage day traders to hold their trading positions longer on occasion. However, because short-term signals may only be effective for a short period of time, we advocate protecting market positions at all times with stop losses. Because markets move in a series of price waves over various time periods, it is important for a trader to prudently place a stop loss and to do it consistent with the time interval which meets his or her trading preference and style.

Price never moves straight up or straight down, even when price moves are news-driven. There are rare instances when each trade over a short period of time will be consecutively higher or lower, but these moves will eventually be punctuated with price reactions until the price surge finally dissipates and trading normality resumes. Typically, price moves unfold in a series of waves. Traders’ collective interpretation of the impact of any news developments upon a market determine the direction and the intensity of these waves. Since the market is a discounting mechanism, as soon as news is released, traders evaluate and process the perceived impact that it may have upon a security. The convergence of all these traders’ expectations is reflected in one figure—price. Ultimately, the critical determinant of price movement is the degree of buying and selling pressure.

One important aspect of price movement which is often overlooked by overzealous traders is the fact that, over time, the intensity of both buying and selling diminishes. The reason is that as more and more traders commit their funds to the market, the reservoir of similarly disposed traders diminishes in size. Our research indicates that markets form bottoms, not because there is a group of smart buyers who are driving prices upward; rather, figuratively speaking, the last seller has sold and by default price moves sideways or higher. Conversely, markets form tops, not because there are smart sellers who are forcing prices downward, rather, figuratively speaking, the last buyer has bought; therefore, price moves sideways or lower. To illustrate this observation, consider the fact that as price moves higher, more and more trend followers enter the market. Usually, fundamental research becomes more positive, convincing the fundamentalists to enter the market as well. As die news continues to be favorable, more and more investors enter the market. At the same time, traders who were negatively disposed toward the market reverse their positions from sellers to buyers. Ultimately, the buyers exhaust themselves and the buying and selling pressure arrive at a standoff. Once the last buyer has bought, price declines. Keep in mind that the reverse scenario holds true in cases where a market’s price is declining. These same principles can be applied to market activity on a time scale as short as one minute and consisting of a series of price ticks to much longer periods of time.

With these market-timing principles in mind, our research has uncovered certain market behavior and tendencies which occur near market tops and bottoms. For instance, we have found that a general skepticism is often associated with market lows. In this case, if price has declined for a period of time and the news continues to be bleak but price actually rallies, this event suggests that there is an apparent absence of sellers required to perpetuate the decline. Traders’ prayers, hopes, or promises will do nothing to force price lower; only additional selling can accomplish that goal. Similarly, as a market rallies, news and analyst recommendations reflect this bullish market outlook. Ultimately, all the potential buyers have bought into the position and, despite additional favorable news, it is insufficient to sustain the rally unless a renewed source of buying develops. Again, prayers or promises will not move the market higher; only additional buying is capable of doing that. Our observations indicate that market bottoms are accompanied by negative news, just as market tops are usually formed with the release of positive news. Furthermore, when a market is incapable of rallying despite good news, it is often indicative of an imminent retreat in buying and a potential downside price reversal. Conversely, when a market is unable to decline despite negative news, it is often a sign that there is a decrease in selling pressure and a potential upside reversal is pending. At major market turns, the news is often so extreme that the sellers and buyers collectively exhaust themselves and the market is susceptible to establishing a meaningful reversal in trend. Since markets typically exaggerate advances and declines, opportunities arise for alert traders who are prepared for these price reversals. The challenge for a trader is to differentiate between the real and the perceived low- and high-risk opportunity zones.

The interaction between supply and demand determines price. Market expectations and news create occasional price imbalances and present traders with opportunities to profit. Fear and greed swing the price pendulum in any market. Fundamental information, such as earnings forecasts, new product introduction, crop reports, government policies, money supply, interest rates, and a host of other variables, are important factors influencing valuation. However, market sentiment and traders’ perceptions have a dramatic impact and are oftentimes responsible for exaggerating and extending price movements. The impact of nonfundamental contributing factors, such as stop losses, margin calls, and so forth, cannot be measured but their influence is also significant.

Stock market specialists and option market makers play an important role in the marketplace. They supply liquidity to a market by providing supply when a market rallies and by providing demand when a market declines. Their method of trading is to operate against the prevailing market trend. Obviously, doing so is not always profitable—occasionally, markets will perpetuate a trend longer than expected. But, most often, retracements and market reactions allow those traders to offset their trades and continuously reset them. With proper discipline and money management, these professional traders are able to produce consistent profitable returns. We have known only one specialist firm to go bankrupt in the past 40 years, and most adequately capitalized, disciplined market makers have been able to withstand any drawdowns. This is not only a tribute to their trading expertise but also a recognition and testimony to their unique trading style. We believe that to trade options and other securities successfully, a trader must emulate their (countertrend) trading philosophy. For example, an option trader must abandon any false impression that trading decisions must be supported by other traders and the media because, very likely, they will not. Traders using our prescribed methods must be resigned to the fact that they must operate against the prevailing market trend and the overall trading environment and ignore external input or confirmation. The trading strategy is described as contra-trend and such traders are certainly market mavericks.

Forecasting precision is our goal but not at the expense of common sense or logic. We rely upon proprietary techniques that we have developed over the past 27 years and which have statistically withstood the rigors of time and countless data samples. By and large, these methods were designed to anticipate tops and bottoms, not confirm them. After all, knowing a high or low after it occurs is meaningless—but that is what most trend followers unwittingly do. Occasionally, our indicators may be premature, our price objectives may be overshot, or our calculated price reversal levels may be slightly off the mark, but the outcome should generally be correct. Sadly, nothing is or will be perfect when following the markets. But by mechanizing these market-timing approaches, traders can minimize ambivalence and ambiguity, two factors that ultimately destroy traders’ confidence as well as their trading accounts.

OPTION PURCHASING RULES

It’s human nature to want to buy a market when the media and brokers are positive, or bullish, and likewise to sell a market when they are negative, or bearish. This response is reflexive and characteristic of most inexperienced traders. However, by dissecting the dynamics of the market, it becomes apparent why the antithesis of this response would be more profitable, especially when day trading. With the majority of markets today, price fluctuates rapidly, leaving little time to enter at important price reversals. Oftentimes, a high or low is established and quickly followed by a price vacuum, as floor traders and other traders scramble to quickly reverse their positions. If one were to enter at this point, that individual would likely suffer considerable price slippage and experience terrible order fills, particularly if one were day trading. That is why we prefer to buy before a market low is recorded and price is still declining and why we prefer to sell before a market high is made and price is still advancing. If the crowd is buying, we are looking for a place to sell, and vice versa, if the majority is selling, we are looking for a place to buy. This way, we can enter the market and, oftentimes, actually enjoy positive slippage, realizing better fills than if we were attempting to participate in the market’s trend. Therefore we realize a greater profit potential for our trades by participating in a larger portion of a market move. This practice is similar to the role played by both market makers and floor specialists. Someone must assume the opposite side of a transaction, as difficult as it may be at the time, both psychologically and emotionally.

We are not encouraging you to ignore fundamental analysis or common sense. After all, it is foolish to immediately take a trading stance against the direction of a news announcement, crop report, or earnings release—doing so is akin to stepping in front of an express train or catching a falling dagger. However, we are suggesting that traders view these announcements as opportunities to anticipate and identify key areas of price exhaustion, particularly when day trading. And because these important news releases are often followed by sharp price retracements, anticipating trend reversals can create sizable trading profits.

Our recommended practice of buying into market weakness and selling into market strength is an important trading lesson we learned early in our careers. This approach is applicable to all markets and is particularly valuable once a market’s volatility, or intraday price movement, increases. More often than not, news serves as a catalyst causing a security’s price volatility to increase. The increased public interest and participation in the market is reflected in the expansion of volume and wider price swings in the underlying asset. If the underlying security undergoes a transformation in its trading profile, a similar change becomes apparent in any related option activity since the accompanying option premium will expand to adjust to the increased volatility. Generally, if the news or market’s perception of the news is tilted toward the positive, the premium attached to the calls is greater than that assigned to the puts. Conversely, all other factors being equal, if the outlook or traders’ expectations are perceived negative, then the put premium is greater than that of the call premium. Regardless, the impact of news upon a security reverberates and resonates throughout its respective derivative markets as well.

Again, to reiterate, markets usually record trend reversals at a bottom when the last seller, figuratively speaking, has sold and at a top when the last buyer, figuratively speaking, has bought. Also, contrary to popular belief, the release of negative news generally coincides with and exhausts the downside of a market just as the release of positive news coincides with and exhausts the upside of a market. Obviously, as price declines, the ultimate low draws closer in terms of both time and price; and as price advances, the eventual high draws closer in both respects as well. Sooner or later, a down close signals the final low of a decline as does an up close signal the final high of a rally. By applying this concept to option price activity, the initial rule for trading is formulated. In other words, by requiring that the closing price of an option be down versus the prior period’s closing price for a low-risk call buying opportunity and by requiring that the closing price of an option be down versus the prior period’s closing price for a low-risk put buying opportunity, a distinct trading advantage can be established. One could also require that not only the option adhere to this trading qualifier, but also that the underlying security conform similarly by closing down for a call and up for a put. Additional layers of requirements can also be introduced to further filter short-term trades. By applying these concepts to both long-term and short-term trading, investors can realize greater trading success.

To take advantage of these observations we have outlined, we have devised a set of rules to determine the opportune environment in which to buy call and put stock options. Similar rules can be applied to futures options but since the homogeneity among contracts is lacking in this market, the prescription must be altered somewhat. Ideally, each of these trading rules should be aligned before entry into a market occurs; however, in the real world this requirement may be less restrictive. These rules stand well on their own and help prevent one’s emotions from running rampant in the market, but the addition of other indicators, such as TD Percent Factor (TD % F) and the interrelationship between call and put volume and open interest, can be utilized to further fine-tune a trader’s entry.

RULES FOR BUYING CALLS AND PUTS

Rule No. 1: Buy calls when the overall market is down; buy puts when the overall market is up. By and large, when the stock market rallies, most stocks rally, and when the stock market declines, most stocks perform likewise. The extent of this movement can easily be measured by observing stock indices. We recommend using the advance/decline index as a proxy for the overall market. However, if this is unavailable, one could also use the net price change of a comprehensive market average, such as the Standard & Poor’s 500, New York Stock Exchange Composite, NASDAQ, or Dow Jones Average. For the overall market to rally, the majority of individual stocks must rally, too. Sure there are days in which the market is rallying even though the number of advancing issues is less than the declining issues but this cannot last long if the stock market is to mount a sustainable advance. Similarly, on the downside, the market can-not undergo an extended decline unless the number of declining stocks outnumber the advancing stocks.

When the overall market trades lower, call option premiums typically decrease. Therefore, by requiring the market index to be down for the day at the time a call is purchased, the prospects for a decline in a call’s premium are enhanced. Similarly, when the overall market trades higher, put option premiums typically decrease. Therefore, by requiring the advance/ decline market index to be up for the day at the time a put is purchased, the prospects for a decline in a put’s premium are enhanced similarly. Since most stocks rise and fall with the general market—with the possible exception of gold stocks—this provides a measure of much-needed discipline and helps prevent emotional, uncontrolled option buying.

Rule No. 2: Buy calls when the industry group is down; buy puts when the industry group is up. Just as most stocks move in phase with the market, most industry group components move in sync with their counterparts within their specific industry as well. Therefore, when one stock within an industry group is down, chances are the others are down as well. It’s the exception when one component of an industry advances while all the other members decline, or vice versa, especially over an extended period of time. For example, situations can arise where a buyout occurs and the accumulation of one company’s stock causes it to outperform the others within the industry group. However, announcements such as these typically cause the other stocks within the same industry group to participate in the movement since the market’s perception is that all companies within the group are likely acquisition candidates and their stocks are “in play,” so to speak.

Rule No. 3: Buy calls when the underlying security is down; buy puts when the underlying security is up. In order to time the purchase of calls, we look for the price of the underlying security to be down relative to the previous trading day’s close. If the stock’s current market price is less than the previous day’s close, most traders extrapolate that the down trend will continue. It is also possible to relate the stock’s current price with its opening price level to make this rule more stringent. Either relationship, that is, current price versus yesterday’s close or current price versus the current day’s open, can be applied or a combination of the two can be used to insure that the composite outlook for the market is perceived bearish by most traders.

In order to time the purchase of puts, we look for the price of the underlying security to be up relative to the previous trading day’s close. If the stock’s current market price is greater than the previous day’s close, most traders extrapolate that the up trend will continue. It is also possible to relate the stock’s current price with its opening price level to make this rule more stringent. Either relationship, that is, current price versus yesterday’s close or current price versus the current day’s open, can be applied or a combination of the two can be used to insure that the composite outlook for the market is perceived bullish by most traders.

Rule No. 4: Buy calls when the option is down; buy puts when the option is down. Just as the previous series of rules required that specific relationships be fulfilled, so too must this prerequisite be met. In fact, of all rules listed, this requirement is singularly the most important. The option’s price, be it a call or a put, must be less than the previous day’s close. As an additional requirement, it may also be less than the current day’s opening price level as well. Obviously, if an option’s price is inevitably going to rally, it is smarter to buy as low as possible. Further, if the call or the put unexpectedly continues to decline to zero, then the loss incurred is nevertheless less than if one had chased the price upside and purchased the option when it was trading above the previous day’s close.

The combination of the preceding rules serves to remove a degree of emotionalism from operating in the options markets and instills a level of discipline in the trading process. We can’t tell you how long it took to acquire and apply these important rules to our trading regimen. Obviously, the risk always exists that despite the fact that all the previously described rules may be met, option prices may continue to decline, and as a result purchasing the call options or the put options will translate into a losing proposition. That’s a concern that can only be diminished by introducing a series of sentiment measures or various market timing indicators to confirm option buying at a particular point in time. The integration of these rules together with market sentiment information comparing put and call volume and the information regarding various indicators presented in the other chapters within this book enhance the timing and selection results further by concentrating upon ideal candidates which are low-risk opportunities based upon all four requirements.

We have included as an alternative to the closing price bar comparisons, the comparison of the current trading bar’s close versus the current trading bar’s open, as well as the current trading day’s close versus the prior trading day’s close. We believe the media and data-reporting services have unknowingly performed a disservice to traders by publishing daily price change in terms of the current trading day’s close versus the prior trading day’s close. Our work throughout the years has shown that the activity from the current trading day’s open to the current trading day’s close is more valuable to a trader. Why do we believe this is the case? What occurred yesterday in the market is history and what happens today is current and relevant. After yesterday’s close a news announcement could have been released which affects the market and therefore prices. By inserting the current trading day’s open as a proxy for the prior trading day’s close, we can process and accommodate this information. The price movement above the opening suggests buying or accumulation and the price movement below the opening indicates selling or distribution. Now if the market had closed yesterday at 97 and closed today at 100 (up 3), the assumption might be that accumulation or buying had taken place from one close to another. However, if the market had opened this morning at 103, after a perceived positive news announcement overnight, and then proceeded to trade lower and close at 100, the accumulation/distribution picture would appear quite different. Instead of price closing up 3 points from one close to another, it closed down 3 points from its open. The perception to the part-time market watcher was that the market strength was exhibited, whereas market weakness was the true price movement. We refer to this particular pattern and its counterpart at a market low where current day’s close is below the prior trading day’s close but the same trading day’s close is above its open as TD Camouflage. Not only is this pattern prevalent at the turning points for underlying securities, but it also appears, to a lesser extent, with the related options. Obviously, this method is not suitable for day trading options or their underlying securities since one must await the close for confirmation of internal, hidden weakness or strength. The technique can be used for short-term trading but it does require a few qualifiers to enhance its predictive abilities. A further discussion of TD Camouflage appears elsewhere in the book.

OUR INTRODUCTION TO OPTIONS

We believe the methodology we present in this book will supply you with the ammunition to buy options successfully. By citing one example in particular, you can appreciate the importance of market timing. In the late 1970s through 1980s we had a successful institutional consulting service. In this service, we would often share the results of a sensitive volume price change model we created to identify possible stock buyout candidates, the results of which were excellent. Occasionally, the buyout indications were so pronounced that we would inform our clients that an expected buyout was to be announced. Oftentimes, they would ask us about the timing of this expected takeover since they wanted to take advantage of the leverage conveyed by purchasing options. We discouraged the purchase of options only because it was often difficult to time the entry for this indicator accurately; despite the fact we were convinced of some positive news, we had no definitive means of confirming a low-risk option purchasing opportunity since our option-timing tools were still in the development stages. In any event, we had just been successful in alerting our clients to a series of successful buyouts, specifically Chenetron, Kennecott, Cutler Hammer, Monroe Auto, Pizza Hut, Babcock and Wilcox, and Budd Company, and many of these clients were satisfied with the results and willing to trade the findings. A relatively new institutional client was amazed by this string of accomplishments and frequently asked about the next buyout candidate. After a period of time, our model indicated to us that Cities Service was a prospective candidate—this occurred in April of 1982. Unknown to us, this client purchased a large number of shares of stock in this company but invested much more, relatively speaking, in options. Much later, after the transaction was completed, we learned that the options were the June expiration. Throughout this period of time, the director of this fund would often inquire about the timing of the impending buyout. We cautioned him that our accumulation/distribution work was accurate but incapable of pinpointing the specific week, let alone the exact day.

Coincidentally, the third Friday of June 1982, we were on the floor of the CBOE and just minutes after the close, indicating the expiration of the June call options, lo and behold, on the news monitor was the official announcement of the buyout of Cities Service. Accompanying us on the floor was an individual who was aware of our buyout prediction on the stock. He congratulated us and remarked, “Look at all the option ‘chumps’ who watched the June option series expire, only to hear the announcement after the close.” Although we were frustrated by this revelation, for our client’s sake, it made a lot of sense. Other companies made similar announcements subsequent to the nearby option expiration, we believe in an effort to frustrate and discourage illegal option insider trading. We admonished our client that this experience was the very reason we recommended trading the underlying security as opposed to the option. Subsequently, the exchange introduced Saturday settlements, which only added insult to financial injury for our client. The events of this and similar situations served as the catalyst in conducting additional work to develop most of our current option-timing techniques.