Trading Software and Books Reviews

Trading Systems, Fibonacci and Other Forex-Related Q & A

Greetings from New York City! I have some great email questions this week about a variety of topics – please keep those questions coming! Let’s get started with a question about trading during the U.K. session…

Q) Hello Ed! I’ve been following you for the past year or so; I like your articles! I have a full time job, and I’m almost sure that I will not be able to wake up around 2 or 3 AM to trade when the London markets open. Is there any pair that I could trade after 5 PM ET? That’s when I get home from work … I think I heard that Australian markets open at 5 PM ET…so AUD/USD would be a good pair to trade (I’m also wondering about volume at this time of day).

Ed Ponsi) Thank you for your question. There was a time when I used to get up around 3:00 am (New York time) to place trades at the beginning of the London session. Since London is 5 hours ahead of New York, 3 am New York time translates to 8 am London time – a time of day when breakouts are common. Breakouts are common at the beginning of the London session because London is the world’s capital of Forex trading. There is a tremendous rush of volume that enters the market at this time because so many big institutional traders are based in the U.K. and Europe. It is also the time of day when economic news out of the U.K. hits the newswires. Here’s an example; on December 1, 2008, the GBP/USD broke out of a sideways consolidation at around 8 am London time (3 am New York time). The pair fell nearly 400 pips over the next eight hours (see figure 1).

If you are looking for particular pairs to trade at around 5 pm New York time, you are correct to be concerned about volume. 5 pm Eastern is a “dead zone”, and any moves that occur at that time are likely to retrace. If you are working regular hours and do not wish to get up early, why not wait until the Asian markets really get rolling, around 7 pm New York time? The Japanese Yen tends to be very active from about 7 pm to midnight, so you might find great trades in EUR/JPY, GBP/JPY, and of course USD/JPY. Good luck!

Q) Great article and agree with your conclusions. On the subject of Fib fans and arcs, I believe the reason why they work is because of business cycles, reporting periods and accounting periods. There could a coincidental reason why an FX pair has a major turn about the same time each year or it could be that the flow of money may have something to do with it. Small turns are not as obvious but the major ones are. Time, price and astronomical observations are what Gann theory is based on and I postulate the time factor is what makes arcs and fans tend to work.

There are so many unanswered occurrences in life and we are never going to be able to explain them so your simplistic approach works fine. I tried for almost a decade to get Gann theory to work and now believe that simple is best. Our psychological side I believe is more important than all of this complexity.

Ed Ponsi) Very well put. I also made that journey from simple support and resistance to gradually more and more complicated systems, culminating in Elliot Wave and Gann techniques, and guess where I wound up? I ended up right back where I started, with simple but robust trading techniques that are based on market tendencies. I think it is intuitive for intelligent traders to believe that highly complicated systems might be more effective than simple techniques, but my experience has been the opposite – it was the simple things that wound up being the most effective, at least for me. To me, this is just another example of the counter-intuitive nature of trading. For the uninitiated, here is a Gann wheel (see figure 2).

Q) Dear Ed, thanks a lot for your informative articles on Forex trading. I’ve been a Forex trader for over one year. I have tried Forex signals, trading systems, trade analysis from pros. But still it ain’t easy. My main question is, what is your comment on the trading systems out there? Is there anyone that you have ever tried and what were the results? I subscribed to XXX (signal provider company name removed by E.P.) but it made me lose a lot of money (demo of course). I also subscribed to another signal provider who was also so inaccurate. Please start a debate about the trading systems.

Ed Ponsi) Thank you for your email, I’m very thankful that you decided to try out this trading system in a demo account. I wish there were more room for debate on this topic, but I feel strongly that there is little of anything of value to new traders in the form of signal services, trading systems, etc. – in fact, there are many shady operators working in this area. I would like to refer you to an earlier article that I wrote on this topic titled, “Scamming the Scammers”, that might be helpful in understanding this part of the trading world.

Most of these scammers measure their “performance” in terms of how many pips they made. What they don’t tell you is how many pips they lost. By the way, no real trader measures his or her performance in this manner. Real traders measure performance in terms of percentage gains/losses over the course of a month, quarter, year, or since inception.

Here’s the bottom line – you have to learn how to trust your own analysis. This can only be done by doing the work and learning to trade correctly. Once you can analyze currencies yourself, you’ll stop looking to outside sources such as the ones mentioned above. Signal services and trading systems may seem like nice shortcuts to the novice trader, but they only serve to delay the real work that needs to be done. Good luck!

Ed Ponsi, Online Trading Academy Forex Instructor

Human Action is a Direct Result of Your Belief System

At the core of any significant economic, political, scientific, social, medical, psychological or cultural theory lies a quest to understand and quantify the forces of change, action, or energy. The theories that attempt to quantify “force” that have stood the test of time, date back centuries and are extremely simple. In 1686, noted physicist Isaac Newton suggested in his laws of motion that an object will remain in motion until it is met with an equal or greater force. Noted economist Adam Smith suggested hundreds of years ago that when supply exceeds demand at a price level in a given market, price will decline. Smith and Newton didn’t create or invent the laws and principles for which they are famous. Supply, demand, motion, and the relationships therein existed long before Smith and Newton, long before humans walked the earth for that matter. What these two individuals did, however, is look mass conventional perception in the face and challenge it with a reality that had been there all along. They were able to discover what no one else had because of a belief system that allowed them to open doors others never knew existed. If you notice, Newton and Smith didn’t figure out one specific issue. They had a belief system that allowed them to rather easily apply the core principles of their knowledge to a host of issues, producing answers the rest of the world still considers “ingenious”, centuries later.

Throughout history, there are countless examples of individuals who looked mass conventional perception in the face and challenged it. Long ago, challenging conventional thought often meant a death sentence. Galileo was almost burned at the stake for suggesting that the earth was not the center of the universe. Certain minds throughout history such as Einstein, Newton, Galileo, Smith and others were made famous because of their discoveries. What I have always focused on is not the results of their work but the belief system that allowed them to realize what most other people have never even considered.

Are Newton’s three laws of motion really any different than Adam Smith’s laws of supply and demand? In my quest for truth, I have realized that whether you are talking about Newton’s laws of motion, Smith’s theories of supply and demand, or Maxwell’s laws of electromagnetic force, the basic governing dynamic of these laws and principles are different manifestations of the exact same governing dynamic. What I did many years ago is apply this simple and straight forward truth to financial markets. The result was a profound reality that opened up a door of extraordinary low risk / high reward opportunity in any and all markets.

At any university across the country, Chemistry is taught in one building, History is taught at another location, and Mathematics is taught somewhere else. While these are three different subjects, at their core, there is one common governing dynamic that is responsible for answers. For example, the equation that allows us to understand how to split a cell is the same equation that allows us to figure out how and when an earthquake will occur. The cell will split and the earthquake will occur when a specific threshold of force is reached. Why bring all this up in a piece dedicated to speculating in markets? When you realize that this one governing dynamic is solely responsible for the movement of price in any and all markets, you are able to discover the simplicities of market speculation.

I began my trading career on the floor of the Chicago Mercantile Exchange (CME), clerking for a firm in the currency futures. I will never forget my first day on the floor, it was very intimidating. Numbers flashing non-stop all around, people screaming words not appropriate for this piece, and huge money changing hands at lightning speed. My first thought was to spend the day and never come back but my friend got me the job so I stuck it out for the first week. That first weekend off, I evaluated this crazy job choice and thought that I had better get educated on all these markets and the basic world of trading if I was going to stay at the CME. I spent a little time in the education department after work and looked over bits and pieces of material but none of it made sense to me so I stopped seeking this education. Instead, I focused on what was happening around me each day. That choice is the most important choice I have ever made in my career and I only made it because I was not smart enough to understand the text book version of what was happening in front of me each day. As a phone clerk, I took orders from large funds, money managers, and big individual traders. I would take many buy and sell orders before the market opened. As the opening of trading would approach, I would organize the orders based on price and then I would split them into buys and sells. Obviously, the larger the stack of buy or sell orders at a specific price, the greater the supply and demand imbalance at that price level. The movement of price in any and all free markets is a function of the laws of pure supply and demand. Buying and selling opportunity emerges when this simple and straight-forward relationship is out of balance.

If the answers to the most basic questions in life are so simple and right in front of us, why is it that most people never see them, or consider them for that matter? Before we explore that question, let’s take a basic look at how people think. Instead of focusing on changing our actions, let’s look at where those actions come from. Moving backward one step at a time, actions stem from behavioral patterns, and behavioral patterns stem from beliefs. So, it’s at the level of beliefs that decisions are made, and moreover, where your ability to differentiate reality from illusion lies. It’s time to start considering where your beliefs about what works and what doesn’t come from. In life, which includes trading and investing, most of us tend to repeat the same processes over and over, expecting a different result.

The common thread in any quest for irrefutable answers is the search for truth. To obtain irrefutable answers, one must look truth straight in the face, void of any illusion. The presence of even the smallest amount of illusion in the quest for truth ensures truth will never be found. Our quest for truth is in financial markets, specifically addressing proper trading and investing. The question for market speculators needs to begin with this: How do we derive consistent low risk, high reward, and high probability profits buying and selling anything?

Recently, I instructed a Global Futures course in London and on day one of the class, the word “futures” was maybe mentioned once. It was only mentioned on day one to let people know that this was a futures course and that we would NOT be discussing futures specifically on day one. We spent day one learning how a market works, exactly how and why do prices move in any and all markets, and so on. New traders always skip or ignore this most important lesson in trading. Make sure you begin your trading education with the basic thought of how you make money buying and selling anything. This will not only empower you to see and act on what is real and not what you feel, but it will also have the same effect as getting a flu shot, making you immune to all the poisonous, complicated, and useless information that has nothing to do with trading. I tend to call this the “illusion creators.”

It is well known that around 90% of people who attempt to speculate in markets lose money. If you take the same path as this group, don’t expect different results. As Albert Einstein pointed out, it is not possible to solve a problem with the same level of awareness with which the problem was created. Ironically, the natural human tendency is to dive deeper into issues and work harder at them when attempting to come to a conclusion. Keep it simple…

Let me revisit the question I never answered before. If the answers to the most basic questions in life are so simple and right in front of us, why is it that most people never see them, or even consider them for that matter? All the answers we need are incredibly simple yet, the vast majority miss the whole game being played out because of the illusions presented to them by those who have more to gain by obscuring reality.

In the Extended Learning Track (XLT) Futures and Forex classes, my goal for the traders under my guidance is to first instill awareness that ensures they don’t fall prey to the many illusion traps. Lastly, to make sure they are a part of the 10% of profitable traders/investors who know exactly how to set the trap.

As a final thought, never put too much of your hard earned money at risk until you have results that suggest you are part of the 10% of market speculators that know exactly how to get paid from the 90% who don’t.

Sam Seiden, Online Trading Academy Instructor

Large Pullbacks

Using Limit Orders

We also would like to take the above combination, and if possible, buy the stock on an intra-day limit order below yesterday’s close. As we have discussed in the previous lessons of this course, these intra-day drops have increased the average gains per trade going all the way back to 1995.

Short Term PowerRatings

Another way to identify large pullback candidates is to use our Short Term PowerRatings. Look for stocks which have had large 2-3 day increases in their ratings, up to the 9 and 10 levels. A big jump in a PowerRating means the stock has had a significant drop and is entering levels which it has historically risen from. Here’s a good example…

Chart of IRBT

On 9/13/07 IRBT closed at 24.23 and had a PowerRating of 3 signaling that it was oversold. A few days later the stock had a powerful pullback taking it to 17.49 and bringing its PowerRating all the way up to a strong 9. This type of move (from 3 to 9) has historically produced very good short-term trading results. And as we can see here, we can exit either a few days later on a close above the 5-day MA, or exit when the stock rating goes from green (8-10) to blue (4-7). Both types of exits have produced positive returns since 1995, in simulated trading.

PowerRatings Charts

Large pullbacks don’t occur as often as the other pullbacks, but when they do occur, they’ve been the best pullbacks to trade. The simplest way to find these pullbacks is by using the PowerRatings 9’s and 10’s list, and then looking at our new PowerRatings Charts. That way, you can see how far they have pulled back over the past few days and how much the PowerRatings have risen.

Trading Markets

Mid-Level Pullbacks

Combine Price and Time

Ideally we want to combine price and time with our pullbacks. What does this mean? It means we want to see the pullback occur over a period of time (not one day), and we want to see the pullback be at least 3-5% from its highs.

The further the pullback, the greater the returns have been in testing going back to 1995.

Finding Mid-Level Pullbacks

1. Look for stocks which dropped at least 5% from their highs over the past 3-5 days. These stocks will potentially be setting themselves up for a rally. In fact, approximately 66% of these stocks have closed higher when you use a 10-day moving average exit, when they were above their 200-day MA.

2. Now, let’s look to increase the edges even further. How do we do this? By waiting for these stocks to pull back even further intra-day. For example last week we looked at stocks which were above their 200-day MA, when they had certain liquidity requirements and were at 10-days lows. As we saw the results were as follows:

Limit Order Entries

Now let’s look what happens if we wait for these stocks to pull back even further intra-day and we buy them on a limit 5% below yesterdays close. As you can see, the results improve, and we’re now trading higher quality pullbacks.

Here are the results of a 10-day low, buying on a limit order 5% lower the next day. Exit on a close above the 10-day MA.

Higher Quality Trades

By waiting for the pullback to become deeper, you see that there are fewer trades. But the quality of these trades improves by a healthy amount. The % correct stays the same, but the average gain per trade nearly doubles.

Here is an example of a mid-level pullback which was able to capture a healthy gain over a few trading days:

Trading Markets

Shallow Pullbacks

Identifying Good Pullbacks

First, we want a stock to be above its 200-day moving average before we buy it. Why? Because stocks tend to trade higher more consistently in pullbacks above their 200-day moving average than below it.

We tested a stock’s behavior above and below its 200-day MA looking at over 8.25 million trades from 1995-2006. What we found, is that the average gain for all stocks above their 200-day MA five days later was comfortably ahead of the average gain for all stocks below their 200-day MA when looking ahead five days.

Simply stated, it’s better to be buying stocks above their 200-day MA than below. When stocks break down under their 200-day MA, they often have a tendency to continue dropping.

Catch a Falling Knife?

A good example is Freddie Mac (FRE | charts | news | PowerRating):

As you can see, the stock reached above $60 per share, and after closing under its 200-day MA, it proceeded to collapse into the $20’s. Within a 30 day period of time, the stock lost more than 50% of its value. By staying away from the stock once it broke under its 200-day MA, you would have avoided a great deal of pain and losses that fund managers and investors felt when they bought it much higher, believing it was a cheap stock. In reality, it was a falling knife, and the 200-day MA rule often helps us avoid stocks like these.

Citigroup (C | charts | news | PowerRating) is another example:

10-Day Highs versus Lows

Before looking at the various levels of pullbacks you’ll want to focus on, we’d like to share a research study of ours. The study looked at the average gain per trade for all stocks above their 200-day MA making 10-day highs (breakouts) versus those making 10-day lows (pullbacks). The exit was a close on the opposite side of the 10-day moving average.

The average gain for the stocks making 10-day lows was more than three times greater than the stocks making 10-day highs. This test is one of the strongest pieces of evidence that the short-term edges have been greater when buying a pullback versus buying a breakout.

Three Types of Pullbacks

There are three types of pullbacks we want to focus on. They are shallow pullbacks, mid-level pullbacks and deep pullbacks. Each has its pluses and minuses, and when you blend them together, you have a combination of pullbacks which potentially gives you a healthy trading edge. In this lesson, we’ll look at shallow pullbacks.

Shallow Pullbacks

What is a shallow (or small) pullback? It’s exactly as it sounds. It’s an up-trending stock which pulls back for a few days, before resuming its longer-term up-trend. These types of stocks are usually momentum stocks giving fund investors little opportunity to accumulate the stock at lower levels.

This chart of Freeport-McMoRan Copper & Gold (FCX) is a good example of shallow pullbacks:

10-Day Lows

Now that we have these filters, let’s first look at stocks that closed at a 10-day low. We’ll also need to exit these stocks (there is no more guessing when to exit!), so we’ll exit once the stock closes above its 10-day simple moving average.

A 10-day low is exactly as it sounds. It’s a stock which closes at its lowest price over the past ten trading days (today inclusive). As you can see from these results (Jan 1, 1995 through Sep 30, 2007), these stocks have had an edge.

Stocks which have made 10-day lows using these filters and exits have outperformed the average of all stocks. And they have outperformed 10-day highs by a very healthy margin.

Here are two examples of stocks which made 10-day lows and then rallied to close above their 10-day MA:

As you can see, the stocks pull back to levels which attract buyers, and then resume their moves higher.

Since 1995, if you bought each stock using this criteria, each day at a 10-day low, and exited when it closed that day above it’s 10-day MA, you would have been profitable (before slippage and commission) 69% of the time, and your returns would be more than double versus randomly selecting any stock during this period of time. This is the beginning of you finding trades which have had historical edges.

2-Period RSI

Now, let’s look at stocks which have a 2-period RSI below 5. Before we do that, we want to make sure you understand what a 2-period RSI is.

What is RSI? It’s an oscillator which measures the strength of a stock on a 0 to 100 basis. The stronger the stock has been, the higher the RSI is likely to be. Most charting packages and books look at the 14-period RSI. This is too long for traders (and we can find no statistical evidence that a 14-period RSI has any edge). We use a 2-period RSI, as that is one of the best ways to identify how overbought or oversold a stock is. Ideally we want to focus on stocks whose 2-period RSI is below 5.

When we use our filters and then look at all stocks that have had an RSI below 5, we see edges. For example, from Jan 1995-Sept 30, 2007, buying a stock with an RSI below 5 and exiting on the close when the 2-period RSI closed above 70, you would have been correct 70% of the time (before slippage and commission). And the average gain was 1.69%, approximately three times greater than the average gain for all stocks during that 12 ? year period of time. These are healthy edges and it shows you that edges trading edges can be found when using the proper entry and exits.

Here’s an example of a stock with a 2-period RSI below 5 that then traded up and closed with a 2-period RSI above 70:

Trading Markets

Trading Markets Philosophy

Trading Markets Philosophy

The TradingMarkets Philosophy is to buy on weakness and sell into strength. This type of trading is known as swing-trading and pullback trading.

What is a pullback?

It’s simply a stock that has pulled back off its highs and is trading lower than it was a few days ago. Much has been written on this type of trading, as it is very popular. The problem with a great deal of the information that’s out there is that it’s not quantified. Meaning, people will say “buy on a pullback” without exactly defining what that pullback is and what the edge is in buying at that time.

In this course, we’ll define exact pullbacks and discuss the edges for these pullbacks.

The Best Pullbacks

There are three types of pullbacks that you should understand as you are developing this trading approach. As mentioned earlier, they are shallow pullbacks, mid-level pullbacks and deep pullbacks. Each has pluses and minuses to them, and in the next three lessons we will look at them more closely.

In the perfect world, we want to allocate capital to trading all three types of pullbacks, and we want to be able to know what the edge has been in these pullbacks. By “edge” we mean what is the average gain per trade using a specific exit and what percentage of the time it has been correct. There are, of course, no guarantees this is how it will play out in the future, but it gives us a good idea about how these stocks behaved in the past.

Much of our testing is done from a database of over 8.5 million trades going back to 1995. We like to test large amounts of data, as it gives us further confidence that the findings are real. Many times, you’ll see on television or read in a publication that whenever the market has done something in the past, it has risen or dropped a certain amount of time in the future. Unfortunately, the person telling you this will likely be talking about something that happened 5 or 10 times. When you hear this information, it’s probably meaningless. Why? Because there aren’t enough occurrences to be statistically significant – ideally you want to look at events that have occurred hundreds, if not thousands of times. That way you can get a feel of whether the behavior is consistent over a longer period of time.

Edges

We’ll also teach you about edges and the types of edges you should be trying to find.

If you study all stocks traded from 1995 and then look ahead five days, you’ll see that the average gain has been about 0.25% per stock over that period of time. This is our baseline. Can we find stocks that have done better than this?

The answer is yes – all you have to do is look at stocks that closed at a 10-day low and were above their 200-day simple moving average. These stocks have risen more than 2 ? times greater over five days versus all stocks (on the opposite end of the spectrum are stocks which have made 10-day highs; these stocks have performed worse than the entire universe over the next five days).

What you start to see is that larger edges can be found in stocks that are trading down (pull backs) versus stocks which have shown strength. This has been shown over and over again in our studies going back more than a decade.

The moral of this is that buying pullbacks is a superior trading strategy to buying breakouts, at least over the very short-term.

Exits and Locking in Gains

Entering stocks with edges is important, but just as important is properly exiting a stock. We always want to be selling into strength.

The academic world calls this “reversion to the mean” trading. In other parts of the trading world it’s also know as “feeding the ducks when they are quacking”. A good friend of ours is a former market maker for a major Wall Street firm, and he told us he made the most money “feeding the ducks when they are quacking”.

As you will learn, when a stock is rallying, the ducks are usually quacking, that’s the time to be selling your positions and many times locking in your gains. We’ll look at optimal selling points, including using the 5-period simple moving average, along with looking at the 2-period RSI as systematic exit points. Each offer significant edges versus guessing when to exit a position.

By the time you’re done with this course, the guesswork should no longer exist for when to lock in gains.

Protecting Your Edges

We’ll also discuss how to lessen our risk when trading. We’ll look at hedging from market risk and ways to lessen sector and corporate risk. The more we can protect ourselves from this risk, the greater our chances for success become.

Trading Systematically

The majority of our trading is systematic, meaning there is a specific plan in place, and this plan is executed each day. This means we know which stocks we are going to buy, at what price, what percentage of our portfolio is allocated to these stocks, and where to exit and when to exit. We also have a game plan that looks at market, sector and corporate risk.

This is known as model driven trading. It’s not only the way some of the biggest and best hedge funds and trading firms trade, it’s the way many successful individual traders trade.

In this course, you’ll be able to use this information in any manner you like, including trading with it in a discretionary manner. But, in its truest form you will likely be able to maximize this knowledge in a systematic manner, which allows you to trade only a few minutes a day. You simply get the set-ups for the upcoming day and place your orders with your broker and then you’re done. Not only is this more efficient, it’s also less emotional.

Trading Psychology

We’ll discuss emotion and psychology in the final part of the course. Many books have been written on this topic, and it’s of utmost importance in executing your game plan.

By the time you’ve completed this course, you will understand when to buy a stock, when to exit, how to protect yourself and why it’s important to use the same approach day after day.

Trading Markets

Weak Weekly Options

On several occasions, I was asked to share my impression of the weekly options on some major indices, and in this article I shall first define them and then emphasize some of the pros and cons of trading them.

The weekly options were introduced by the CBOE (Chicago Board Options Exchange) at the end of 2005. The core difference between the weekly options and the regular options is the date of expiry. The regular options stop trading at the end of the third Friday of each month, and they expire on the following day Saturday. Unless there is a holiday on the third Friday, in which case they stop trading a day earlier.

However, the weeklies, as they are called, stop trading at the end of Friday of each week.

Usually, their label on an option chain has the name of current month and either Week A or Week One the same current month. For instance, the weeklies for the first week of December shall be listed either as Dec WeekA or simply as DEC1, depending on the different brokerages. The customary set up of the weeklies excludes the Week C, or the third week of the month, due to the fact that the Week C is by its default setting the third week of the month.

The weeklies emerge on the option chain on Friday mornings prior to the opening bell; thus at any given Friday there are two sets of weeklies listed. For example, at the end of the first week of December, there will be the weeklies for Dec WeekA listed with one day left to trade, normally posted as the number of days in parenthesis (1), as well as the weeklies for Dec WeekB with (7) seven calendar days left. There is a big difference between the number of trading days left, and the number of calendar days left. In our example, a trader could sell Dec WeekB (7) on the day they were listed and profit from the option’s premium time decay over the weekend while the markets are closed.

Moreover, the main reason why so many option traders have not encountered the weeklies is that they do not exist on most of the optionable products. In fact the weeklies are being traded only on several major indices. Specifically, the weeklies are listed on the SPX (Standard & Poors 500), OEX (S & P 100), and XEO (European version of S & P 100). A word of caution, the weeklies on the SPX do not stop trading on the Friday of each week but actually at the end of Thursday. However, their settlement price is based on the opening price of the SPX on Friday.

Lastly, an additional difference between the weeklies and the regular options lies in the liquidity. For example, when an option trader places an order to either purchase or sell a call or a put, there are six exchanges competing for the order. Namely, they are the AMEX (American Stock Exchange), NYSE (New York Stock Exchange), CBOE (Chicago Board Options Exchange), BOX (Boston Stock Exchange), ISE (International Securities Exchange), and PHLX (Philadelphia Stock Exchange). In the case of the weeklies, a buying or a selling order goes to a non-competitive environment of the Chicago Board Options Exchange because the weeklies were invented by them and trade on the CBOE exclusively.

Having defined the weeklies, we shall examine some of the more numerous cons of trading weeklies. Normally, the Open Interest and Volume for the individual strike prices on the weeklies is much lower than on the regular options. In the examples below, two weekly options chains were being compared on Thursday morning 11-13-08 prior to the opening bell. The blue lettering (OpInt) stands for Open Interest. In Figure 1, the XEO (European version of S & P 100) shows the highest open interest of 26 on 430 calls for November Week B.

Whereas, in Figure 2, the OEX (American version of S & P 100) has the highest liquidity of 666 on 420 calls, and 675 on 420 puts for the same week. Both products had closed at the same price 411.15 on Wednesday 11-12-08

In short, the lack of liquidity on the weeklies is a major obstacle.

The second disadvantage is due to the limited amount of strike prices that are posted for trading each week. On both the OEX and XEO there were only seven strike prices listed. On both of them the increments are priced in five points which makes it difficult to time a good entry for the spread trades. (On the SPX, the increments are ten points apart. Even those market makers that have worked on the CBOE floor and left it suggest avoiding trading the SPX altogether, weeklies or not.)

An additional nuisance is that the advanced option strategies such as Iron Condors are out of the question due to the limited number of strike prices posted.

Besides the limited amount of strike prices, the spread between the Bid and Ask is huge. Observe in Figure 2 that the calls for 420 are priced at 5.80 Bid and 6.90 Ask which is a dollar ten (1.10). In Figure 1, the spread is even greater for the same 420 call; 5.30 Bid and 7.00 Ask. Hence, the XEO is worse than the OEX.

By contrast, there are very few pros for trading the weeklies. One of them is the “juicy premium.” Certainly, the CBOE had made them attractive in order to catch the attention of the traders to the weeklies. Yet, the fact that they had been around now for almost three years and did not gain popularity which is self-evident in the lack of liquidity as well as the lack of open interest, speaks the multitude about the trading weakness of the weeklies.

Thus in conclusion, the cons of trading the weeklies outweigh the pros. As a final point, I wish to state what I would like to see in the future and what would attract me to them: the greater liquidity (open interest and volume on individual strike prices), more strike prices listed, tighter spreads between the Bid and Ask as well as between the strike prices, and the end of CBOE monopoly of the weeklies.

Josip Causic, Online Trading Academy Options Instructor

Markets and Market Timing

This morning I was listening to a cable news network and in the span of about three minutes, I heard that home foreclosures increased 25%, job losses were on record pace, and Congress was meeting today to figure out where the 700 billion dollar bailout was actually going. This was enough to make your head spin so I turned off the tv.

Homes are being foreclosed at a record pace because people borrowed more than they could afford and lenders lent more than they should have to people who could not afford the loans – this is what happens. This is not news, we were expecting this more than a year ago at Online Trading Academy. People are losing their jobs because people in China and other parts of the world are willing to do the same work an American does for a fraction of the hourly wage – this is what happens in free markets. This is not news, we were talking about this over a year ago at Online Trading Academy. The 700 billion dollar bailout program is not working. The money is going to the corporate elite with no restrictions on what they can do with it. This is not news, in the Extended Learning Track (XLT) Futures and Forex classes that I lead at Online Trading Academy, each time a country announces a bailout, it is a hard and set rule for us to find resistance (supply) and short the stock market either by shorting stocks or the futures.

You have two choices during these challenging times. One is to give in to fear and to take no action, or worse yet, take ill-informed action. It is easy for the government to pass ridiculous bailout packages and hand our hard-earned money over to the corporate elite and special interest groups because they know the public is experiencing extreme fear and will agree to almost anything. Your other choice is to rise above the fear, rise above the risk, observe the reality of what is happening, and understand that with the most challenging times come the most outstanding opportunities. More on this subject later in this piece.

As market speculators, volatility is at record levels and we love this because we are experts at identifying turning points in markets based on the laws of supply and demand. Volatility is tremendous because the distance from our demand (support) levels to our supply (resistance) levels is big, that’s all. When these areas tighten up again, volatility will decrease. Whatever the scenario and whatever markets we speculate in, we always apply the same set of rules.

For stock traders, one of the most important functions of your routine needs to be proper analysis of supply and demand in the S&P and NASDAQ prior to doing any analysis on stocks. Why? Simply because stocks ebb and flow with these broad markets. Thursday of this week in the Extended Learning Track (XLT) Futures class, we used our rule-based supply and demand analysis to attain a very low risk, high reward, and high probability trade that worked out very well. I will explain for your review using some of the rule based information we use each day in the XLT. This opportunity was found in the NASDAQ futures using a very small time frame. Area “A” on the chart shaded in yellow represents an area of supply (resistance). We know this because when price was at area “A”, it could not stay there, forming candle wicks which are the footprints of sellers. Price only declines from “A” because there are more sellers than buyers at area “A”. Another factor that made that level an ideal supply level is that 1175 also happened to be the overnight (globex) high price that morning in the NASDAQ futures. Why was it the high? It was the high because that is where all the supply was. Area “B” represents the first time price revisits supply level “A”. Our rules tell us here that novice, consistent losing traders are buying (at “B”). We know this because these buyers are buying AFTER a period of buying, mistake number 1, and they are buying AT a price level where supply exceeds demand, mistake number 2. The objective laws of supply and demand ensure that the trader who commits these two mistakes will consistently lose. We simply sell short at the lower black line with our protective buy stop just above the upper black line. The lines represent the “supply zone”. As active traders, we determine these zones each day. When we swing trade, we do the same thing in the larger time frames.

Let’s now discuss the key point that made this trading opportunity so high probability. Notice the area shaded gray. It is a strong rally built with NO DEMAND levels during the rally, just nice big green candles. This means that as soon as price reached supply, it was likely to fall very quickly through that gray shaded area. We require strong rallies in price such as this one to our pre-determined supply levels as that increases the odds of our short position working dramatically. In other words, price reached our supply level and we shorted at “B” for a move down to “C” because of the very clear and large PROFIT MARGIN (the gray space).

Some might say that we traded too close to the open of trading and that is risky. This all depends on your definition of risk. Why trade near the open? Because if you really understand how markets work, you know that the largest imbalance of order flow demand and supply is at or near the open of trading in any market which means high probability opportunity. I would much rather take on risk when the odds are stacked in my favor then later in the day when the odds are not that great. In this trade, people who bought from us at “B” fell for the emotion “trap” called “greed”. In the Extended Learning Track (XLT) Futures and Forex program, we don’t fall for those traps, we set them.

For those who only trade stocks, your odds dramatically increase when you time your equity trades with the S&P and NASDAQ. Instead of spending hours scanning through hundreds of stocks for setups when starting your daily analysis routine, spend five minutes creating buy and sell zones in the S&P and/or the NASDAQ markets. Then, trade a handful of stocks at most and TIME long and short positions with the S&P and NASDAQ supply and demand levels.

As for the global bailouts and comical intervention, don’t expect these to have any positive effect on your financial well being. You see, markets do a fine job of making everyone’s lives better in time, if left alone. In a free market with NO bailouts or intervention of any kind, banks and lenders who make bad choices that lead to insolvency simply fail. This removes the bad banks from the system and we are left with quality banks that don’t make these same bad choices and this outcome is good for all. In other words, the strongest foundations have no cracks, they are strong and solid. Banks that would otherwise be insolvent due to bad business practices are kept in the system with bailouts. These bad banks are cracks in the foundation of our economy. When a government saves a bank with our tax dollars, it does not make the bank better. Instead, it ensures the crack in the foundation of our economy will remain, until it is removed. If you reward a thief for stealing, the thief will steal again. If you reward a child for bad behavior, they continue to behave poorly. When governments attempt to intervene with bailouts and other forms of intervention, this futile action ensures that cracks in the foundation of our economy will not only remain but get worse.

Free markets naturally force change. They force cheaters to be honest, they force market prices to be at levels that are acceptable for all willing and able workers and producers, they reward the educated with direct deposits from the uneducated which forces education on those who wish to survive. When left completely alone, free markets create a wonderful economy and life for all. It’s really natural selection at its finest. When governments stop intervening to save those who would otherwise fail and begin to dramatically reduce taxes world-wide, expect the markets to begin to recover nicely.

Hope this piece was helpful. Send comments and questions. Have a nice day.

Sam Seiden, Online Trading Academy Instructor

Contract Sizes and Strike Prices

When writing both put and call options over shares it’s important to check the underlying contract size before placing your order with your broker. Too often an option writer will automatically assume that one option contract in Australia is equal to 1,000 underlying shares.

It can be a very frustrating exercise to buy shares in multiples of 1,000 in order to write covered call options, only to find that you can’t write the required call option contracts due to the fact that you don’t own enough shares to perform the exercise.

One reminder to check the underlying contract size will usually be the fact the option contract exercise or strike prices are at odd numbers. This will usually mean that the company has undergone a capital return or bonus or entitlement issue to shareholders and the current option contracts are adjusted to protect the exercise value of the options that are in existence before and after the entitlement has expired.

So how does the option contracts become odd contract sizes with odd strike prices then?

Well let’s look at the current options for Telstra Limited. Telstra’s option exercise prices are at odd price numbers. For example Telstra is trading at $4.70 and the two nearest strike prices for both the near dated put and call options are $4.72 and $4.47. In other words the strike prices are now all 3c lower per share.

If we now check the contract size we can see that the underlying contract size for Telstra has been adjusted to 1007 shares per option contract. So we need to own 1007 shares in Telstra in order to write one covered call option contract.

It’s the same if we wanted to write put options over Telstra in order to purchase the shares at a discount to the current market price. We now need to lodge the collateral or margin to purchase 1,007 shares instead of 1,000 shares.

The reason for this adjustment is that Telstra paid out a special 3c bonus dividend to shareholders on the 17th of March 2003. Therefore when the announcement was made and the ex-dividend date was declared, the call options that were in existence after that date would normally fall by 3c per share and the put option premiums would normally rise by 3c a share, as it was taken into consideration that the underlying stock would naturally fall by the dividend amount on the ex-date.

So to keep the options market orderly, the ASX applies the following formula for such incidents.

The contract size is adjusted by taking the current contract size and adding it to the special dividend per share divided by the volume weighted average price of the stock on the last day of cum-dividend trading, minus the special dividend amount.

Now that the option contract size has been adjusted, the option exercise prices must also be adjusted too.

So the formula here is to multiply the current strike or exercise price by the old contract size divided by the new contract size.

Once the stock goes ex-special dividend, the new contract size and strike prices take effect. Once those options expire, the contract size and strike prices revert back to normal on the new options.

Glen Van Ooran

Become A Wise Trader

It is a wise person who recognizes his limitations, a courageous person who overcomes them, and a fool who does not recognize they exist.

Children arrive into this world with two instinctive fears, fear of loud noises and fear of falling. All other fears are a learned and conditioned response. B.F. Skinner pioneered operant conditioning in the 1930′s based on Pavlov’s experiments. Operant conditioning rewards positive responses and punishes negative responses.

If you possess fear of losing money, how and where did you learn it? Was it in the markets??

Futures traders are not characters in children’s stories, so few children grow up wanting to be futures traders. I know of know super heroes who trade futures. Certainly, Spiderman, Superman, Batman, and others like them are not presented as futures traders.

Ah! But you read Market Wizards! Is that where you came into the hero worshipping of futures traders? Tell me something: Did any of those wizards tell you how they became market wizards? Did they show you what they do? What did you learn from the market wizard books? Was there any proof that what these wizards told the author is true?

A person’s life is short and should be spent on doing what he truly wants to do without any financial incentives. If the fear of financial loss is greater than the potential rewards of trading, do not trade the markets. It is a wise person who recognizes his limitations, a courageous person who overcomes them, and a fool who does not recognize they exist.

Courage is not lack of fear, it is overcoming fear. The best traders are armed with the knowledge of what actions should be taken for any given market condition to provide the highest probability of a profitable expectation.

Being a stalwart hero is not a good idea for trading. Gritting one’s teeth and trying to ride out an adverse move, gains you nothing. I’ve seen countless traders go to their financial ruin trying to tough-it-out when prices were moving against them. Nevertheless, stubbornly hanging onto a losing trade is what is required of most system traders.

Anyone is allowed to make one mistake. When the same mistake is repeated a second time, caution should be noted. The third repetition of the same mistake constitutes self-destructive habitual behavior that must be reversed. All trading must stop immediately until the trader’s self-discipline is thoroughly examined. Once the reason for the repetitive mistakes is understood, usually fear, anger or guilt, it must be corrected before trading may begin again. Some traders lose money because they are atoning for guilt feelings or gifts they feel are undeserved. Such traders should donate funds to their favorite charities, not to other traders.

Any flaw in a trader’s character, like greed, hatred, dishonesty, revenge, arrogance, etc., will soon result in a loss of money. Traders must know the market as well as they know themselves. Negative feelings towards any person, or one’s self, must be replaced with the understanding that these feelings are choices the trader has made that will eventually cause personal and financial destruction. Negative feelings prevent the trader from realizing his maximum growth potential, because his choices for growth have been limited by his self-defeating thoughts. The mind’s electrochemical network sends energy impulses throughout each atom of the body as it thinks. Thoughts create feelings experienced by the trader. Traders should take trades based on scientific price action analysis, not feelings. Deschapelles, the French chess champion, would give his opponent a pawn before the game began. This action always provided the necessary excuse for losing. Give nothing away when trading markets; enough will be taken from you.

All the best in your trading.

Joe Ross, Trading Educators Inc.